metadata: authors: 0: author: Bourguignon, Francois
1: author: de Melo, Jaime
2: author: Akiko Suwa
docna: 0: docna: Distributional effects of adjustment
            policies : simulations for two archetypes economies
docty: Policy Research Working Paper
subtopic: Economic Theory & Research,Industrial Economics,Labor Markets,International Trade and Trade Rules,Economic Growth,Inflation,Inequality,Rural Labor Markets
teratopic: Health, Nutrition and Population
abstracts: cdata!: The 1980s was a period of external
            shocks for developing countries, and domestic macroeconomic
            imbalance and structural inefficiencies compounded the
            effects. But the performance of developing countries was not
            uniform. The authors devised a model for simulating the
            effects of terms of trade and interest rate shocks on two
            archetype economies, one representing an average Latin
            American economy, and the other an average African economy.
            The study examined the effects of the shocks and of
            different adjustment policies. Identical shocks and
            adjustment packages yield different outcomes for growth,
            poverty, and income distribution in the two economies. The
            simulations suggest three important conclusions : i) with
            the standard adjustment package, inequality increased
            significantly for the Latin American archetype but decreased
            significantly for the African archetype; ii) adjustment can
            lead to a sharp redistribution of income from groups with
            low marginal propensities to save towards groups with a high
            marginal propensity to save; and iii) trade and tax reforms
            that improve allocative efficiency by equalizing incentives
            across sectors can reduce inequality significantly, provided
            that governments are able to implement these revenue-neutral measures.
repnme: repnme: Distributional effects of adjustment
            policies : simulations for two archetypes economies
display_title: Distributional effects of adjustment
            policies : simulations for two archetypes economies
listing_relative_url: /research/1991/05/699984/distributional-effects-adjustment-policies-simulations-two-archetypes-economies
topicv3: Economic Growth m1326241 471,Labor Markets m1326488 855,Poverty m1326687 695,Inflation m1326709 0870F4727ACED1CF8525815C00471347,Trade m1326924 698
publishtoextweb_dt: 2010-07-01T00:00:00Z
historic_topic: Health, Nutrition and Population
origu: Policy, Research & Ect Affairs
no_of_pages: 41
model_extractions: <!-- Start of picture text --> Policy, Research, and External Affairs I<br><!-- End of picture text --> <!-- Start of picture text --> World Development Report<br><!-- End of picture text --> <!-- Start of picture text --> WPS 674<br><!-- End of picture text --> This papera product of the Trade Policy Division, Country Economics Department -was prepared as a background paper for the _1991 World Development Report._ Copies are available free fiom the World Bank, 1818 H Street NW, Washington, DC 20433. Please contact the World Development Report office, room SI 3-060, cxtension 31393 (36 pages, with figures and tables).

The 1980s was a period of extemal shocks for developing countries, and (iomestic macroeconomic imbalance and structural inefficiencies compound>l the effects. But the performance of developing lountries was **not** uniform.

The authors devised a model for simulating the effects of tcrms of trade and interest rate shocks on two archetype economies, one representing an average Latin American economy, and the other an average African economy.

The study examined the effects of **the** shocks and of different adjustiment policies. Identical shocks and adjustiment packages yield different outcomes for growth, poverty, and income distribution in the two economies.

The simulations suggest three importint conclusions: With the standard adjustmcnt package, inequality increased significantly for the Latin American archetype but decreased significantly for the African archetype.

This happened for two reasons. In the Latin American archetype, the rich are able to protect their financial assets through capital flight. In the African archetype, the poor are helped as **ihc** real incomes in rural areas increase because of the higher export earnings induced by the real cxchange rate depreciation.

a Adjustment can lead to a sharp redistribution of income from groups with low marginal propensities to save towards groups wiLh a high marginal propensity to save.

> * Trade anld tax refonns that improve allocative efficiency by equalizing incentives across sectors can induce inequality signilicantly, provided that goveinments are able to implement these revenue-nleutral measures.

**The** l'RE Working Paper Series disseminates tihe findings of work under way in thc Bank's Policy, RcsearT h, and Extemal AffairsComplex. An objectiveofilie scries is to get these findings out quickly, cven ifpresentations ;re less Iall fully poAlished. Thc findings, interpreLations and conclusions in thesc papers do not necessarily represent official Bank policN.

Produced by **thic** PRE Dissemination Center
# TABLE **OF** CONTENTS

|||Eage No.|
|---|---|---|
|1.|Introduction|t|
|2.|Model Outline|4|
|3.<br>|Adjustment to an External Shock in the Two<br>Archetype Economies|11|
|4.<br>|Distributional Effects of Alternative<br>Adjustment Packages|22|
|**_5._**|Conclusions|28|
|R|eferences|30|
||Appendix|31|

This paper was partially funded by RP') (675-32) at the World Bank.<sup>An</sup> earlier version was prepred as a background<sup>paper for WDR (1990). We thank</sup> Rebecca Sugui for her unfailing logistic<sup>support and three referees for</sup> comments on an earlier draft.
# 1. Introduction

It has long been recognized that so long as basic social services are provrided to the poor, economic growth remains the primary means<sup>of reducing</sup> pe :ty and improving the quality of life. When growth slows markedly, however, as it did during the 1980s, the focus shifts towards the<sup>role of</sup> public policy in reducing poverty. Confronted with the macroeconomic crises of the 1980s, policies to alleviate poverty become more difficult<sup>to design</sup> because of the need to both stabilize the economy and promote restructuring<sup>so</sup> as to ensure long term growth. The interaction of initial macroeconomic conditions and economic structure with stabilization<sup>and structural adjustment</sup> policies (or lack thereof) explains the divergent growth and distribution performance across countries during the last decade.

To recount briefly, the 1980s will be remembered as a decade of external shocks for developing countries. Weak demand from developed countries, declining terms of trade (prices for many primary commodities fell to their lowest levels since World War II), a diminishing supply<sup>of external</sup> finance, and an increase in the level and volatility of interest rates combined to produce an unusually unfavorable external environment. For many countries, the need to adjust was also compounded by macroeconomic imbalances resulting from overly expansionary fiscal policies made possible by external borrowing prior to the crisis.

For all countries, a reduction in absorption was required to adjust to the terms of trade and interest rate shocks. But in countries where initial conditions were relatively favorable because of manageable macroeconomic imbalances and relatively little need to restructure, adjustment was accompanied by an acceleration of growth and an alleviation (or<sup>containment)</sup> of poverty. This was largely the case for East and South Asian countries whose average real GDP per capita grew 1.5 to 2.0 percentage points faster per annum during 1980-89 than during 1973-80.

In Sub-Saharan Africa and in Latin America and the Caribbean, initial macroeconomic imbalarices were large and/or the need for structural adjustment was greater because of many years under heavily distorted incentive systems.
2 Implementing the riglt policies vas also often harder because of structural rigidities caused by weak institutions (Sub-Saharan Africa) or by distributional conflicts (Latin America and the Caribbean). The outcome was an average annual per capita GDP growth of -2.2 percent in Sub-Saharan Airica and -0.6 percent in Latin America and the Caribbean during the 1980s. For Sub-Saharan Africa, per capita GDP growth during 1973-80 had been barely positive, but for Latin America and the Caribbean, average per capita GDP growth had been 2.6 percent. It is, therefore, no surprise that the past decade has been called a lost decade for the poor in these regions. The Worl Development ReRort (World Bank, ?"^3) estimates that in 1985, 30 percent of the population in Africa and 12 percent in Latin America was in extreme poverty.

The strikingly different performance between the East and South Asian countries on the one hand, and the African and Latin American and Caribbean countries on the other raises several issues. Was the difference mostly attributable to market characteristics (flexible vs. non-flexible economies), levels of development (middle-to-high income vs. low income), institutional development (economies financially developed and integrated :.nto the world financial markets vs. financially underdeveloped economies)? It would be useful to investigate how important these various differences are in practice. In particular, how will growth and income distribution respond to similar (or identical) policies in these different economic environments? Is it likely that poverty and income distribution indicators will react in the same way in the African and Latin American economies?

This paper is concerned with the interaction of "typical" stabilization and structural adjustment policies on income distribution in what we shall refer to as "typical" Latin American and African economies. This label is, of course, only suggestive and one could just as well think of our archetypes as representative of low-income and middle-income economies or of flexible and rigid economies. Because of stylized differences between the two archetype economies, the same packages or shocks can be expected to have different
3 distributional effects in spite of the same sectoral and s _.oenonomic group classifications.

To anticipate what is described in greater detail in the body of tho paper, we build t W archetypical economies to which we apply the same external shock that will result ir. different effects because of different structures and initial conditions, The first typical adjustment package is arrived at by roughly calibrating the model to produce changes in average values of key macroeconomic variables like growth, external debt, and investment rates that were observed between 1979-81 and 1986-89. The result of this rough calibration exercise is labelled the standard (or average) adjustment package. It includes countries which implemented stabilizatic; and adjustment policies advocated by the World Bank and IHF as well as countries that did not or that did so only intermittently. To keep things simple and to identify more clearly the effects of structural differences acrozis archetypes, we identify the standard adjustment package with exchange rate adjustments. We first analyze in some detail the macroeconomic and distributional effects of this standard adjustment pattern with the alternative scenario of a no-shock growth path.

We then compare this standard adjustment package with three oth. typical packages. The rationing adjustment package can be characterizea by the failure to reduce imbalances and alter economic structures by changing policy incentives. In our framework, this amounts te resisting :eal exchange rate depreciation. The structural reform package corresponds to adjustment packages supported by the World Bank and the IMF. In that typical package, rationalization of trade and fiscal incentives is intended to help reduce the fiscal imbalance and restructure the economy. Finally, the redistributive package combines the reforms of the previous package with redistributive measures along the lines advocated in recent studies on poverty alleviation. One can think of this package as approximating the strategy advocated in the 1990 World Development ReRort.
4 The remainder of the paper is organized as follows. In section 2, we describe in some detail the main features of the simulation model, including the differences in model closures between the tvo archetype economies with r pect to the fur.ctioning of labor, goods and foreign exchange markets. Calibration to initial macroeconomic conditions in the early eighties is described in section 3 along with an analysis of the effects of the shock under the standard adjustment scenario. In section 4 we compare adjustment under the standard package witha adjustment under the three other ty- 'tal packages described above. Conclusions follow in section 5.

# 2. Model Outline

The model is designed to capture the short and medium to long-run effects of stabilization and structural adjustment policies on the distribution of income. It is fully described in Bourguignon, Branson and de Melo (forthcoming) and is available upon request. We refer to the model as a "maquette" because of the variety of closures affcrded by the 'micro-macro" linkages built into it. Micro-linkages come from the interactions across the six sectors included in the model. These long-run linkages are well known from the literature on computable general equilibrium (CGE) models and are not discussed here. Macro-linkages come from the standard IS-LM macro framework for an open economy [see Tobin, 1969]. These linkages are not discussed either, although they will become apparent from the description of the differences in our modelling of the labor, goods, and financial markets in the two archetype economies.

The construction of the archetypes draws on the work of Chenery and his colleagues (Chenery and Syrquin, 1974 and Chenery and Robinson and Syrquin eds., 1987), and is detailed in the appendix. Archetypical economies have the same disaggregation across labor markets, goods markets, and socioeconomic groups, but to reflect differences in their levels of development and economic structures, the relative importance of sectors, labor markets, and sociceconomic groups differ. For example, the agricultural labor market is
5 more important in the African archetype economy than in the Latin American archetype. Initial conditions such as the size of the external debt, and the rate of interest on the external debt also differ. Further, demand and supply elasticities are usupeLy lower in the African than in the Latin American archetype, and most importantly, the fun. ioning of labor, goods, and financial markets differs between the two archetype economies.

In both archetype economies we distinguish five financial units: government, households, firms, the consolidated banking system, and the foreign sector. By assumption, governments do not lend, households do not borrow and because of thin (or nonexistent) equity markets in most developing countries, the equity market is modelled rudimentarily so that the endogenously determined proportion of households savings allocated to equity is made directly available to firms.

The different modelling aEsumptions (or closures) are summarized in table 1. In the African archetype, there is no market for government debt, the government holds all foreign debt, and household financial wealth is made up entirely of domestic financial assets (money and equity). By contrast, in the more developed financial market of the Latin American archetype, part of the government debt is held ip domestic bonds, households hold foreign assets, and firms have part of their debt in foreign currency.

Because it is difficult to sterilize capital flows in Latin American economies with relatively integrated financia. irkets, it is assumed that monetary authorities can only partially control zhe money supply in the Latin American archetype. The change in base money, H, is given by:

# AH - AL4 - eOKAp + ABb

where LI is the liability of the banking system, e is the exchange rate (units of domestic currency per unit of foreign currency), KAp is the private capital account, Bb is government issued domestic debt and O (O **<** O < 1) measures the degree of sterilization of foreign capital flows. Also, due to the evidence
6

## .able 1. Macro Closures

## African ArchetyRe

## Latin American Arcl,t'eg

## Financial Sector

- Money supply exogenous (O - O)'

- No bond market: govornment holds only foreign debt (B:)

- Households hold cash (HE) and equities in firms (p,E)

- Firms use working capital (Ht) and liabilities of the banking system (Lb)

- ?,ney supply partly endogenous (9 - .3)'

- Bond market: government holds domestidebt **(Bb)** and foreign debt (B:)

- Households hold cash and foreign bonds (Ft) in their portfolio as well as equities in firms (p.E)

- Firms use working capital (Hf), liabilities of the banking system **(Lb),** and foreign-denominated debc (LZ)

## Fgrgign Exchange Market

- Limit on government borrowing (E3) Firms and households have no access to the foreign capital market

- Limit on government borrowing (Bi) and on firm borrowing (LZ) but no limit on foreign assets held by households (foreign and domesti_ assets are imperfect substitutes)

## Lbor Ma

- Agricultural labor: flexible wages Modern sector labor: downward nominal rigidity

- Agricultural labor: flexible wages Modern sector labor: full indexation on cost of living, i.e. full real wage rigidity

# _Goods_ Market

- Flexible prices for all sectors

- Mark-up pricing in modern sector flexible prices in other sectors

arope: o. O is the monetized proportion of private capital movements.
7 thac inflation leads to flight from money, households' real demand for money, Hh, is where signs under the variablc" indicate the signs of the corresponding partial derivatives, y is real income, i is the nominal interest rate, and p is the exogenously given expected infation rate.

In the foreign exchange market, with a normal external environment, i.e. vithout shock, there is no constraint on foreign borrowing. The exchange rate is then predetermined and endogenous government borrowing, AB:, is given by: where CA is the interest inclusive current account and for the Latin America - - archetype KAp AL: (i, e) 4F` (i, e) where L: is firm borrowing from abroad and Fh is households' holdings of foreign bonds. For a given domestic price, the current account responds positively to the exchange rate and negatively to the interest rate because of investment demand. For given expectations, private firms (households) shift towards domestic debt (foreign assets) when the exchange rate devalues (revalues) and when the interest rate rises (falls). In the African archetype, the capital account is exogenous by assumption. In all simulations, except the no-shock scenario, it is assumed that each archetype faces **_'.Ll_** exogenously determined foreign exchange constraint, and the government borrows an exogenously set amount AB:. Money is the only financial asset held in the African archetype so that when the amount of foreign borrowing is fixed, the fiscal deficit is financed from seignorage on the cash holdings of firms and households. In the Latin American archetype, big farmers and capitalists hold a fraction of their financial portfolio in foreign assets and domestic bonds. The fiscal deficit is
8 therefore also partly financed from domestic borrowing. Also, in the Latin American economy, not only does the government face a foreign borrowing - constraint, but firms can no longer borrow abroad, i.e. ALZ 0. Households, how.,ver, continue to hold foreign bonds in their portfolios even when there is foreign exchange rationing. In addition, we assume that foreiEn exchange controls are ineffective in the Latin American archetype, so that we are able to capture the widely documented capital flight phenomenon. Thus while there is a foreign borrowing constraint in both economies, there is the possibility of portfolio shifts by households towards foreign-denominated assets in the Latin American archetype in response to changes in the domestic economic environment.

In both archetypes the economy is divided into six sectors (primary - export, agriculture, nontraded informal private services and cottage shop activities - and three modern sectors; consumer goods, intermediate and - capital goods, and nontraded formal construction and utilities) and six - socio-economic groups (two capitalist groups large farmers and modern- sector capitalists small farmers, and three worker groups). Of the two primary sectors, the primary export sector is the standard export sector (a mineral or cash crop sector) while agriculture includes activities that compete with imported compete with imported agricultural products. In both archetypes, after-tax profits are largely distributed to the capitalist socioeconomic groups, while worker income comes primarily or exclusively from the selling of its labor services. The appendix describes in more detail. output and final demand structures, taxes, the mapping of factor incomes into socioeconomic groups, and the holding of financial assets.

In the labor markets, agricultural workers are assumed to be paid a competitive wage and informal workers earn their average product. In the African archetype, modern secto -ages are downward rigid in nominal terms, but there is usually enough inflation for the modern labor market to clear. In the Latin American archetype, wages for modern sector workers are fully indexed to the co6t of living. This closure reflects the combination of union
9 power and workers' resistance to a cut in living standards. With real wage rigidity, any disequilibrium in the modern labor market resulting in an excess supply of labor result; in unemployment.

In the goods markets, we assume that pr'ces adjust to clear markets in the African archetype. In the Latin American archetype, we assume that there is resistance on the part of capitalists in the modern sector to cuts in their profit rates. This implies a mark-up pricing rule of the type: (3) **pV** - **W.1** (1 + m) (1 + a p*) where pY is the value-added price, W- is last period's labor cost per unit of output, m is the mark-up rate, and a < 1 depends on how much resistance there is to a cut in profits. In the modern sector, the rate of capacity utilization, U, is adjusted to clear the market in case of excess supply. - Hence supply is given by q' UF(K-, L) where K- is the fixed capital stock, L stands for lhbor and F( ) is th sectoral prod.ction function. Thus, in the Latin American archetype, the combination of wage indexation with a mark-up pricing rule, leads to an extremely rigid modern sector.

Modelling of the government sector is identical in both archety.as. The government collects taxes on domestic and imported goods and pays interest on internal and external debt. Nou-interest government expenditures are divided into three components: wages, consumption expenditures, and investment expenditures. Government workers, whose employment level is exogenous, receive an exogenous wage. To simplify the interpretation of results, we assume that the marginal productivity of government investment is the same as for private investment. We also assume that all components of non-interest expenditures grow at 3 percent per period in all sia"iations. Thus we abstract from any productivity effects that would arise from changes in patterns of government expenditures. However, for a given monetary and exchange rate policy, any changes in the fiscal deficit has an effect on private investment demand via the clearing of the money market.
10 The immediate effect of the external shock considered here is to require a reduction in absorption relative to income. There is no room for supply increases since the economies are initially assumed to be at a fullemployment equilibrium. With more rigidity in goods and labor markets in the Latin .nerican archetype, the shock moves the economy inside its production possibility frontier, and the reduction in absorption is greater than in the more flexible African archetype. Of course, resources are not actually fully and efficiently employed in the no-shock scenario, and structural adjustment policies were intended to move economies closer to their production frontier. We _da_ not model. directly this supply-augmenting effect that structural adjustment policies were presumed to have because of the lack of reliable information on the extent of resource idleness caused by inappropriate incentives. Rather, we implicitly assume that in the no-shock scenario economies would have had sufficient access to external funding to have normal capacity use. In particular, we do not take into account the possibility of immiserizing capital inflows caused by distortions [see Brecher and DiazAlejandro (1977)].

Ilx the longer run, there is also an effect of adjustment on growth due to changes in the composition of absorption. Household savings of capitalists are negatively affected by the incorporation of a wealth effect in the consumption function and, for a given amount of savings, the allocation of savings co physical capical depends on the relative price of equities (i.e. of physical capital) compared to other financial assets.

The other component of absorption is private investment. How it reacts to changes in the endogenously determined macroeconomic variables will largely determine the relative success of stabilization and structural adjustment policies. Irnvestment demand by the private sector, I., is given by: (4) i1 ( _(uPvaF/K)_ **_UI,_** /Pk)
11 Investment demand is a positive function of capacity utilization and that sector's marginal revenue product of capital, pWaF/fK, and a negative function of the cost of capital, Pk. and the opportunity cost of borrowing, i, - p where ir is a weighted sum of domestic and foreign interest rates adjusted for exchange rate changes. In turn, the price of capital goods and the opportunity cost of borrowing is affected by the value of the real exchange rate.

How adjustment affects income distribution among socio-economic groups is influenced by three factors. First is the standard effect coming from the mapping of factor incomes into socio-economic groups. Incomes of factors employed relatively intensively in expanding sectors will rise. Likewise rents will rise in sectors that expand, with the real incomes of immobile factors changing more than those of mobile factors. Second, poor socio- economic groups that have consumption patterns that are not price responsive - because they are concentrated in necessities with low price (and income) elasticities of demand - will be more severely affected by changes in relative prices and real incomes. Third, poor socio-economic groups who have little equity and hold financial assets mostly in the form of non-interest bearing money will lose more from shocks that raise the inflation rate and lead to a real exchange rate depreciation. On the other hand, rich socioeconomic groups that have more diversified portfolios and hold interest bearing assets or assets denominated in foreign currency are better protected against inflation and capital losses.

# 3. Adjustment to an External-Shock in the Two Archetvne Economies

We now turn to an analysis of how an interest rate and terms-of-trade shock affects macroeconomic and distributional indicators in the two archetype economies. The terms-of-trade shock is a 20 percent increase in the foreign currency price of imports (p.) in period 2 only. The interest rate shock is a permanent doubling of the interest rate (i*) on foreign debt beginning in period 2 (simulations run for 7 periods). Because the typical African economy
12 holds publicly guaranteed debt disbursed under donor assistance, It has a relatively high grant element in comparison with the stock of external debt held by the typical Latin American country where the proportion of commercial debt with a variable interest rate is high. Hence the doubling of the interest rate on foreign debt in the African archetype is from 4 percent to 8 percent per annum, whereas for the Latin American archetype the doubling of the interest rate is from 8 percent to 16 percent.

On the assumption that the parametrization of the external shock is sensible, a way to judge the plausibility of the archetypes and of the differing assumptions about market behavior, parameters and initial conditions, is to compare model outcomes with realized values of macroeconomic variables averaged over African and Latin American economies during the period 1979-86. We assume that if the external environment in the 1980s had been benign, average performance achieved during 1978-81 would have continued throughout the 1980s. We compare these average realized values for 1978-81 with period 1 values obtained with the simulation model, which are indicative of macroeconomic outcomes for most flow indicators over the entire simulation in the absence of an external shock. The realized average values of variables during 1986-89 are taken to represent the combination of the unfavorable environment due to the external shock and the standard adjustment to that shock. They are compared with model results from period 7 after the economies have settled down from the effects of the shock and of the standard adjustment package.

Comparisons of realized values of macroeconomic indicators with values generated by the model are shown in table 2. Except for growth rates and inflation where average values are for the entire seven period simulations (with and without the external shock), the results in parenthesis are model results under the standard adjustment package. Looking at the realized values, four stylized outcomes stand out. First growth slowed much more in Latin America than in Africa. But the larger population growth rate in Africa (3.2 percent per annum versus 2.2 percent for Latin America) resulted in
13 Table 2. Macroeconomic Indicators: Africa and Latin America (Model results in parenthesis)

||Af<br>1978-81|rica<br>1986-89|Latin<br><br>1978-81|America<br>1986-89|
|---|---|---|---|---|
|GDP growth per annum|2.9<br>(3.0)'|2.8<br> <br>(2 .6)b|3.7<br>(4.4)|2.4<br> <br>**(t**<br>1<br>I)b|
|Investment/GDP|22.7<br>(21.6)|18.1<br>(15.5)|22.3<br>(22.6)|17.3<br> (14.8)|
|Current account/GDP|-4.8<br>(-4.6)|-5.9<br>(-5.4)|-4.6<br>(-3.3)|-5.2<br>(-7.4)|
|External debt/exports|.89<br>(1.07)|3.59<br> <br>(1.89)|1.16<br>.99)|<br>3.35<br>(2.89)|
|Interest payments/exports|3.4<br>(3.7)|11.1<br>(15.1)|9.9<br>(9.5)|24.3<br>(42.5)|
|Inflation rate per annum (CPI)|20.9<br>(16.4)'|22.1<br> **( 1 8 . 3 )b**|21.1<br>(30.5)'|271.3<br> (3 7.5)b|
|Real exchange rate<br>index (1980-<br>1.00)|1.02<br>(1.00)|1.46<br> <br>(1.09)|1.01<br>(1.00)|<br>1.14<br>(1.08)|

Notes: Average values are unweighted averages. Unless otherwise indicated, figures in parenthesis in the 1978-81 (1986-89) columns are period 1 (7) results.

a. Compounded 7-year average annual growth rates for the no-shock simulation.

b. Compounded 7-year average annual growth rates for the shock simulation.

SQurce: World Bank country data.
14 declining average per capita incomes in Africa. Second, the investment share in GDP fell drastically in both regions. While some portion of the fall in investment rates was certainly compensated for by increases in the marginal efficiency of investment, it is implausible that efficiency gains compensated for the loss in investment volume. Third, the current account deficit worsened slightly for both regions because of the surge in interest payments on the external debt in spite of the sharp real exchange rate devaluation. Fourth, inflation skyrocketed in Latin America, whereas it remained stable in Africa in great part because of the influence of countries in the Franc zone.

Model results broadly replicate these stylized outcomes, though there are some discrepancies. For the Latin American archetype, the treatment of rigidities in the model magnifies the fall in growth rates when compared to the average realized values. Regarding inflation, in the Latin American archetype the exogenous treatment of expectations about inflation and devaluation in the simulations makes any outcome possible. In view of the very uneven inflation patterns, both within and across countries, we have assumed "strong" inflationary expectations only during the period when the shock occurs. As a result, an inflation bout occurs in period 2, and the economy settles back to a "normal" inflation pattern thereafter. Hence we are not modelling the dynamics of hyperinflation. With respect to the real exchange rate index, the two indicators are not strictly comparable since the index calculated from the model corresponds to the relative price of tradables, whereas the calculated value for regional averages corresponds to an index of external competitiveness rather than to an index of resource allocation within the economy. Because the model was designed for counterfactual analysis and not forecasting, one should not require exact replication of realized values. The comparisons indicate, however, that the main changes observed during the eighties are captured by the standard adjustment package built into the model.

We now evaluate the effects of the external shock on income distribution under the standard adjustment package. In the favorable external environment
15 base simulation (AFB, LAB), expectations are realized. The money supply, inflation, expected devaluation (and actual devaluation) all grow at 30 percent per period for LAB and 15 percent for AFB (except for the money supply in AFB which grows at 20 percent per period). Under this scenario, there is no foreign borrowing constraint, real exchange rates and real interest rates are nearly constant, and there is full employment of labor and full capacity use. As shown in table 3, the debt-to-export ratio doubles by the end of the seven period simulation with a worsening of the fiscal deficit in AFB mainly caused by the rising external debt service. Note also that the value of exports grows less rapidly in AFB than in LAB because of a bias towards primary products with low price and income elasticities of demand. This difference reflects the difficulties that African countries have had in expanding export earnings.

Because of higher population growth, the normal external environment for the African archetype is just sufficient to maintain poverty indicators constant throughout the simulation although the distribution of income becomes significantly more equal according to the Theil index of inequality. On the other hand, the combination of higher GDP growth and lower population growth enables the Latin American archetype to achieve a reduction in poverty and a marginally more equal income distribution.

In the simulations with the unfavorable external environment (AFS, LAS) where the interest rate on external debt is doubled for periods 2 to 7 and the foreign currency price of imports is hiked by 20 percent in period 2, the standard adjustment package is derived as follows. In the African archetype, a limit on external borrowing is imposed with no changes in expectations or monetary policy. In the Latin American archetype, the limit on public borrowing is complemented by a freeze on the portfolio choice of firms that see their foreign-denominated debt frozen to its period 2 value. No constraints are imposed on portfolio choices by households. Because of the rigidities built irto this archetype, expectations of inflation and the rate of devaluation are raised to 35 percent in period 2 and 40 percent in period 3
16 Toble 3. Nacroeconomic and Distributional Indicators in the Two Archetypes

|Simulation||AFm||AF||kI||LAm|
|---|---|---|---|---|---|---|---|---|
|Period|2|7|2|7|2|7|2|7|
|GDP|103.0|120.0|103.0|117.0|104.0|129.0|100.0|107.0|
|Export valueb|21.6|23.6|23.8|<br>28.9|17.1|<br>21.5|19.7|21.2|
|Investment/GDPe|21.5|20.5|18.9|<br>15.5|<br>21.4|23.6|13.8|<br>14.8|
|Inflation<br>rate (CPI)|16.8|16.9|20.7|18.1|35.4|30.0|100.3|<br>30.0|
|Devaluation<br>rate|15.0|15.0|27.0|17.6|30.0|30,2|108.0|<br>31.4|
|Interest<br>rate|20.1|21.2|20.3|23.4|35.9|34.1|49.0|42.1|
|Overall<br>deficit/GDP|4.0|6.2|5.2|9.0|6.2|6.7|8.2|17.4|
|Primary<br>deficit/GDPd|3.1|4.6|3.2|5.2|3.9|3.0|4.4|5.8|
|Debt/exportse|113.0|239.0|103.0|<br>189.0|<br>124.0|224.0|107.0|<br>289.0|
|Debt service/exports|4.5|9.3|8.3|15.1|11.3|21.0|17.2|46.2|
|Domestic debt/GDP|-|-|-|-|3.4|4.0|5.8|7.0|
|Domestic<br>Debt service/<br>goverrunent revenue|-|-|-||7.1|9.0|4.7|18.0|
|Householdforeign<br>assets/<br>exports|-|-|||34.4|_42.0|48.2|57.2|
|Theil index'|66.4|58.6|61.5|50.8|37.1|35.0|33.4|43.2|
|Poverty<br>gap<sup>9</sup>|2.68|<br>2.71|<br>2.77|<br>2.71|<br>0.84|<br>OA.3|<br>0.91|<br>1.49|
|Poverty<br>Rate|30.4|31.1|29.9|29.5|11.8|10.5|12.1|19.5|

Notes: AFB: Africa no-shock; AFS: Africa, shock; LAB: Latin America, no shock; LAS: Latin America, shock

- a. Period I u 100.

- b. In foreign currency units.

- c. In real terms.

- d. Does not include interest payments on the public debt.

- e. Public and private external debt.

- f. A decrease in the value of the index indicate less income inequality.

- g. The poverty gap indicates the percentage of income that must be redistributed to bring alt those below the poverty line to the poverty line.
17 with a corresponding increase in the money supply. For subsequent periods, expectations and monetary growth resume pre-shock values. In this adjustment package, to simplify, we have assumed no contractionary change in fiscal (or monetary) policy as a result of the shock. In other words, we assume that the limit on foreign borrowing is met by variations in the exchange rate alone. This clearly overstates the laxity of fiscal policies pursued in a standard adjustment package, but it makes it easier to interpret the effects of differences in economic structure, initial conditions, and market mechanisms on adjustment policies.

The impact of the shock and the standard adjustment on macroeconomic variables in periods 2 and 7 is given in table 3 and figure 1. Private investment declines sharply in both economies (recall that public investment grows exogenously), due to the combined effects of a higher price for imported capital goods (due to the devaluation of the real exchange rate) and a higher real interest rate (because of larger borrowing of the government from the Central Bank to finance interest payments). This effect is particularly strong for the Latin American archetype, and is certainly in accord with the sharp rise in real interest rates that occurred during the past decade in many Latin American economies.

A second clear pattern is the deterioration in fiscal indicators which is particularly pronounced for the Latin American archetype. While the deterioration is rather extreme because we have purposely not built in contractionary fiscal policies in the standard adjustment package, it is interesting to note that the exploding fiscal deficit in the Latin American archetype is almost entirely due to interest payments on the internal and external debt.

This sharp fiscal deterioration in the Latin American archetype results from the price rigidities impairing resource use. Unemployment goes up sharply because of real wage rigidity in period 2, and capacity falls with a lag because of capitalists' resistance to a fall in the profit rate in the modern sector. As a result, in contrast with the African archetype where the
18 PFiure ;

# Resource Use, Growth and Bead Count

<!-- Start of picture text --> Latin American Archetype<br><!-- End of picture text --> <!-- Start of picture text --> African Archetype Latin American Archetype<br>Unemployment, Capacity Use Unemployment, Capacity Use<br>2.4<br>0 a ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~2.2<br>0 6<br>0 3<br>0.2- ,.6 -<br>0.I 0.4<br>2 3~~~~~~~~~~~~~~~~0<br>I 2 3 6 1 2 *S 6 7<br>0 AFBU * AFSU o AFBC AFSC 0 LABU LASU LABC LASC<br>GDP Growth (Index) GDP Growth (Index)<br>11~0<br>'09<br>in4<br>*02 95<br>* 2 3 4 5 6 7 7 3f 4 5 6 7<br>nAFS *AFB o LwAS * LA8<br>30.¶ Head Count Head Count<br>306~~~~~~~~~~~~~~~~~~~~~~~~9<br>30.2 .<br>30.1~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~1<br>304-31 , * 4<br>3903<br>20'<br>a AFS *AFB L AS *LAB<br><!-- End of picture text -->

**Notes: Time period on horizontal sisL(** shock; + no shockc)
19 real exchange rate devaluation achieves expenditure<sup>switching with a</sup> concomitant increase in export earnings,<sup>in the Latin American standard</sup> adjustment pattern, export earnings<sup>remain at the same level as in the base</sup> simulation. Stagnant export earnings<sup>and a severe output contraction imply</sup> less government tax revenue. The deterioratton<sup>in government revenue along</sup> with rising interest payments results<sup>in a large crowding out of private</sup> sector investment and a tripling<sup>of the real interest rate (compared with the</sup> no-shock simulation) by period<sup>7.</sup> For the African archetype, the assumption of wage<sup>and price flexibility</sup> minimizes the adverse growth effects<sup>of the shock and poverty and income</sup> distribution actually improves. As<sup>discussed below, the improvement in the</sup> poverty and distributional indicators<sup>comes from the expenditure switching</sup> policies which raise the real income<sup>of the poor and improves their relati,e</sup> position. On the other hand, poverty<sup>and distributional</sup> indicators in the Latin American archetype are significantly<sup>worse, due to three factors.</sup> First, wage and price rigidity slows<sup>growth and raises the fraction of the</sup> population in poverty. Second, resistance<sup>to the cuts in living standards is</sup> by the richer socio-economic groups, those owning capital. Third, big farmers and capitalists are able to avoid<sup>capital losses by shifting their</sup> portfolios towards foreign-denominat.ed assets.

The evolution of the distribution of income across<sup>socio-economic</sup> groups is shown in figures 2 and 3. In the African<sup>archetype, the real exchange rate</sup> devaluation raises the real income of<sup>rural workers beyone levels reached in</sup> the no-shock environment and small farmers<sup>who earn part of their income from</sup> wages in the export sector lose very little<sup>from the shock. The burden of</sup> adjustment falls most heavily on workers in<sup>the nontraded informal sector, who</sup> lose not only because of the fall in the relative<sup>price of non-tradables but</sup> also because of the decline in the real income of<sup>capitalists who have a high</sup> income elasticity of demand for informal<sup>sector services. Modern sector</sup> workers lose somewhat less than capitalists<sup>because their average wage</sup> includes the exogenously set real wage of civil servants.<sup>Mobility across</sup>
20 F(gure a Oisttbutional<sup>Effects of ExtarmAl</sup> _SWk Afrian_ ArdetYPS (Real he capita hdex) <!-- Start of picture text --> ,,8tal Farmers<br>4<br>Capacalstsy<br>;~~~~~~~~~~~~~~~a<br><!-- End of picture text --> <!-- Start of picture text --> Rural W rS , m<br>4<br>Capacalstsy<br>gFarmers<br>-2 , _ - - { ;~~~~~~~~~~~~~~~a<br>@: 8 * 4<br>Notes:<br>Tbre period on horizofl?81 8xis (Cl sh¶ock; *no g?ick)<br>Ul refers to trnemp1oym5tnt ant C to capacity lJt the cop fiEures on uneuployulOfl<br>and capacity use.<br><!-- End of picture text -->
21 FIWure a3 DlsgbutInal<sup>EffectdExtewnl Shock: Lath American</sup> Artihtype (Real per capita oX) <!-- Start of picture text --> Shan Farmers<br>Rural worker<br>IM -<br>Bi Fanrmw W. Capltalts<br>S.!<br>Iz~~~~~~~~~~~~~~~~~~~~~~~~~~I<br>_________. _ _ _____ ___ _ _ . *<br>Time Farmers onCaorizontal axis03shocki+nostoaliots<br>I a *6 8<br>Vntalraxi Workers+noshck<br>TmodpeWodo r n k rs<br><!-- End of picture text -->
22 modern sectors also mitLgates the effects of the shock. The distribution of income becomes less unequal in the Afrlcan archetype as a result of the shock because devaluation protects the poorest socio-economic groups, rural workers and small farmers.

A strikingly different pattern emerges under the standard adjustment pattern in the Latin American archetype. Despite the sharp recession under &djustment, capitalists and big farmers manage to maintain and even improve their absolute real incomes. All wage earners suffer, with a precipitous fall in the real income of informal sector. Modern sector workers lose on average in spite of real wage resistance in great part because of increased unemployment which results in decreased per capita income in the sector. Finally, the fate of small farmers and rural workers is similar, with both losing because of recession. Clearly, under this adjustment scenario where the poor have to share income with the unemployed and cannot protect their money holdings from the inflation tax, the shock widens income disparities among socLo-economic groups.

# 4. Distributional Effects of Alternative Adjustment Packages

We have seen that differences in assumptions about market adjustment and about household opportunities to protect themselves from shocks can account for radically different distributional effects of identical external shocks and adjustment policies. Maintaining the same assumptions about model closures, we now evaluate the distributional effects of the three adjustment packages referred to in the introduction. As before all policy changes occur in period 2.

In the rationing adiustment package (AFR, LAR), adjustment takes place through import rationing with the Central Bank sticking to an exchange rate policy that maintains a constant real exchange rate pegged to CPI domestic inflation. This adjustment scenario reflects a policy of postponement of adjustment which we assume can last for the seven years in the simulation. The proceeds of the rents accruing from the premium on imports are distributed
23 pro-rata (as dividends) to each<sup>sector. (Rents from the premia on non-</sup> competitive imports are distributed<sup>to the formal non-traded (i.e. commerce)</sup> sector.) Otherwise, all other assumptions<sup>are identical to those describing</sup> the standard adjustment package.<sup>Again, to clearly trace the effects of the</sup> differevces built into each archetype,<sup>we abstract from the useofthe</sup> standard fiscal, monetary, and<sup>exchange rate instrunents.</sup> In the structural adjustment package<sup>(AFSR, LASR), starting from the</sup> standard adjustment package, we apply<sup>the trade and tax reforms advocated by</sup> the IMF and the World Bank. (Tax<sup>and tariff structures across sectors in each</sup> archetype are given in appendix<sup>tables A3 and A4). Export taxes are abolished</sup> for both archetypes. Uniform tariff<sup>rates are set at 15 percent for Africa</sup> and 20 percent for Latin America.<sup>Sales taxes are aLso equalized at 7 percent</sup> for Latin America and 3 percent<sup>for Africa, and profit and income taxes on</sup> modern sector capitalists are set<sup>at 10 percent in both archetypes. To</sup> reflect difficulties in tax administration, all tax reforms apply only to the modern sector, the non-traded informal<sup>and the two agricultural sectors are</sup> not taxed. The equalization of<sup>tax rates is designed to yield broadly the</sup> same revenue levels in period 2<sup>as in the standard adjustment package. These</sup> tax rates may not be at the exact<sup>level actually found in the regions, but the</sup> composition of tax receipts across<sup>the categories of trade taxes, direct taxes</sup> and indirect taxes broadly conforms<sup>to average patterns for low and middle-</sup> income countries.

Finally, in the redistribution package, (AFRE, LARE) the structural adjustment package is augmented<sup>by food subsidies and a public works program.</sup> Because our simulation model<sup>is not sufficiently disaggregated,</sup> especially with respect to the social sectors,<sup>this strategy, which is intended to</sup> simulate the elements of the<sup>strategy advocated in theWM(1990), cannot</sup> reflect all the targeting and redistributive policies that would be included in a complete strategy of poverty<sup>alleviation. A food subsidy of 7 percent</sup> for the African archetype and<sup>of 5 percent for the Latin American archetype is</sup> applied from period 2 on to sales<sup>of agricultural</sup> products. The public works
24 Table 4. Macroeconomic and distributional indicators under different adjustment packages

|Africa|A|FS||ER|A|FSR|A|FRE|
|---|---|---|---|---|---|---|---|---|
|Period|2|7|2|7|2|7|2|7|
|GDP|103.0|<br>117.0|102.0|121.0|103.0|117.0|103.0|<br>117.0|
|Investment/GDP|18.9|<br>15.5|20.5|<br>25.5|19.3|<br>15.3|17.2|<br>13.1|
|Inftation<br>(CPI)|20.7|<br>18.1|22.3|<br>16.7|19.6|<br>18.3|19.3|<br>19.4|
|Devaluation<br>rate<br>Premiumrate|27.0|<br>17.5|22.0<br>27.5|<br>17.3<br>102.3|22.0|<br>18.0|21.0|<br>18.2|
|Interest rate|20.3|23.4|18.4|15.0|19.8|23.0|21.5|26.6|
|Government<br>revenue/GDP|15.3|<br>15.0|15.5|<br>16.5|15.0|<br>15.2|12.5|<br>12.8|
|Overall<br>deficit/GDP|5.2|<br>9.0|6.8|<br>12.6|5.5|<br>8.5|8.0|<br>11.1|
|Theil index|61.5|<br>50.8|61.1|<br>47.9|57.6|<br>46.6|55.8|<br>45.4|
|Poverty<br>gap|2.8|<br>2.7|3.5|<br>4.8|2.3|2.3|1.9|2.1|
|Poverty<br>rate|29.9|<br>29.5|33.9|<br>39.2|26.0|<br>26.0|22.9|<br>24.3|
|Latin<br>America<br>|L|AS|k|m|I|k|L|ARE|
|Period|2|7|2|7|2|7|2|/|
|GDP|101.0|107.0|100.0|100.0|101.0|108.0|104.0|108.0|
|Investment/GDP|13.8|14.8|13.9|16.1|14.4|14.6|13.4|14.2|
|Inflation<br>(CPI)|108.3|30.1|102.8|27.8|102.6|30.7|108.9|30.6|
|Devaluation rate<br>Premiun<br>rate'|108.0|31.4|100.0<br>10.0|26.3<br>115.4|103.0|31.9|109.0|32.1|
|Interest<br>rate|49.0|42.1|48.4|37.4|47.9|42.?|49.3|43.3|
|Govermnentrevenue/GDP|11.5|12.6|13.7|12.9|10.9|12.8|10.2|11.5|
|Overall<br>deficit/GDP|8.2|17.5|8.7|23.9|8.7|17.8|9.3|18.4|
|Theil index|32.7|43.0|32.6|45.6|31.8|41.0|32.4|42.3|
|Poverty<br>gap|0.9|1.5|1.0|3.8|0.7|1.2|0.6|1.2|
|Poverty<br>rate|12.1|19.5|12.5|28.2|10.3|16.9|9.7|17.3|

Notes: Variables as defined in table 3.

(AFS, LAS) a Africa (Latin America): stanc-rd adjustment (exchange rate devatuation) (AFR, LAR) a Africa (Latin Ameriea): rationing adjustment (import rationing) (AFSR, LASR) a Africa (Latin America): structural reform (tax equolization) (AFRE, LARE) a Africa (Latin America): redistribution (tax equalization, food subsidies, and public works) a. Premimn rate on imports under rationing
25 program is implemented so as to result<sup>in the same exogenous government</sup> nominal wage bill as in previous experiments<sup>while achieving full employment</sup> at the same time. In the African<sup>archetype, average public sector wages are</sup> frozen in real terms with an increlse<sup>in public employment, thereby drawing</sup> labor out of the formal sector. In<sup>the Latin American archetype, average</sup> public sector real wages fall reflecting<sup>the hiring of unskilled workers in</sup> the public works program. In this<sup>archetype, government sector increases in</sup> employment come out of the pool of unemployed.

The macroeconomic and aggregate distributional effects of each one of these packages are contrasted with<sup>the standard adjustment package in table 4</sup> and figure 4. For both archetypes,<sup>the rationing adjustment package (AFR,</sup> LAR) results in severe import rationing<sup>by the end of the simulation period</sup> with premia rates on imports exceeding<sup>100 percent. Under this scenario both</sup> poverty indicators also worsen, which<sup>is not surprising since the rents</sup> accruing from rationing redistribute<sup>real income from poor and middle to the</sup> richer socio-economic groups. Figure<sup>3 indicates an increase in the</sup> percentage of population in poverty<sup>in Africa from 30 percent to 40 percent,</sup> and in Latin America from 12 percent<sup>to 36 percent. These estimates are very</sup> high and may exaggerate the actual adverse<sup>impact on poverty of adjustment in</sup> an economy where rent-seeking and non-market<sup>mechanisms are commonplace. It</sup> is interesting to note the higher growth<sup>in AFR which is induced by a strong</sup> Kaldorian effect. Income is redistributed<sup>from households to firms and to</sup> capitalists through the quasi-rents on imports.<sup>Given that capitalists have a</sup> higher propensity to save, the result<sup>is a drop in the rate of interest and an</sup> incYease in investment expenditures.<sup>Of course, this expenditure switching</sup> phenomenon takes place because wage<sup>and price flexibility ensures that the</sup> economy is at full employment. Over<sup>time, the increased share of investment</sup> in GDP also leads to substantially faster<sup>growth.</sup> The overall effect on income distribution<sup>is mixed. The drop in</sup> household consumption contributes<sup>to a fall in agricultural prices and thus in</sup>
26

# Flgure 4

# Grouth and Poverty Under Alternative Adjustment Package

# AfrLcan Archetype

# Latin American Archetype

# Real CDP Index

<!-- Start of picture text --> i AG<br>"0 'I<br>2~~~~~~~~~~~~~~~~~~~~~~~<br>40~~~~~~~~~~~~~~~~~~~~~~~~~~~~~0<br><!-- End of picture text --> <!-- Start of picture text --> r-A/<br>'<br><!-- End of picture text -->

**304**

**'I,** O

*,",,,

33 <!-- Start of picture text --> ~~~~~~~~~~~~~~~~~~~~~~~~~~~~24<br><!-- End of picture text --> <!-- Start of picture text --> 3 4 4<br>-20 ° LAS * LAN ° LASR ^ LARE<br>.<br>LAS LAN LASR LARE~~~~~~~~~~~~~~~~~~~~~~~~II<br><!-- End of picture text --> <!-- Start of picture text --> s ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ 4 ~ ~~~~~~~~~~~~~<br>30 a AFS 'AFSR o AFRE a AFN -20<br>3,~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~1<br>211'~~~~~~~~~~~~~~~~~~~~~~~~~~~~~'<br>26~~~~~~~~~~~~~~~~~~~~~~~~~~~~2<br>26~~~~~~~~~~~~~~~~~~~~~~~~~~2<br>230<br>22 .<br>AFS AFSR AFRE AFN<br><!-- End of picture text -->
27 the real income of all rural groups,<sup>including poor rural workers and</sup> smallholders. Big farmers in the primary<sup>export sector also lose a</sup> substantial proportion of their income,<sup>however, because the real exchange</sup> rate does not fall as in the standard<sup>adjustment scenario. Since the Theil</sup> measure of inequality is very sensitive<sup>to changes at the top of the</sup> distribution, the overall result<sup>is a slight drop in inequality. Some other</sup> measures of inequality would indicate the<sup>opposite.</sup> While the preceding effects also<sup>operate in the Latin American</sup> archetype, resistance to real wage<sup>cuts and price rigidity in modern sectors</sup> prevent the preceding Kaldorian<sup>expenditure switching phenomenon. Because of</sup> price rigidities, import rationing<sup>results in a cut in real expenditures and a</sup> fall in economic activity. The<sup>rate of unemployment thus is much higher than</sup> in the standard adjustment package,<sup>with a consequent deterioration in poverty</sup> indicators. The outcome is that<sup>real GDP stands at the same level as in the</sup> base year at the end of the seven<sup>years simulation. At the same time, in</sup> spite of a lower real cost of servicing<sup>the external (and internal) debt, the</sup> overall fiscal situation is worse<sup>under this scenario because of forgone trade</sup> tax revenues caused by the refusal<sup>to devalue the real exchange rate. In sum</sup> the rationing adjustment scenario<sup>has strongly adverse effects on poverty.</sup> Compared with the rationing adjustment<sup>scenario, the two reform packages</sup> (AFSR and AFRE, LASR and LARE) yield<sup>relatively smaller effects of the shock</sup> precisely because the reforms are once-and-for-all measures introduced in period 2. Overall, with either reform package,<sup>the macroeconomic indicators</sup> are very close to the values achieved<sup>under the standard adjustment package,</sup> although there is a slightly larger<sup>fiscal deficit in the redistribution</sup> package at the end of the simulation.<sup>As can be seen in figure 3, the change</sup> in the poverty rate occurs in period 2,<sup>as soon as the reforms are</sup> implemented. Significantly, the redistributive effect achieved in the African archetype in period 2 is largely maintained<sup>throughout the entire simulation.</sup> Clearly if it is possible to carry out<sup>trade and tax reforms that improve</sup> allocative efficiency by equalizing incentives<sup>acrosa sectors, and to</sup>
28 implement revenue-neutral redistributive measures, poverty reduction is possible.

At a more general level, structural reforms will be largely unsuccessful when there are rigidities, as in Latin American archetype,<sup>that prevent</sup> adjustment in relative prices. Under those circumstances, reforms will not induce firms to work closer to full capacity. From the simulations with the African archetype where (effective) indirect taxes are relatively low and production structures are relatively rigid because of largely non-competitive imports, reforms have a negligible effect in the small modern sector. Hence efficiency gains are small. Of course, abolishing export taxes benefits the agricultural sector, reduces poverty and equalizes incomes but the expansionary effect on output is negligible because of diminishing returns<sup>in</sup> agriculture.

# 5. Conclusion

The question raised in the introduction to this paper was whether differences in economic and market structure, and levels of institutional development were important in the analysis of adjustment policies on poverty and income distribution. We asked whether these differences could result in identical adjustment policies applied in response to a common external shock having radically different, and even opposite, effects on poverty and income distribution. While such an outcome is not, in itself, surprising, differences in magnitudes and in the channels that account for these results were often found to be interesting and, at times, surprising. These results suggest a payoff to the careful modelling of relevant differences across countries in an economy-wide setting when analyzing the effects<sup>of adjustment</sup> policies on poverty and income distribution.

Several important differences emerged in the comparisons of different adjustment packages across the two archetype economies. As an illustration, we recall three results. The first is the result that in the standard adjustment package, inequality increased significantly for the<sup>Latin American</sup>
29 archetype, but decreased significantly for the African archetype. We traced these differences to two factors: 1) the ability of the rich<sup>to protect their</sup> financial assets through capital flight in the Latin American archetype; 2) flexibility in the African archetype which helps the poor as the real incomes of the rural areas are raised through higher export earnings induced by the real exchange rate depreciation. The second result, often stressed by structuralists, is that adjustment can lead to a sharp redistribution of income from groups with low marginal propensities to save towards groups with high marginal propensities to save. In the context of supply (rather than demand) constrained economies, such Kaldorian redistributive<sup>effects will tend</sup> to raise investment and growth which helps reduce poverty.<sup>The third result</sup> is that redistributive policies through trade and tax reforms that improve allocative efficiency by equalizing incentives across sectors,<sup>can reduce</sup> inequality significantly provided that governments are able to implement<sup>these</sup> revenue - neutral redistributive measures.

Other interesting contrasts were also discussed in the paper. These included the relatively small effects of reforms on growth and income distribution in both archetypes even though the reasons were<sup>found to be</sup> different between archetypes. Perhaps, most significantly we showed that our macro-micro model replicated broadly the stylized changes in<sup>macroeconomic</sup> indicator values during the eighties (lower growth, a fall in the investment share in GDP, a current account deterioration because of higher interest payments on the external debt and a surge in inflation in<sup>Latin America). In</sup> this context, wage and price rigidities built into<sup>the Latin American</sup> archetype resulted in a significant worsening of the distribution<sup>of income as</sup> a result of the external shock. On the other hand,<sup>wage and price flexibility</sup> built into the African archetype insulated the distribution of income from the external shock.