Congo uses these inflows to finance its imports. The balance of payments clears (inflows and outflows are equalized) via adjustments in the real exchange rate (the ratio between the international and domestic price levels) which take place when the balance is in surplus or deficit.<sup>8</sup> <u>Private investment financing</u> is provided from domestic private savings (net of lending to the government) and foreign direct investment (FDI). Private investment spending adjusts in response to changes in available funding.

In domestic commodity markets, flexible prices ensure balance between demands for domestic output from domestic demanders and supplies to the domestic market from domestic suppliers. The part of domestic demands that is for imports faces exogenous world prices – Congo is viewed as a small country in world markets without any impact on the import and export prices that it faces. Domestic demanders decide on import and domestic shares in their demands on the basis of the relative prices of commodities from these two sources. Similarly, domestic suppliers (the activities) decide on the shares for exports and domestic supplies on the basis of the relative prices received in these two markets.<sup>9</sup> <u>Factor markets</u> reach balance between demands and supplies via wage (or rent) adjustments. Across all factors, the factor demand curves are downward-sloping reflecting the responses of production activities to changes in factor wages. On the supply side of the labor markets, unemployment is endogenous – for each labor type, the model includes a wage curve (a supply curve) that is upwardsloping until full employment is reached, at which point it becomes vertical (see Figure A2.2; its supply curve assumes a minimum unemployment rate of 5%). Unemployment is defined more broadly than in official statistics to include un- and under-employment. In the simulations, a broad definition of unemployment increases the scope for the existing labor force to generate a larger (smaller) amount of effective labor if the incentives to work were to improve (deteriorate); typically, this seems realistic. For non-labor factors, the supply curves and total employment are vertical in any single year.

The above discussion refers to the functioning of model economy in a single year. In MAMS, growth over time is endogenous. The economy grows due to accumulation of capital (determined by investment and depreciation), labor (determined by share of the population in labor force age, the labor force participation rate, and the educational system), other factors (on the basis of exogenous growth data), as well as because of improvements in total factor productivity (TFP). The educational system is important as it drives the evolution of the educational attainments of the labor force, influencing their productivity, but keeps the population who is enrolled in schools away from the labor force. Apart from an exogenous component, TFP depends on the levels of government capital stocks.

> 8 For example, starting from a balanced situation, a balance of payments surplus could arise from increases in foreign exchange receipts (perhaps due to an increase in foreign aid or the world price of an export). In this situation, the exchange rate would tend to appreciate, reducing the domestic prices of exports and imports relative to the prices of domestic output sold domestically. This relative price change would encourage domestic producers to switch part of their outputs from exports to domestic sales and induce domestic demanders to switch part of their demands from domestic sources to imports. This process would continue until the balance of payments surplus is eliminated. The opposite would happen in the case of a balance of payments deficit.

> 9 Individual production activities do not respond to changes in relative prices for exports and domestic sales if their output only has one destination, either exported in full or sold domestically in full. In the Congo database, construction and all types of government services are only sold domestically. By the same token, domestic demanders do not have a choice between imports and domestic output for commodities that only have one source; in the Congo database, this is the case for the forestry, oil and government service sectors. Such structural features reduce the flexibility of Congo’s economy.

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