-16-

The demand for foreign bonds by domestic residents is derived
from portfolio balance considerations, and is discussed along with the
consumer maximization problem. The exchange rate (the price of foreign
bonds) is determined in equilibrium as one of the prices which equate
supply and demand in all markets, including the market for foreign
bonds. As the supply of, and demand for, foreign bonds are determined
simultaneously with the current account and the capital account, the ex-
change rate determination mechanism employed here is more general than
those which assume one of the other to dominate. a Note, however, that
by postulating a high degree of substitutability between domestic and
foreign bonds any deviation from interest parity would cause large
capital flows, and the capital account would therefore exert a much
larger influence on the exchange rate than would the current account.
Consumption

There are H consumers who live for the two periods of the
model, and in order to motivate savings in period two, for a third, or
future period. They are assumed to have perfect foresight about period
two in period one; that is they perfectly anticipate all period two
prices and taxes.

h

Let Xt be the hth individual's consumption of good j in period

t, h=1,...,1; J=0,...,N; t=1,2. Good 0 is leisure and the other N goods

1/ Models of exchange rate determination which focus exclusively on the
current account include Johnson (1958) and Dornbusch (1973). Those
which focus exclusively on the capital account include Dornbursh (1976)
and Branson (1977).


-37-

rate, thereby attempting to stabilize the trade balance. As an example,
we will suppose that the exchange rate is devalued by 20 percent in

1981. The following results occur.

Table 6: Welfare and Trade Balance Implications
of Alternative Exchange Rate Regimes, 1981-82

Fixed Fixed 2/ Float

1981: Trade Balance (billion USS) 1.2 -0.7 4.1
1982: Trade Balance (billion US$) ~4.4 2.9 3.7
Utility, Consumer 1 0.80 0.77 0.82
Utility, Consumer 2 9.02 8.63 8.69

a/ With 20 percent devaluation.

We thus note that the 20 percent devaluation leads to a
solution that in the short run is welfare inferior to both the float and
the original fixed regime. At the same time, it still leads to an
unsustainable trade deficit, although one that is less severe than that
caused by the original, highly overvalued, fixed rate. We thus have an
example of a situation in which an overvalued exchange rate leads to
welfare improvement for only part of the economy, as compared to a fixed
rate, and is unsustainable because of the loss of reserves it brings
about.

As a final example, we may impose the fixed exchange rate

regime on 1983-84, when a floating regime was actually in place. The


- 33 -

Table 3. Fixed Vs. Floating Exchange Rates, 1981-82

1981 1982
Floating Fixed Floating Fixed

(In percent of GDP)

Tax reveme 25.9 25.8 26.8 27.2
Government expenditures 26.4 28.6 24.8 28.2
Budget surplus 0.5 28 2.0 -1.0
Gross private investment 13.5 13.3 9.9 11.8
Exports of goods 13.3 11.5 16.9 9.4
Imports of goods 10.8 12.5 13.2 12.7
‘Trade balance 2.5 -1.0 3.7 3.3
(In percent)
Inflation af af 27.1 12.0
Interest rate 15.8 4.6 37.4 17.6
Exchange rate (US$/AS) 1.47 1.13 0.69 1.13
Change in exchange rate af _ 53.1 -
Growth in real GDP b/ af af 4.7 12.3
Real GDE' (In constant AS)— 133.6 128.8 139.9 144.5

a/ No percentage changes are generated for the first period.

‘b/ We have normalized 1981 figures so that real GDP simulated by the
fixed rate regime equals its historical value in that year.

The most striking result is that the equilibrium floating
exchange rate depreciates by over 50 percent between period one and
period two, suggesting that the fixed rate in Australia in 1982 was
sharply overvalued. As are result, import prices. would have been
sharply higher under a float. Thus inflation in the simulated float was
27 percent compared with 12 percent in the simulated fixed regime. In
order to induce investors to hold Australian currency-denominated assets

in the face of the large depreciation in 1981, simulated floating-regime


-42-

BIBLIOGRAPHY

Allen, Polly R. and Peter B. Keren. 1980. Asset Markets, Exchange
Rates, and Economic Integration. Cambridge University Press.

Australian Economic Statistics, 1949-50 to 1982-83, I Tables (Sydney:
Reverse Bank of Australia, 2984).

Australia National Accounts, Input-Output Tables, 1977-78, (Canberra:
Australian Bureau of Statistics, 1983).

Bewley, R. A. (1982), “On the Functional Form of Engel Curves: The
Australian Household Expenditure Survey, 1975-76," The Economic
Record , Vol. 58, No. 16, pp. 82.81.

Blanchard, Oliver, J. 1985. “Debt, Deficits, and Finite Horizons".
Journal of Political Economy 93(2): 223-47.

Branson, W. 1977. “Asset Markets and Relative Prices in Exchange Rate
Determination". Sozialwissenscaftliche Annalen 1:69-89.

Chan, Kenneth S. 1982. “Rational Expectations and the Optimal Foreign
Exchange Regimes", Canadian Journal of Economics (15(1):164-74.

Cushman, David 0., “The Effects of Real Exchange Rate Risk on
International Trade”, Journal of International Economics
(Amsterdam). Vol. 15 (August 1983). pp. 44-63.

Customs and Excise Revenue Australia, Annual Summary Tables, 1982-83
(Canberra: Australian Bureau of Statistics, 1984).

de Grauwe, Paul and Bernard de Bellefroid, Long-Run Exchange Rate
Variability and International Trade,” mimeo 1986.

Dixon, P. B., B. Re. Parmenter, J. Sutton, and D. P. Vincent. 1982.
ORANI: A__Multisectoral Model of the Australian Economy.
Australian: North Holland Publishing Company.

Dornbusch, Rudiger, 1976. “Expectations and Exchange Rate Dynamics".
Journal of Political Economy 84:1161-76.

Dornbusch, Rudiger, 1973. “Currency Depreciation, Hoarding, and
Relative Prices”. Journal of Political Economy 81(4):893-915.

Enders, Walder and Harvey E. Lapan, "Stability, Random Disturbances and
the Exchange Rate Regime," Southern Economic Journal 45, July 1979,
pp. 44-70.



-10-

Thus, the investor sells a nominal quantity of bonds

Cee = Bye (9)

The Government

The government produces a pure public good using capital and

labor. This good is assumed not to increase private utility or produc-

tion. Output of the public good, > is given by
6. 1-6
=e at Qt =
Qa = Kor Loe Soe > 0, t=1,2 (10)

The government chooses cost-minimizing levels of capital and

labor, Rot and Loe» to produce a: Thus, government expenditure on the

public good is

Coe = PxeXge + weboe (11)

Define i, and TM as the time-t nominal interest rate and

inflation rate, respectively.

N N
l+m 2 2 ap./ cap (12)
tT ry Pea’ 42, 4Pe-1,
where 5, is the weight on good j in the price index and 1 4 =l.

The real rate vr, is approximated by

Tr, Fi, mM, (13)


- 20 -

Equation (28) can be rewritten as

N

Y > aa 95 1%51 + 1%) + s + me (32)

The second-period budget constraint is

N

E, + 1,8, +m, > Eq

Xx, + Si+
20

42%42 * %2Xoq + Spt mys (33)

where E, = Po(1 - 6K +woL+T .

In order to have consumers hold bonds in period 2 we assume a

savings rate, o, equal to the long-run savings rate for the economy. 1/

Period 2 savings thus depends on consumption and is given by:

N
S, =o £ q.oX.n6 (34)
2 te 52-52

Money is held solely for transactions purposes. One could
specify a transactions technology and find the utility-maximizing choice

of {m,}, but instead we simply posit that the solution is

N

m = ar, ese? (35)

i For a discussion of other possible closure rules in similar model,
see Blanchard (1985).


- 38 -

same methodology was imposed as in the previous example. In order to
make the comparison, we fixed the exchange rate in both periods at the
rate that prevailed in the floating rate simulation in 1983. We will
summarize the results of the comparison.

Table 7: Welfare and Trade Balance Implications of
Alternative Exchange Rate Regimes, 1983-84

Fixed Float

1983: Exchange Rate (US$/A$) 0.70 0.70
1984: Exchange Rate (US$/A$) 0.70 0.66
1983: Trade Balance (billion US$) -1.6 1.2
1984: Trade Balance (billion USS) -1.9 2.1
Utility, Consumer 1 1.03 1.14
Utility, Consumer 2 11.76 12.73

We thus notice that in this example, where the fixed regime
outcome was calculated at the “realistic" exchange rate of the floating
regime in 1983, the differences between trade balances under fixed at
floating regimes is less extreme than in the previous simulation. The
floating regime also leads to a short-run welfare improvement over the
fixed regime, due primarily to the impact of increased exports. End-of-
model reserves are 15.1 percent higher under the floating rate, probably
outweighing the 13.3 percent lower real investment level. We may
conclude accordingly, that at least in this Australian case, floating
the exchange rate is probably welfare-superior to fixing the rate, even

in the short run. Only if the fixed rate is set at a highly overvalued


I. INTRODUCTION

The analysis of fixed and floating exchange rate systems has
attracted considerable attention in recent years. There are a number of
reasons for the interest, among which is the belief that the choice of
regime may have significant implications for the real economy, and thus,
for consumer welfare. The analysis is of considerably more than
theoretical interest, as a number of countries have recently been
confronted with the necessity of choosing between the two regimes. For
example, in 1984 and early 1985, one industrial country and five
developing countries opted to move to freely floating exchange rate
systems. Australia, the example of our empirical analysis, switched
from a fixed rate to a free float in 1983. In this paper we construct
an intertemporal macroeconomic model that is intended to be able to
incorporate both fixed and floating exchange rate regimes, and apply the
model to Australia. We use a numerical solution method to compare both
types of regimes in two periods: 1981-82 when the country had a fixed
rate regime, and 1983-84 when it had a floating system. Our results,
although not necessarily having any absolute significance for the
comparison of exchange rate regimes in general, may be taken as an
example of the way in which a comparison of regimes might be carried out

for a particular. country.


-31-

(1985). We have resimulated that model, changing slightly the exogenous
parameters. For all estimable behavioral and technological parameters
(money demand, export demand, consumption and production parameters), we
have used identical values to those generated for the floating exchange
rate model. The initial allocations and government policy parameters
are period-specific and based on 1981-82. The solution to that model is
only slightly different from the result reported in Feltenstein (1985),

so we shall not report its comparison with actual outcomes again here.


-17-

are the intermediate and final goods. An individual's utility level is

given by

U=

a,
2 N Ht
t=

nm X (25)
1 j=0 Jt
where the superscript h has been omitted. Parameter values may vary
across individuals and 5? 0, with equality holding for strictly

intermediate goods. Without loss of generality let

N
Zoa, = 1.
joo
and define
N
B= joo Oyo

The parameter 8 can be thought of as the rate of time preference and is
assumed to be constant across consumers. This particular specification
of preferences is not crucial to the working of the model and permits a
simple analytic solution to the consumer's problem.

In period one consumer h is endowed with ri units of domestic
money, domestic bonds with a nominal value of 3, foreign bonds with a
nominal (in terms of the domestic currency) value of Bh ra units of
physical capital, and rh units of labor. The bonds pay interest at the

start of each period. The endowment of home bonds consists entirely of

government debt, as initial private debt holding would be inconsistent


- 23 -

III. AN ESTIMATION OF THE MODEL FOR AUSTRALIA

Australia is particularly suited for an application of our
model. The economy is sufficiently market-oriented that the use of a
general equilibrium model does not seem too far-fetched. It is also
reasonable to assume that the country is a price-taker in all of its
imported goods markets. We will, in addition, make the Armington (1969)
assumption that traded goods are distinguished both by physical charac-
teristics as well as place of origin. Perhaps most important for the
comparison of fixed and floating rate regimes is the fact that Australia
moved from a system of fixed to floating rates at the end of 1983, while
liberalizing capital markets. We will therefore use 1981-82 to
represent the period of fixed exchange rates, and 1983-84 to represent
the floating-rate period. Since we will only attempt to give a
illustrative example, we will go no further in attempting to describe
Australian reality.

Our first task will be to demonstrate that the model represents
a reasonable approximation to the actual outcomes of the two time
periods. We will assume that all utility functions and production tech-
nologies remain the same in the two periods, and that the only changes
are In initial allocations, exogenous government policy parameters (such
as tax rates), and the foreign exchange regime. It will then be

possible to make comparisons, isolating the effects of the exchange


-19 -

where Vit = C1475 Pye and Kor is the consumption of leisure in
period t.

Consumers save in the form of nominal interest-bearing bonds.
While uncertainty is not explicitly modeled here, we wish to capture the
idea that, because of risk considerations, home and foreign bonds are
not regarded as perfect substitutes. Investors wish to hedge against
uncertainty by holding a diversified portfolio. In a perfect foresight
framework, equilibrium requires that the real returns in home and
foreign bonds are equalized and investors are indifferent as to the com-
position of their portfolio. We capture the idea that consumers wish to

hedge by imposing
* * d
be oR /Re yy) bee (29)

Note that as d+ the bonds become perfect substitutes. Let nominal

savings of bonds be denoted by

S. =b, +b.”
fc Fhe TB

= (tc(R F/R )b, (30)

and the gross nominal return on bonds be denoted by

*

(10(R,* 78, )*)- (31)

=R
teen 7 Bead


- 32 -

IV. A COMPARISON OF EXCHANGE REGIMES

Having now carried out approximate replications of the fixed
and floating exchange rate periods, we may turn to a question. What
would the implications, in particular for consumer welfare, have been if
exchange regimes had been reversed? Thus the floating regime would be
applied in 1981-82, and the fixed in 1983-84. The comparison will be
made in the following way. We will suppose that all initial allocations
remain as they were in the benchmark simulation. Thus, for example, the
initial allocations for the 1981-82 fixed rate case are maintained when
the floating rate regime is imposed on those years. In addition, all
exogenous policy parameters, such as tax rates, the level of real
government expenditures, and budget deficit financing rules, as well as
all calibration parameters, remain unchanged. As we mentioned earlier,
it is assumed that all behavioral parameters are the same under both
fixed and floating regimes. Thus when, for example, we impose the
floating rate regime in 1981-82, the only difference from the fixed rate
regime will be in the exchange regime itself. It may, of course, be
claimed that an experiment that supposes that behavioral parameters
remain constant during a change in regime is invalid. This is, however,
beyond the scope of this study.

Let us now turn to our first counterfactual example, in which
we impose a floating exchange rate in the fixed exchange rate years,

1981-82. Corresponding to Table 2, we have the following results.


-14-

We assume that the foreign currency-denominated value of total

f
export demand in period t, Xe is a function of relative export: prices

and world income, Ze» as follows:
b bee c
£ PX_) 0 (PX ) 1 PX. mo n
2 Gale Gave oe Gweee et Zeta ee @1)

where m and n are lag lengths, the world export price index (PXW) is
given exogenously, the home export price index (PX), in terms of foreign

currency, is given by

n tt
PX, = a nyp;/e, (22)
t N t
where uF is the export share of the jth sector, £ = 1. Note that,
j=l

for a given foreign currency value of exports, the home-currency value
of export demand is unit elastic with respect to the exchange rate. It
is only the total volume of exports which may vary, however, the
proportion of exports in each sector remains constant in each period,

independent of relative prices, and is given by
xf = n,X 23
pe 7 Xe (23)

Import demand equals the sum of final consumption demand and
demand for intermediate inputs to production. One or more columns of
the input-output matrix represent imports, hence final demand for

imports is determined through the consumer maximization problem.


dollar at US$/AS$ = 1.13 in 1981, the authorities fixed it at USS/A$ =
0.94, a rate much closer to the simulated equilibrium rate. In this
cases, a comparison of short-run utility levels under alternative
regimes reveals that floating would have been better in the short run.
Moreover, end-of-period stocks of foreign reserves and capital are
higher, suggesting that long-run utility would be higher as well.
Similar results were obtained from a simultation in which a fixed
exchange regime is imposed on 1983-84, when the rate was actually
permitted to float.

The next section will describe the analytical framework of our
model, while section III will give data estimates for Australia.
Section IV presents the results of counterfactual simulations, designed

to compare exchange regimes, while the final section is a conclusion.


~ 29 -

included to help account for serial correlation. 4 The estimated

equation is:

log(x*) = - 2.526 + .770 10g (Xz) - .606 10g GEa)
(-2.5)

(-2.2) (4.0)

+ .056 log (EE) _, + 1.485 log(USGDP) - .218 log (UscpP) _,

(0.3) (2.6) (0.3)

-1.20 log(USGDP)_, + .650 1og(x*)_, (51)
(-2.3) (4.7)

R? = .9938

where FX and PXW represent home and foreign export price indices, and

world income is proxied by USGDP. Figures in parenthesis are t-

2/

statistics. —

1/ When estimating models with lagged variables, it is common to impose
‘a lag structure (e.g, polynominal distribution lags) in order to reduce
the number of estimated coefficients and reduce the risk of
collinearity. For our purpose, however, we care only for the predicted
values of the equation and not for the particular parameter estimates,
hence collinearity is not of great concern. As a check, we ran the
equation for a lag length of 10 using a polynomial distributed lag
(Almon lag) or order 3, and compared the predicted values from this
equation to those generated by the equation in the text. The predicted
values for one equation had absolutely, no explanatory power for the
residuals of the other equation (both R° values were less than 0.1).

2/ We may note that the lag weights reflect a 'J-curve' phenomenon,
that is, the price elasticity of demand 'value' in the first period is
positive, and is larger than the long-run 'value' elasticity (the sum of
the lag price coefficients is .220). Further, this long-run elasticity
is positive, indicating that even in the long run the value of exports
increases with the relative price of exports -- hence the demand

‘quantity’ elasticity is less than unity.


- 26 -

then: 1/
Y, = 0.178 Yo = 0.187
We use the average personal income tax rate to represent the tax on
labor usage, Yu? while the capital tax is taken to be the corporate

2/

income tax rate, Yee * These are —

Yet 7 9246 Yup 9-23, Y= 0-218

Our model has three consumer categories: high income Austra—
lian, low income Australian, and rest of the world. Initial allocations
of the five factors are given by the end-of-1983 holdings by
consumers. The derivation of allocations of capital, labor, and money
is described in Feltenstein (1985). Holdings of domestic bonds are
given by the 1983 interest obligations on government debt, with the
shares being given by the shares in capital income of the two domestic
consumer categories. Similarly, initial holdings of foreign reserves by
domestic consumers are given by end of 1983 foreign reserve holdings,
while the rest of the world's holdings, is given by the value of 1983

Australian exports. The allocations are:

1/ See, 1984/85 Budget Paper No. 1, Commonwealth Government.

2/ Op. cit.


the regime which yields greater stability is deemed superior. In
general, the results indicate that the choice of regime depends upon the
nature and origin of the stochastic shocks affecting the economy. For
example, Fischer (1977) and Mundell (1973) find the economy will be
better insulated from foreign shocks under flexible exchange rate and,
conversely, in the face of real domestic shocks, fixed exchange rates
would provide greater stability as the shocks are more easily “exported”
abroad. Conclusions from this literature are, however, highly dependent
on certain assumptions made. In particular, it is common to ignore
private capital flows. Clearly, if capital is mobile, many of the
insulation properties of flexible exchange rates will be lost. au,

The third approach to comparing exchange rate regimes, of which
this paper is an example, attempts to answer the question: which system
better facilitates international trade in goods and services? This is
the approach taken, for example, by Helpman and Razin (1979) 2/, and
necessarily involves intertemporal utility maximization subject to a
budget constraint. Welfare conclusions in this approach are derived
explicitly from the intertemporal utility function, and that regime is
preferable which offers the wider choice of consumption possibilities
over time. Clearly, the framework must allow capital flows under

flexible exchange rates in order to permit the desired consumption

1/ Other papers analyzing the question with emphasis on the origin and
Tature of the shocks are Enders and Lapan (1979), Flood (1979) and
Frenkel and Aizenman (1982).

2/ Other examples of this approach are Hause (1966) and Helpman (1981).


Comparisons of exchange rate regimes have typically taken one
of three alternative approaches. The first approach asks which regime
leads to greater exchange rate variance. The analysis relies on the
fact that, ultimately, fixed exchange rate regimes are not sustainable
and are hence subject to periodic realignments. A general consensus has
emerged that, at least for the major industrialized countries,
variability under floating rates has been much greater than under fixed
rates. Moreover, much of the changes have been unexpected. 4/ However,
proving that one regime leads to greater variability does not mean it
leads to lower welfare. A decrease in exchange rate variability due to
fixing the exchange rate might lead to an increase in the variability of
other prices. Using partial equilibrium frameworks, large amount of
econometric work has been focused on whether exchange rate variability
hampers international trade. Only minimal evidence that this is so has
been found. 2/

Along with the effect exchange rate variability itself can have
on individual agents, exchange rates can influence the effect of
internal and external shocks on the domestic economy. Thus, the second
approach attempts to answer the question: which system leads to greater
stability of real and nominal variables in a small open economy in the

face of such shocks? Welfare analysis in this literature is implicit;

1/ See, for example, IMF (1984).

2/ See Cushman (1983), de Grauwe and de Bellefroid (1986), Hooper and
Kohlhagen (1978), IMF (1984), Kenen and Rodrik (forthcoming) and Thursby
and Thursby (1981).


-15-

Foreign borrowing for investment purposes, Fi, is assumed to

t
take place entirely within the public sector. This is intended to cap-
ture the notion that all foreign borrowing is eventually guaranteed by
the government. Thus, the government sells bonds denominated in foreign
currency in addition to domestic currency bonds. These bonds may be
purchased by both domestic and foreign residents. 4/ The foreign

denominated bonds pay the exogenously given world rate of interest in

period t, af

We also allow foreign borrowing for consumption purposes. This
is set exogenously in period t at level Fe and has domestic currency
value c,Fre The exogenous setting of foreign borrowing may be
interpreted in one of two ways. Either there are government imposed
capital controls, or there is a supply constraint to foreign lending.
We wish to avoid the additional complexities of having optimizing
behavior in foreign borrowing. such behavior would, however, be
compatible with the structure of our model. It should be noted that
although gross borrowing is exogenous, consumers may freely divest
themselves of foreign assets, so that net borrowing is endogenous.

Thus the outstanding foreign debt in period i, ye, on which

the government pays interest is given by:

Fo= Fo +F (24)

1/ In practice, of course, the bulk of government's foreign borrowing
would be from foreign residents.


possibility of capital flows. In addition, models that deal with trade
generally do not have a time dimension, so that savings, and hence
portfolio choice decisions cannot be analyzed. In the paper presented
here, investors save home or foreign bonds and money. Consumers live
for two periods and allocate consumption optimally between the two
periods.

The results of this paper indicate that, if in 1981-82,
Australia had floated rather than fixed its exchange rate, utility of
one of the higher income representative consumers would have been lower
in the short run due to a capital loss associated with increased
domestic interest rates. Fixing, however, leads to an unsustainable
trade deficit, and therefore, without a significant initial devaluation,
would not have been a viable option. This result is not surprising,
since Australia's exchange rate in 1981 was substantially overvalued
relative to the equilibrium floating rate we simulate. In our model a
floating regime leads to a rate that is 53 percent lower than the fixed
rate. In order to induce investors to hold Australian dollars the
interest rate is much higher than under floating and import prices are
higher as well. Eventually the higher savings, as compared to the fixed
regime, would result in higher output, employment, and consumption, but
this would occur beyond the time horizon of the model,

Out model does not indicate, however, that in the short run it
is better to fix the exchange rate. One important factor in determining
which regime is better in the short run seems to be how overvalued the

fixed regime is. We suppose that instead of fixing the Australian


-21-
where a and b are estimated parameters. aus Note that velocity will vary
with the interest rate. Letting Z = ar? and substituting (35) and
(36) into (33) and (34) gives the consumer's problem.

n 2
max (25) with respect to be. }-0, {S.}e2y

subject to

L > Xe t=1,2 (36)
N
my? 4%) Bagk yt Xo, * Sy (37)
N N
BE, + 158) + 2, Ts 41? (1 + o+ 2) 1 52X42 + MpX%pq (38)
If L is large enough, then the solutions are:
(4, i+ E,)
XK, = a Na §21,.6.,N (39)
jl 95 ,AH
(XY, +E 2)
xo) Lz" 2! (40)

ol wA

1/ The specification which implies a constant interest elasticity of
money, is chosen because facilitates the algorithmic solution of our
model. One might also choose to specify equation (35) in terms of a
partial interest elasticity of money, as is more commonly done. In our
estimations, however, neither specification proved superior to the
other.


International Finance Discussion Papers
Number 273

February 1986

AN ANALYSIS OF THE WELFARE IMPLICATIONS OF ALTERNATIVE
EXCHANGE RATE REGIMES: AN INTERTEMPORAL MODEL WITH AN APPLICATION

by

Andrew Feltenstein
David Lebow
and
Anne Sibert

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
material) should be cleared with the author or authors.


- 44 -

Mussa, Michael, “A Model of Exchange Rate Dynamics”, Journal of
Political Economy, 90 (1982):74-104.

Shoven, John B., and John Whalley, 1984. “Applied General Equilibrium
Models of Taxation and International Trade", Journal of Economic
Literature, Vol. XXII:3, pp. 1007-1052.

Thursby, Marie. 1980. “The Resource Reallocation Costs of Fixed and
Flexible Exchange Rates: A Multi-Country Extension", Journal of
International Economics 11(Nov. 1981): 487-493.

Thursby, Marie C., and Jerry G. Thursby. “The Uncertainty Effects of
Floating Exchange Rates: Empirical Evidence on International Trade
Flows". It is scheduled to be published by Ballinger in
Rates, Trade, and the U.S. Economy, ed. by Sven W. Arndt, Ri
Sweeney, and Thomas D. Willet.



cost of using capital and labor in the production of one unit of time-t

good-j output is
Che = Pp (l + Yee Rye +w, (1 + Yt eye" j=1,...N3; t=1,2 (2)

t
Let ayy

necessary to produce one unit of time-t output from industry j and let

be the number of units of output from industry i

t t
AL be the matrix with representative element aye Let Yay be the

output from industry 1 used in industry j and let yt be the output of
j

industry j. By the definition of aty Wn = any" Let x be the

final demand for good j. Then

t ot ot
a Ya

+
*

yo Boa jal,e..N, t=1,2 (3)
i=]

uw

Solving (3) for y, (yfe++yy) gives

t
y= aye (4)
t t t’

where -X, = [Xy «+. X© ] and I is the NxN identify matrix. Zero

profits requires

Nit t

- = = + t=1.2
= 42195174 Cre 0. j=l ...N; t=1,2

(5)

where PLE (py ++ -Py) is the vector of goods prices. Solving (5) for p

gives


II. THE MODEL

Our model has two periods and all agents have perfect
foresight. We will describe the various parts of the model.
Production

The production technology in our model follows that described
in Feltenstein (1985). Output of the N intermediate and final goods is
produced using these goods, as well as capital and labor, as inputs. It
would be possible to use any standard representation of the production
technology; however since we wish to empirically apply the model we
employ a structure that allows us to use available data. We assume that
intermediate and final good production is represented by an NxN input-
output matrix so that there are fixed coefficients and no joint produc-
tion. At least in the short run, this probably resembles the actual
technology. In order to combine the inputs of intermediate and final
goods into output it is necessary to use capital and labor. This value
added is accomplished via Cobb-Douglas production technologies. For the

jth sector the time-t value added is

8, 1-6
= x,Jt,

it
se yt ye

1> ated 0; j=al,...N3 t=1,2. (1)

Denote the cost-minimizing amounts of capital and labor needed

to produce one unit of good j output by Ke and Lye» let Pye and

wy, be the time-t rental rates for capital and labor, and let

Yee and Yo be the ad valorem taxes on capital and labor. Then the


- 40 -

Vv. CONCLUSION

We have constructed a two-period model of an open econony and
have used the model to analyze the welfare implications of fixed and
floating exchange regimes. Consumers have perfect foresight and save by
holding domestic and foreign bonds, which are chosen according to rela-
tive interest rates, deflated by the rate of devaluation of the domestic
currency. The government finances its deficits by issuing money,
domestic bonds, and by foreign borrowing. The government's bonds
compete with private investment, which is entirely debt financed.
Foreign exchange, i.e., foreign bonds, are made available via the
current account, private borrowing, which is endogenous, and public
borrowing which is exogenous. The government, in turn, acts as a
passive auctioneer, trading foreign currency at market prices, and the
exchange rate is defined as the domestic price of foreign bonds.

The parameters of the model have been estimated for Australia,
and two counterfactual simulations have been carried out. In the first
of these, a floating exchange regime has been imposed upon 1981-821, when
the exchange rate was actually fixed. Assuming that all exogenous
parameters remain constant, the welfare implications of the two regimes
are compared. The floating regime is found to be welfare improving for
the low-income consumer, although the high-income consumer suffers a
short-run welfare loss. The fixed rate is highly overvalued, however,
and leads to trade deficits which, in the long run, would be

unsustainable. A 20 percent devaluation of the fixed rate leads to an


- 28 -

log M/C = .0936 - 0.169 log r (49)
(1.723) (-5.931)
2
R” = 0.90 DW. = 2.16

where M is nominal broad money, C is nominal consumption, and r is the
nominal interest rate. The numbers in parenthesis are t-statistics.
Here we have assumed instantaneous adjustment of the actual *o the
desired money stock. The original form in equation (35) may then have

its parameters identified as:

M = 1.098 r7*!6% (50)

Due to difficulties in data availability, we have not attempted to
estimate directly the portfolio equation (29), but have allowed both the
intercept and elasticity to vary to fit the benchmark years.

All capital inflows are taken to have their actual values for
1983-84, corresponding to our treatment of these flows as being
exogenous. auf Foreign financing of the government budget deficit is
taken to have its actual values, while the shares of money and domestic
bonds in financing the remainder of the budget are allowed to vary.

Equation (21), representing demand for Australia exports, is

estimated with a log length of 2, and a lagged dependent variable ts

l/ All data comes from Australia Bureau of Statistics, Balance of
Payment, various issues.


IFDP

NUMBER

274

272

271

270

269

268

267

266

265

264

International Finance Discussion Papers

TITLES

1986

International Comparisons of Fiscal Policy:
The OECD and the IMF Measures of Fiscal
Impu:.se

An Analysis of the Welfare Implications of
Alternative Exchange Rate Regimes: An
Intertemporal Model with an Application

1985
Expected Fiscal Policy and the Recession
of 1982

Elect:ions and Macroeconomic Policy Cycles

Assertion Without Empirical Basis: An
Econometric Appraisal of Monetary Trends
in... the United Kingdom by Milton Friedman
and Anna J. Schwartz

Canaciian Financial Markets:
Proposal for Reform

Was It Real? The Exchange Rate Interest
Differential Relation, 1973-1984

The U.K. Sector of the Federal Reserve's
Multicountry Model: The Effects of
Monetary and Fiscal Policies

Optimal Currency Basket in a World of
Generalized Floating: An Application to
the Nordic Countries

Money Demand in Open Economies:
Substitution Model for Venezuela

A Currency

Comparing Costs of Note Issuance Facilities
and Eurocredits

The Government's

AUTHOR(s)

Garry Schinasi

Andrew Feltenstein
David Lebow
Anne Sibert

William H. Branson
Arminio Fraga
Robert A. Johnson

Kenneth Rogoff
Anne Sibert

David F. Hendry
Neil R. Ericsson

Garry J. Schinasi
Richard Meese
Kenneth Rogoff

Hali J. Edison

Hali J. Edison
Erling Vardal

Jaime Marquez

Rodney H. Mills

Please address requests for copies to International Finance Discussion
Papers, Division of International Finance, Stop 24, Board of Governors of

the Federal Reserve Board, Washington, D.C.

20551.


-27-

Table 1. Initial Allocations (1983)
(Rows 1-4 in millions of A$, row 5 in millions of uss)

Australian 1 Australian 2
(Low Income) (High Income) Rest of World
1. Capital 2/ 11386 35373 0
2. Labor 2 30384 52338 0
3. Noney 2/ 16972 44681 0
4. Domestic Bonds s/ 818 2553 0
5. Foreign Bonds =! 1530 4025 17645

a/ See Australian Economic Statistics (1984), Tables 5.5. See Income
of Individuals, Australia 1981-82 (1984) for the distribution of
income.

b/ See IFS, various issues.

c/ See Australian Economic Statistics (1984), Table 2.22.

d/ Cp. cit. Table 1.19.

The budget shares in the individual domestic consumers’ utility
function are taken from the addilog estimates for Australia in Bewley
(1982), and are reported in Feltenstein (1985). It is assumed that the
shares remain the same in each period. We have also assumed there to be
positive elasticity of demand for leisure, which we have not attempted
to estimate, but have allowed to vary in order to achieve an
approximation to the benchmark years. Similarly, the rate of time
preference has also been allowed to vary.

The money demand equation, specified in equation (35) is

estimated in log form as:


stream to be attained. Indeed, Helpman and Razin indicate that flexible
exchange rates are preferable to fixed rates, as flexible rates allow
the country to conduct an independent interest rate policy, and hence to
fully exploit the benefits of money.

This paper contributes to the literature in two ways. First,
none of the previous literature has analyzed the distributional effects
of alternative exchange rate systems. This paper does this by
considering the utility of two representative consumers who differ both
in preferences, and hence are affected by relative price changes, and in
factor endowments, and hence are affected by changes in returns to labor
and capital.

Second, there has been very little attempt to present an
equilibrium empirical analysis of the problem. Jager (1982) estimated a
model for the Netherlands in which the optimal exchange regime minimizes
a postulated loss function, but the loss function, depends on deviations
of macro variables from trend, and thus is not derived from individual
preferences. To our knowledge, there have been no empirical studies
explicitly analyzing utility of consumption under differing exchange
rate regimes in an intertemporal framework.

Computational general equilibrium models offer apparent
possibilities for empirical comparisons of exchange regimes, given their
disaggregated nature. Previously, however, virtually all such models,
as described in Shoven and Whalley (1984), have either assumed a fixed
exchange regime, or have not allowed the existence of financial assets,

thereby requiring equilibrium in the current account and precluding the


- 18 -

with the intertemporal investment problem specified. The consumer's

nominal initial wealth is
(26)

where R, =1+ i, and gy = aH e/e._) are the period-t gross nominal
returns to holding domestic and foreign bonds, respectively, and Ty, is
the period-t nominal transfer from the government. The superscript h
has been dropped. Transfers may vary across consumers.

In period two the consumer is again endowed with E units of
labor. It is assumed that there is no secondary market for physical
capital and that this capital depreciates at a rate yw. Thus at the
start of period two the consumer's nominal wealth is

Y, 2p, Q- wk +, Lend +e tem en, (27)
2 k2 2 201 21 1 2
where bi vt and m, are the consumer's first-period net acquisitions
of home and foreign bonds and home money.

Purchases of the N non-leisure goods are taxed at the ad
volorem rates (yeh Labor income taxes are withheld by the firm so
that w, represents the after tax wage. The first- and second-period

budget constraints are given by

N
*
x, > si 9X jet Xn + De + DE t ms (28)


-35-

In the years 1981-82 the higher income consumer is worse off
under the floating regime. This is because he suffers a large capital
loss on his holdings of domestic bonds and because imports account for a
large fraction of his consumption. The low income consumer, however, is
initially made better off by floating the exchange rate.

Of course this welfare comparison is a short-run ranking as the
model extends for only two periods and the end-of-model stocks of
capital, reserves and debt differ under the two regimes. Total private
investment was almost two percentage points of GDP higher under the
fixed regime in 1982, but the budget deficit was about three percentage
points higher and reserves were lower, suggesting that in the longer run
the fixed rate regime would be inferior. Thus the model suggests that a
low income consumer ought to have preferred floating rates in 1982. The
high income consumer would have initially been worse off, but would
eventually have been made better off.

One obvious difficulty in making welfare comparisons with the
model is that, while consumption and savings of bonds are derived while
consumption and savings of bonds are derived from utility maximization,
money demand is not. Presumably, because money facilitates
transactions, it indirectly raises utility, but this is not captured
here. Thus, all other things being equal, an increase in money holdings
results in an opportunity cost of lost interest earnings with no
attendant increase in utility. Under the fixed rate case a slightly

larger amount of money is held (due to the lower nominal interest rate),


- 36 -

which should bias down utility for that regime. 4 For the high-income
consumer this strengthens the argument that in the short run a fixed
regime is better. However, for the low-income consumer its possible
that this in the near term. We attempted to compensate for this as
follows. We computed the additional amount of money held in the fixed
regime over the floating regime. We then assumed that consumers in the
fixed regime could optimally allocate the money on consumption goods at
equilibrium prices. Even with prices not being allowed to rise to
reflect the increased demand, the low income consumer in the fixed
regime was not made as well off as the low income consumer in the

floating regime. The results are summarized belows.

Table 5: Compensated Utility Levels: Fixed Vs. Floating Revimes,

1981-82
Floating Fixed
Consumer 1 (low income) 282 813
Consumer 2 (high income) 8.69 9.16

Although the fixed rate regime is welfare-superior to the
floating regime for one consumer, it clearly is unsustainable, as
indicated by the trade deficits in each year. Suppose that the

government had devalued the exchange rate in 1981 and had then fixed the

1/ In the floating regime the low income consumer allocated 51.7
percent of his consumption budget to money while the high income
consumer allocated 50.8. In the fixed regime the low income consumer
allocated 52.1 while the high income consumer allocated 51.6.


- Oh -
regime. auf Rather than solving for parameters that give the exact
outcomes of the years in questions, we have chosen to estimate these
parameters directly wherever possible. 2/

We will describe the benchmarking of 1983-84 under the float:ing
exchange regime first. The Australian production technology is repre-
sented by a 30x30 input-output matrix, in which activities 29 and 30
represent imports of complementary and competing goods. We have assuned
no technical change, so that the 1983 and 1984 technologies are given by
the same matrix. We have imposed a Cobb-Douglas structure on the
sectoral value added functions, and have estimated the individual
coefficients from the relative shares of capital and labor in each
sector in the 1977 input-output matrix. The aggregate investment
function is also assumed to be Cobb-Douglas, and its coefficients

ype and 1-8, for capital and labor, respectively, are derived from

aggregating sectoral shares. The resulting coefficients are:

ie = 0.5758 1“ = 0.4242

1/ These types of comparisons will be subject to the Lucas criticism
that behavioral parameters would not remain constant when the exchange
regime changes. It would be interesting test whether, in fact, the
parameters have remained stable, but due to the shortness of the
floating rate period we have not done this.

2/ This method of “calibration” is described in Shoven and Whalley
(1984).


AN ANALYSIS OF THE WELFARE IMPLICATIONS OF ALTERNATIVE

EXCHANGE RATE REGIMES: AN INTERTEMPORAL MODEL WITH AN APPLICATION

Il.

Itt.

Iv.

Bibliography.......

Table of Contents

Page

INTRODUCTION...

Sede cence cecccccc ccc ccccsccccccccccccsccseel

THE MODEL... ecccccccccccccccccccccccccccceces

eee eeeeel

ProductLon.sscccecccee
The Government.......
The Foreign Sector
Consumption......e06

ceeeel

+10
213

eee ceee ee elb

AN ESTIMATION OF THE MODEL FOR AUSTRALIA...

eee ccceeeeee 23

A COMPARISON OF EXCHANGE REGIMES.....cccccccscccccccevceese32

CONCLUSION. coc eeccccccccrcccccccvcccccccccsscscsscevsseces39

Initial Allocations (1983). ccsccccccccccccccccccccccevcceee2]
Simulated Vs. Actual.ccccccscecececccccccccsccccecscscesess30

Fixed Vs. Floating Exchange Rates, 1981-82.... 00033

Utility Levels: Fixed Vs. Floating Regimes, 1981-82.......34

Compensated Utility Levels: Fixed Vs. Floating Regimes —

19B1-B2. cee seceeccccecccceccrceccececcecescscsececeesecees o36

Welfare and Trade Balance Implications of Alternative
Exchange Rate Regimes, 19BI~B2.ccccccccccccccccccceccccceeed7

Welfare and Trade Balance Implications of Alternative
Exchange Rate Regimes, 19B3-B4A. cece ccccccccscccecccccccceee38

See ccccecccccceceeeGl



-43-

Feltenstein, Andrew, 1985. “An Intertemporal General Equilibrium Model
of Financial Crowding Out: Theory with An Application to
Australia", IMF Staff Papers (forthcoming).

Fischer, Stanley, 1977. “Stability and Exchange Rate Systems in a
Monetarist Model of the Balance of Payments". In Robert Z. Aliber
(ed.), The Political Economy of Monetary Reform, pp. 59-73. New
York: Macmillan.

Flood, Robert P., “Capital Mobility and the Choice of the Exchange
Systems", International Economic Review 20, No. 2 June 1979, pp.
405-16.

Frenkel, Jacob A. and Josha Aizenman, “Aspects of Optimal Management of
Exchange Rates", Journal of International Economics 13, No. 3-4,
November 1982, pp. 321-56.

Hause, John C. 1966. “The Welfare Costs of Disequilibrium Exchange
Rate". Journal of Political Economy 74:333-52.

Helpman, Elhanan, and Assaf Razin. 1979. “Towards a Consistent
Comparison of Alternative Exchange Rate Regimes". Canadian Journal
of Economics 12(3):394-409.

Helpman, Elhanan. 1981. “An Exploration in the Theory of Exchange Rate
Regimes”. Journal of Political Economy 89(5):865-90.

Hooper, Peter and Steven W. Kohlhagen, "The Effect of Exchange Rate
Uncertainty on the Prices and Volume of International Trade",
Journal of International Economics 8 (Nov. 1978 483-511.

IMF, Exchange Volatility and World Trade, a Study by the Research
Department of the IMF, Occasional Paper, No. 28. Washington: (IMF,
July 1984).

Income: Distribution Australia, 1978-79, Individuals (Canberra:
Australia Bureau of Statistics, 1981).

Jager, H. 1982. “Optimal Exchange Rate Policy in an Open Economy”. De
Economist. 130(2):228-63. —_

Kenen, Peter, B. and Dani Rodrik, “Measuring and Analyzing the Effects
of Short-Term Volatility in Real Exchange Rates", Review of
Economics and Statistics, forthcoming.

Mundell, Robert, “Uncommon Arguments for Common Currencies”, in the
Economics of Common Currencies ed. by H. G. Johnson and A. K.
Swoboda. London: Allen and Unwin 1973. pp. 114-32,



- 41 -

improvement in the trade account, but is inferior to both the floating
regime and the original fixed regime in the short run. In the second
simulation a fixed regime was imposed on the period 1983-4 when a
floating rate actually prevailed. In this case floating was preferred
by both consumers in the short run, and probably the long run as well.
Our initial conclusion would thus be that, from the point of view of
consumer welfare, floating exchange rates were superior to fixed rates
in this Australian case. Only in the short run with an overvalued, and

unsust:ainable rate does fixing represent a welfare improvement for some

consumers over floating.


-ll-

The government would like to target the output of public goods
5 however it is necessary to impose certain constraints on
government expenditure to reflect the fact that arbitrary targets for
the public good may be impossible to finance. Accordingly, it sets
guidelines for inflation and real interest rates, a» The If
inflation and real interest rates rise above these guidelines, the
government will scale back its output of public goods. These
guidelines, which are described in detail in Feltenstein (1985), are

required to ensure the boundedness of the issue of financial assets by

the government. Thus we define actual output of the public good as 1

Q = O,/(1 + a + max (rE mn Te» 0)) a>oO (14)

The government also has interest obligations on borrowing, both
domestic and foreign, that it has undertaken in the past. Let Bey be
the stock of outstanding home-currency government bonds at time t, F

£

be the outstanding stock of the government's foreign debt, i, be

t-1

foreign nominal interest rate, and e be the price of foreign bonds in

A/ Any decreasing function of r, and 1m could have been used.


-13-
3
zi f,, =1, £., >0. (18)

Here fa; » j=1,2,3 represent the share of the deficit financed by

money, domestic bonds, and foreign bonds, respectively. Accordingly,

the government's issuance of financial assets is determined by:

Pe Poet ee + Pref en (Oe Pe + Pare hes (PED,

The flows of assets from the government, M Be and Fo are then de-

It?
fined by:

Me = Fp, pe, Be = Fen(De De» Fe = fp 3 (DED, (20)

The Foreign Sector

The foreign sector (or rest of the world) is explicitly linked
to the home country through both the current and capital accounts.
There is no foreign exchange per se in the model, as domestic investors
hold foreign bonds but not foreign currency. a/ This may be rational-
ized by viewing foreign-exchange as foreign currency-demoninated bank
accounts, which pay interest equivalent to that on foreign bonds.

Foreign bonds, then, are the mechanism by which all foreign trans-

actions, current or capital take place.

1/ It is common in models of exchange rate determination to suppress
domestic residents' holdings of foreign exchange. See e.g., Allen and
Kenen (1980) and Mussa (1982).


Abstract

We construct a two-period model of an open economy and use the
model to analyze the welfare implications of fixed and floating exchange
regimes. Consumers have perfect foresight and save by holding domestic
and foreign bonds, which are chosen according to relative interest
rates, deflated by the rate of devaluation of the domestic currency.
The government produces a pure public good and finances its deficits by
issuing money, domestic bonds, and by foreign borrowing. The
government's bonds compete with private investment, which is entirely
debt financed. Foreign exchange, i.e., foreign bonds, is made available
via the current account, endogenous private borrowing, and exogenous
public borrowing. The government, in turn, acts as a passive
auctioneer, trading foreign currency at market prices, and the exchange
rate is defined as the domestic price of foreign bonds.

The parameters of the model are estimated for Australia, and
two counterfactual simulations have been carried out. In the first of
these, a fixed exchange regime has been imposed upon 1983-84, when the
exchange rate was actually allowed to float. Assuming that all
exogenous parameters remain constant, the welfare implications of the
two regimes are compared. The floating regime is found to be welfare
superior for both categories of domestic consumers. Similar results are
derived in a simulation in which the floating regime is imposed upon
1981-82, when a fixed exchange regime was actually in place. our
initial conclusion would be that, from the point of view of consumer
welfare, floating exchange rates are superior to fixed rates in this
Australian case.


- 34-

real interest rates are much higher than simulated fixed rate regime.
The trade balance under the floating case is positive and improving,
while under the fixed case it was negative and worsening, suggesting
that the fixed regime would not have been sustainable.

The fact that the government budget deficit as a percentage of
GDP is larger under the fixed regime may be attributed to the fact that:
the initial outstanding stock of both foreign and domestic government:
debt is same in both simulations. As indicated in Table 3, the 198].
exchange rate is lower under the floating than under the fixed regime,
so that government interest payments on foreign debt is correspondingly
lower. The lower 1981 budget deficit under floating rates required less
bond financing than the fixed rate deficit and, accordingly, 1982
interest payments under the floating regime are sufficiently low so as
to cause these to be surplus in the government budget. Domestic
interest rates rise sharply in the floating regime, as the devaluation
in the exchange rate causes the equilibrum price of domestic bonds to
fall.

We now turn to the problem of welfare ranking the two
regimes. Utility levels for the two representative consumers are

summarized below.

Table 4. Utility Levels: Fixed Vs. Floating Regimes, 1981-82

Floating Fixed

Consumer 1 (low income) 0.82 0.80
Consumer 2 (high income) 8.69 9.02



9422) + Ba)

-22-

j=l,...,N

Xx
42 Vy 04 at 2,
xe Spa t9¥) + Ep)
02 WA
_ H((B + Gy) SX) - (ay) + 1DE,) - 2, (8%, + E,)
1 AHS
2
— a8(15¥, + E,)
2 Alo + Zz
ae 20%) + E,)
1 AH
. 2,8(1,¥) + Ey)
TM ale + Z))

where Ail + %, + B+ %Ho and

He (1+ 2) - a

By (30) and (31),

b, = Me
t * d
1+ c(RA/R. 41)

b *
d
1+ (Rey /Reay)

d
sO eR t/a) Sp

(41)

(42)

(43)

(44)

(45)

(46)

(47)

(48)


AN ANALYSIS OF THE WELFARE IMPLICATIONS OF ALTERNATIVE

EXCHANGE RATE REGIMES: AN INTERTEMPORAL MODEL WITH AN APPLICATION

by

Andrew Feltenstein *
David Lebow *
Anne Sibert **

—_—

* World Bank
** Board of Governors of the Federal Reserve System

The views presented here do not necessarily represent the views of the
Federal Reserve Board or any other member of its staff, neither do they
express the views of the World Bank. We would like to thank Daniel

Cohen, John Cuddington, Mohsin Khan, Lyn Squire and Sweder van
Wijnbergen for helpful suggestions.


IFDP
NUMBER

263

262

261

260

259

258

257

256

255

254

253

251

250

249

International Finance Discussion Papers

TITLES

Some Implications of the President's Tax
Proposals for U.S. Banks with Claims on
Developing Countries

Monetary Stabilization Policy in an Open
Economy

Anticipatory Capital Flows and the Behaviour
of the Dollar

Simulating Exchange Rate Shocks in the MPS
and MCM Models: An Evaluation

Trade Policy for the Multiple Product
Declining Industry

Long Memory Models of Interest Rates, the
Term Structure, and Variance Bounds Tests

Currency Substitution and the New Divisia
Monetary Aggregates: The U.S. Case

The International Transmission of Oil Price
Effects and OPEC's Pricing Policy

U.S. Banks' Lending to Developing Countries:
A Longer~Term View

Conditional Econometric Modelling:
An Application to New House Prices
in the United Kingdom

Low Pushing: Doctrine and Theory

1984
(partial listing)
Postwar Financial Policies in ‘Taiwan, China

Foreign Exchange Constraints and Growth
Possibilities in LDCs

The Determination of Front~end Fees on
Syndicated Eurocurrency Credits

Monetary Policy Games and the Role of Private
Information

AUTHOR(S)
Allen B. Frankel
Marcus H. Miller
Arnold Kling
Arnold Kling
Catherine Mann
Gary S. Shea
Jaime Marquez
Jaime Marquez
Henry S. Terrell
Rod Mills
Neil R. Ericsson

David F. Hendry

William Darity, Jr.

Robert F. Emery
Jaime Marquez

Rodney H. Mills
Henry S. Terrell

Matthew B. Canzoneri


- 30 -

We now have all parameters needed to solve our model, and may

turn to a benchmark solution. Table 2 gives actual and simulated

values.
Table 2: Simulated Vs. Actual
(Benchmark Case, Floating Rate)
1983 1984

Simulated Actual Simulated Actual

(In Percent of GDP) (In Percent of GDP
Tax revenue 27.6 27.2 28.0 26.2
Government
expenditure 30.0 29.9 30.9 30.5
Budget surplus 2.4 -2.7 2.9 -4.3
Gross private
investment 10.0 15.3 8.1 12.0
Exports of goods 13.1 12.8 14.1 12.8
Imports of goods 12.0 13.4 12.3 12.7
Trade balance -1.1 -0.6 1.8 0.1

(in percent)

Inflation af 4.7 4.0
Interest rate 19.7 14.3 12.0 13.8
Change in exchange
Rate (U.S.$/A$) 5.9 8.2
Growth in real GDP 5.1 6.7

al No first-period value was generated.

We thus notice that our model generates a reasonably accurate
approximation to actual outcomes.
A benchmark solution for the corresponding model operating

under fixed exchange rates in the years 1981-82 is given in Feltenstein


- 39 -

level does it lead to a short-run welfare improvement, for some
consumers. Since this rate leads to an unsustainable trade balance, it

is not a realistic alternative to the float.


- 25 -

so that capital has a larger share in investment than does labor. 4/
Targets for government expenditure on goods and services as a percentage
of GDP, a> are taken to be their actual values for 1983 (t=1) and
1984 (t=2). Thus 2/

Q = 0.3825 Q, = 0.3903

We have also assumed a Cobb-Douglas form for government production. The

resulting coefficients for capital, Sor» are?

891 = 0.4140 899 = 0.4483
Finally, the rate of depreciation, uw, is taken to be wy = 0.0629. 3/
We lack sufficient data to derive effective sales tax rates on
a sector-by-sector basis. Accordingly, we have imposed a uniform rate,
a simplification that seems justified since the Australian system
charges uniform sales taxes on all goods except certain household

durables and private motor vehicles. The sales tax rates, Y_, are

l/ The above figures are derived from Australian National Accounts
Input-Output Tables (1983), Tables (12) (Input-Output Coefficients),
(11) (Value-added Functions), (18) Investment Coefficients).

2/ See Australian Economic Statistics (1983), Table 2.1 and
International Financial Statistics, various issues.

3/ ‘his figure is taken from the ORANI general equilibrium model of
Australia (see Dixon et al. (1982)).


A)
W
Q

-1
: (1 - AL) > t=1,2 (6)
where C, = (c,, oo oCyy ) and I is the NxN identify matrix.

Time-t capital and labor may also be combined to produce time

t+l capital via the technology

6 1-6
Kt Kt
Reet 7 Kee Tee ’ te1,2 @)

where Xe > 0. Because profits are not realized until a period after

production takes place, production is financed by selling bonds to the
private sector. Given factor taxes and rents, let Coe be the minimum

cost of producing K Then zero profits requires that the gross

t+1°
nominal return on bonds issued in period t and paid off in period t+l,

Pes times the nominal value of bonds issued, yee equal the next-~

period price of capital. Thus,

Geo, = Pxyttikeai? (8)

It is assumed that investment is entirely debt financed, and

that investors must carry out their borrowing in the domestic market. 4/

i The first restriction could be relaxed, in the case of sector-
specific capital, to allow investment out of retained earnings. Because
we do not permit foreign borrowing to finance private investment, the
degree of crowding-out predicted by our model is stronger than would
otherwise be the case.


-~12-

terms of home bonds (or the exchange rate). Then total period-t
government expenditure is
£
= +
C= Cy tA Bp tet + By (15)
Taxes are collected from two sources. The first is the levy on wages

) and interest earnings ) in equation (2) and the second is

ue Oe

sales taxes on the consumption of final goods. Let be the time-t

Ye
sales tax on good j. Recalling that Be and Lye are the cost-minimizing
amounts of labor needed to produce one unit of good j, the total taxes
in period t are

N t t
Te Dyer (ge Meee tHe + YePLe®y) (16)

The time-t budget deficit is

(17)

The government finances its deficit by monetization, sales of
domestic bonds, and foreign borrowing. We will assume that the govern-
ment has a rule which determines the proportions of the deficit to be

financed by each asset. Suppose

FDL) = (£,;0D), f9(D)s £,30))

is a continuous function of D such that