metadata: authors: 0: author: O'Connell,Stephen A.
docna: 0: docna: Uniform trade taxes, devaluation, and the
            real exchange rate : a theoretical analysis
docty: Policy Research Working Paper
subtopic: International Trade and Trade Rules,Employment and Unemployment,Macroeconomic Management,Social Conflict and Violence
teratopic: Environment
abstracts: cdata!: Theoretically, uniform trade taxes
            (uniform tariff-cum-subsidies, UTCSs) are equivalent in
            effect to devaluations of the commercial rate in a dual
            exchange rate system - if one disregards smuggling and
            customs fraud. When either form of illegal trade is factored
            in, this equivalence is broken, and the real exchange rate
            may actually appreciate in response to an increase in the
            uniform trade tax rate. When illegal trade takes the form of
            customs fraud, the rate for exportables will depreciate, but
            the rate for importables will appreciate.
repnme: repnme: Uniform trade taxes, devaluation, and the
            real exchange rate : a theoretical analysis
display_title: Uniform trade taxes, devaluation,
            and the real exchange rate : a theoretical analysis
listing_relative_url: /research/1989/04/693089/uniform-trade-taxes-devaluation-real-exchange-rate-theoretical-analysis
topicv3: Current Account m1326278 1135,Trade m1326924 698,Balance of Payments m1326965 441,Counterfeit Goods m1327550 2454,Unemployment m1504051 2747
publishtoextweb_dt: 2010-07-01T00:00:00Z
historic_topic: Environment
origu: Policy Plan & Prog Review Dept
no_of_pages: 55
author_keys: 0: author_key: 141960
model_extractions: The author of this paper analyzes the macroeconomics of uniform trade taxes - uniform tariff- cum-subsidies, or UTCSs by comparing UTCS policies as an alternative to devaluation of the exchange rate.

The model he sets up establishes a basic equivalence between UTCS schemes and devaluation of the commercial rate in a dual exchange rate system. This equivalence disappears when smuggling and customs fraud are incorporated into the model.

In the flexible price, full employment world of the model, a UTCS scheme can change the real exchange rate if either smuggling or customs fraud is going on. What is striking, however, is that when smuggling is factored in, using a UTCS to raise the relative domesdc price of traded goods may backfire and. actually appreciate the real exchange rate. If customs fraud is factored in, the real exchange rate will appreciate for importables but will depreciate for exportables.

The author suggests further extensions to his model for a reasonably full understanding of the macroeconomics of UTCS schemes. First, he would incorporate distortionary means of government finance into the analysis of illegal trade. One of the primary results of a UTCS scheme, when there is illegal trade, is to transfecr income from the public to the private sector. This revenue shock is likely to add to the welfare burden of the UTCS scheme, when the govenmment cannot levy lump-sum taxes.

Second, he would add investment to the model and investigate the relationship between investment response, the real exchange rate, and fiscal revenues under a UTCS when the govemment does not have lump-sum taxes. The taniff component of a UTCS satisfies the govemment's relative prce and revenue objectives simultaneously, but the export subsidy component brings out a conflict between the two objectives. The govermment may therefore have an incentive to renege on the export subsidy component of the package.

Finally, a parity change (devaluation) or a UTCS scheme could be used to alleviate transitional unemployment due to sticky nominal wages in the short run. The author suggests examining the tradeoffs between the direct contractionary effects of the two policies and their expansionary effect through the tradeables product wage.

This papz is a product of the Macroeconomic Adjustment and Growth Division, Country Economics Department, Copies are available free from the World Bank, 1818 H Street NW, Washington DC 20433. Please contact Aludia Oropesa, room _NI 1-055,_ extension 61758 (47 pages with charts).

The PPR Working Paper Series disseminates the findirgs **if** work under way in the Bank's Policy, Planning, and Research Complex. An objective of the series is to get these fmc.ng ; out quickly, even if presentationm are less than fully polished. The findings, interpretations, and conclusions in those pal _rs do not necessarily represent official policy of the Bank.

Produced at tfie PPR Dissemination Center
1

# Uniform Trade Taxes, Devaluation and the Real Exchange Rate A Theoretical Analysis

## Stqpen A. OConnell

## Table of Contents

||Introduction.......**.**.....................|1|
|---|---|---|
|1.|A Two-Period Model<br>......................|3|
||Govaenment<br>..........<br>|6<br>|
||PolicyAlmtives ..................... ..............<br>|12<br>|
||Permanent Policies .............................................|.....9|
||Temporary<br>Policies ............................................<br> <br>|<br>10<br>|
||Potential Importance<br>of Podolio Effects...............|12|
|2.|Nontraded<br>Goods and the Real Exchange Rate........|...14|
|3.|illegal Trade and UTCS Schemes, I: Smuggling<br>........|15|
||AModel of Smuggling<br>...................................<br> <br>|<br>18|
||Production<br>and Smuggling<br>...................................|<br>18|
||Consumption<br>and Taxes .20||
||Equilibrium<br>.....<br>.......................<br> <br>|21|
||Two Remarks<br>.24||
||Income Distrbution Effects .27||
|4.|Illegal Trade and UTCS Schemes, II: Fraudulent||
||Invoicing<br>.28||
||Importers<br>.....<br>..<br>...................|30|
||The Domestic Price of Importables<br>........................|. 33|
||The Domestic Price of Exportables<br>........................|. 35|
||Equilibrium<br>...................................|35|
|5.|Transitional<br>Unemployment<br>...................................|40|
||Caveats<br>...................................|42|
|6.|Conclusions<br>.<br>.....|43|
||Flgures<br>......|46|
||References<br>.<br>.50||
# introduction

The purposo of this paper Is to analyze **the** mcroeconomics of uniform trade **taxes** uwder capital nobility **and** currency convertlbllity. Since uniform tariff-cum-subsidy (UTCS) policits **are** often proposed **as** alternatives to devaluation of the exchange rate, we emphasize the comparison between these alternatives, as well as the intermediate came of a dual exchange rate system. We do the analysis in a two-period, representative consumr framwork, in order to bring out the iportance of the time path of the alternative policies. The nodl is idealixed In most respects, but should morv as a usoful benchmark for further analysis in more realistic settings.1 The paper is organized as follows. In Section 1, we set up a model based an Adas and Groenwood (1985), with exogenous output, lump-sum taxes, no gsvernomnt sponding, and perfect capital mobility. The model is aimed at 1 This paper was motivated by the UTCS scheme recently instituted in Cote d'Ivoire. Cote dlvoire is a member of the West African Monetary Union, a group of countries whose coion currency (the CFA franc) is freely convertible into French francs by agreemnt with the French Treasury, which guarantees convortibility by extonding overdraft privileges to the Union's Central Bank (see Krum (1985)). Increases in domestic inflation starting in the mid 1970s, together with the recent nominal appreciation of the French franc and significant nominal depreciations in neigboring Ghana and Nigeria, have produced roal appreciations in Cote dl'voire and a number of other CFA countries. This has led a number of authors (e.g., Krum (1987), * varajan and da Halo (1987)) to suggest that an optimal macroeconomic policy package would include a devaluation of the nominal exchange rate, if it were not for Cots d'Ivoire's responsibilities to the CPA Zone. The argument, and the rationale for the UTCS scheme that is currently in place in lieu of a parity change, is that sluggishness of domestic price adjustments is making adjustment to terms of trade shocks and lnternational borrowing shocks excossively contractionary. Initial experience with the UTCS has not boon encouraging, however; there is anecdotal evidence of widespread overinvoicing of Liports, and there **has** Leen late payment by the government of the export subsidy. The purpose of this paper is to provide a theoretical framework in which these **and** other macreoconosic aspects of UTCS schemes can be analyzed. **We** assume perfect capital mobility because the CFA countries have mintial capital controls regarding transfers with France, and therefore "import" the relatively free French regime regardlng capital account transactions.

1
distinguishing **the real balanc and real interest rate** effects of **the alternative policies, and forns the** basis for later sections. We show that in this model, a UTCS Is identical in all real respects to a devaluation of the conmerolal exchange rate in a dual exchane rate system. Both policies Impose capital losses on all existing financial wealth, both ehange tho real Interest rate only if they are anticipated to **be** temporary, and neither affects the domstic nominal lnterest rate.

Section 2 adds **a** nontrLded good to **the** wodel In order to study real xchangs rate effects. When prices are flexible, permanent changes in exchange rates ov uniform trade taxes feod directly through to the price of nontradeablos, _leaving_ the dosestic price of traded goods relative to nontradeds unaffected. Teporary policies, in contrast, affect **the** current real exchange rate by altering the real **Interest rate.** The results of Sections 1 and 2 establish a basic equivalence between UTCS schemes and devaluatlons of the coomercial rate in a dual exchange rate system. Sections 3 and 4 demonstrate that this equivalence is broken In the presence of illegal trade. We deemphasize monetary and intertemporal considerations here and analyz. a **simple** three-sector model augoented to incorporate illegal trade.

In Section 3, we model traditional smuggling as an activity using up domestic resources. We show that an increae in trade taxes drives down real income by drawing resources into smuggling, thereby producing negative supply and demand shocks in both the tradeables and the nontrad:ables sectors. The effect of this on the real exchange rate ic ambiguous; If the nontradeables sector has a relatively low income elasticity of demand or a relatively high cross-elastLeLty of supply with respect to the UTCS rate, a rise in the UTCS 2
rate will actually *Uoori-t **the** real **exchnge rate,** rather than achieving the desired deproeciatLon. Equivalenco with exchange rate changes is broken **as** long * prices are flexible, since a depreciation of the comercial rate does not alter the wedge _(if_ any) between international and dometic prices of traded goods and thus **does** not **increase** incentivex for illegal trade. Soction 4 deals with custoos fraud, which does not **use real** resources but affects the real ezchange rate through its effect on the relative price of tradod goods. We show that a rise in **the** UTCS rate **_raises_ the** tax/subsidyinclusive terms of trade, leading to a reallocation of resources towarLs exportables and a rise in the price of nontradeables relative to iuportables. Section 5 givoe a briof discussion of the role that devaluations and UTCS schemes can play in alleviating transitional unemployment after a contractionary economic shock. Section 6 concludes the paper.

1. A Two-Period Model As in Adams and Greenwood (1985), the reprosentative consumr maximizes

# - (1) U(.) U(c 1 ) + U(C2)

where ct is consumption of an imported good, ubject to the intertemporal budget constraint. Financial welth can bo hold in the form of domestic monty or interest-bearing foreign nominal bonds. Domestic noney is held to economize on transactions costs; if **real** income and money balances In terms of imports are Yt and at then transactions costs are v(mt/yt)yt, **where** v<sup>1</sup> s 0, v " > 0, and v e [0,11. A proportion v(.) of output is therefore lost due to 3
transactions costs.2 The government has four instrumens in period t: (1) the commercial exchange rate, St; (2) the financlal exchange rate, *t; (3) a uniform advalorea tariff/subsidy rats st applying to imports and exports; and (4) lump- **sun** tex.s, Tt. Th* privatt sector's budget constraint in period t-1,2 **reads**

**wtere** Pt - (l+St)EtPt and Pxt - (l+st)KtPxt are the domstic prices of the importable and exportable, Kt is **the** nominal money stock, Xt is **the economy's** endowment of **the** exportable good, it is **the foreign** nomlnal interest rate, and St ls **the** private sector's holding of forelgn nominal bonds.<sup>3</sup> Deflating by **the** before-tariff price of importables, EtP*t. and defining St ' (St-st)/et as-tNo percentage gap between **the** coimercial and finoncial exchange rates, the budget constraints in real terms for periods I and 2 **are**

(3i) **(l+s1)cl-** [l-v( (+s1)Y )1(1+s1)y V - 1 (-+g+) **a**

* m2 |a (3b) (l+s 2) 2 I [l-v((j+"2)3(l+s 2<sup>)y</sup> - 12 - a2 + (l+92)(1+W )

+ ,(l+r)b (1+62) 2 at is end-of-period real money balances.

3 We assume in (2) that there are no illegal transactions. See Sections 3 and 4 below.

4
**re** Yt - PxtXtt*t - (1+t)(P*t/P*t)Xt is **the real value** of output, ft bt are the **real values** of lump-am town **and** foreign bondholdings, s*t ( - - P*t.l)/P't l Is the foreign iuflatior rate, St - (It - t-l)/t-l is the rate of depreciation of the comercial excbh-e rate, and ao is the real value of initial fitaial vealth:

+ ei(l+i*)so (1+rl)bo (4) a-+ a. + (4) *0PI. l + (121i)(14+W) ( l+g) Notice that **we** have imposed the terminal conditlon 32 - 0 in writing (3b). Howevor, m2 > 0; money is still held at **the end** of period 2 inec transactions services during the period depend on end-of-period money **balances.** Equation (2) Implies that a unit of consumptlon invested in foreign bonds In period t-l yields (Pt.l/*t.-l)(l+it)(*t/Pt) units of consumption in perLod t. SubstitutLng for **the** domestic prlce of the iLportable using Pt - Et(l+st)P*t, **the** real consumption rate of interest is therefore given by (l+i)(l+st, 1<sup>)(l+Fgt.)</sup> __________ (5) l+rt - (l+*1t)(l 4 st)(l+gt) (-4s t)(l4-t) as one can conflrm by eliminating bl from equations (3a) and (3b). To get the socond equallty tn (5), we deflned growth **rates** 6 and 'y in **the trade** tax factor (l+s) and the relative **exchange** rate factor (1Fg): S
Consumption nd soney demands are characterized by equality In the budget constraints and **the** following three first-order conditions:

# - (6.) U'(cl) p(l+r2 )U (c2)

<!-- Start of picture text --> (6b) v (..h....) - 2 l<br>(6b) , (1+) (l+4*)(l_1<br>(6c) V#- 1.<br><!-- End of picture text --> Squations (6b) and (6c) yilld money demand functLons ql - h(i2)+sj)y avYd K2 k k.(l+s2)Y2, **whore** h' < 0 and k > 0. Velocity is constant in perLod 2 because **there In** no financial opportunity cost to holding money In that period; real balaces **are** Increased until **the** marginal saving in transactions cost In equal to one unit of foregone consumption. Although the domestic real Interest rate is sufficiont to determlne tho tilt* of privare consumption path by (6a), the privato soctor mUst know the time path of **taxes** (rl,T2) in order to determine its **overall** wealth and therefore the "level" of the consumption path. This leads us to an examination of the government budget.

**The** goverment faces two constraints In each period: the central bank

4 NotLce that (1+7t) - (l+tt)/(l+$t), whero It and & are the rates of depreciation of **the** co mrclal and finan-Lal exchange rate, respectlvely.

6
balanc sheot and the public finance constraInt. The central bank balance shoot states that *oney creation is the result of foreign exchange intervention or dbomstLc credit expansion. In nominal terms.

# (7)

# Kt w.vCt + ZtAFt,

where hFt is the aount of international **reserves** (foreign bonds) acqulred through **excbhng** market intervention and hDC is the change In domestic credit to the government.5 In real terms, the central bank balance sheot is given by (8) **Ut** -t mt/(l+tt)(l+ - **+** - -) ft,l/(l *) The government finance constraint states that the differenco between expendituro and revenue must bo made up by domestic credit creation and foreign borrowing. In nominal terms, (9) -wt Ot Tt -*t -rt - tLt (3Gt pt.1) + Et(BG where Gt and<sup>T</sup> t are govermuent consumptLon and lump-sum **taxs, respectively,** Ot is the value of central bank profits from exchange intervention, rt - StatPt[ct - (l-v(t))yt] **ic** the value of trade **taxes,** and Bi is foreign lending by the government.

_We_ **assum** that capittl gains and losses due to exchnge rate **changes Ar** not onatixzod. hus, if Ft.l is **the** initial value of foreign exchange holdings, the change in the domestic currency value of **reserves is** EtFt - St_lFt_l - AZtFt.l + ItAFt - hAt + AFt, where EKAt - AEtFtl **is the exchange** equalization account, entered **as** a liabilLty to offsot AEtFt-1 on the central bank's balance sheet.

7
The term te requires some explanation. When **the** central bani makes transactions **ac** more than one exchange rate, there will **generally** be a difference betw en the central bank's valu ation of foroLgn exchange acquired through lntervention and the amount of domeste curreney actually used in the _Latervention._ **We** denote by 9 the excess of the fore r over the latter. In period 1, for example, **9** is given by (10) * ( a * )IL*J - 2 -

**We** asoum in equation (9) that both * and Literest on the centrol bank's foreign exchange holding are transferred directly to the governmnt account and therefore reduee domsatLc credit requirements one-for-one - In real terus, and using the shorthand v(t) v(ut/(l+st)yt), the finane constraLit reads

(1l , - t , -t a [e- t.Ct (I-v(t))Ytl + r (bG, ftl _bG_ t b The terminal constraints facing the government are bg, f2 t 0. ImposLng these with equallty, and eliminating pt from (8) and (11), we have the following consolLdated government budget constraints for periods 1 and 2: (12a) - 8 1 -l s 1 [c-(lv(l))My 1 [a - g° I (f 1 + b - (<sup>+r</sup> 1 1<sup>)(fo</sup> + bo) 8
# (12b) t2 - **'2 *2** - 2<sup>[</sup> 2<sup>(l-v(l))ly</sup> 2 - Ul2 1

The interpretation of **these equations is** straightforward: lump-sum **taxes** pay for **goverM*nt expenditure and** accumulation of external assets by **the g@0erient** in each period, but consumers receive * rebate of central bank profits, trade taxes, seigniorage revenues, and interest on **the** net **external asets** of **the** goveruiment.6 The goverment' Laterteporal constraint can be derived by eltinrAting net official net foreign assets (b? + f1) from (12a) and (12b). Notice that **the** government always trades off consuwption in the two periods **at** the world real interest rate r. This **mons** that **when there** ic a variable 4=ul **exchange** rate sYsten or toeporary UTCS in place, **the** goverment and private sector face different real interest rates. Ricardian equivalonce therefore faLls in this situation. As we will see, this provides a chbnel for real effects of the varlous policies even in the absence of other frictions like sticky prices.

## Policy alternatives

**We** can now use equations (3) - (6) and (12) to study the differences between the various alternative policies. We consider permanent and temporary policies in turn, under the assumption that the policies are unanticipated but

6 One **can** substitute (11) into (3) to verify that the balance of **payments** identity holds period-by-period; for period 1, for example, we get ([l-v(l)Jyl - cl - g1 + (1+rt)(bo + fo)) + (bo - bl) - fl - fo, which states that the current account (the term in ()) plus the capital account (bo - bl) equals the change in reserves.

9
# that **perfect** foresight holds once **the** policieo **are** in **place.**

# Pormnent policies

Consider first an unantlcipated UTCS or chane in exchange rates that oc§urs **in** period 1 and In umderstood to be yormenwnt. Since no future trade **tax** or exchange **rate changes are** implied, both 62 **and 72 are zero** in equation (5). Permnent policies therefore have no effect on tho **real interest rate.** From (6a), this **mans** that any effect on current consumption levels onst operate through changes in the consumer's Initial wealth. To **see how the** wealth effects of the alternatives differ, rewrite **the** real value of initial financial wealth **as** follows: (13) (1+31) 13 w° __+sJ_ (l+6j],(l+*I _S_ mrl(l+s+ 1<sup>) (l</sup> ) + (lr (1+1) 1 where bo and so are real values of inltial money and foreign bond holdings. An across-the board devaluation (61 - 7l - 0 t > 0) **has** the familiar effect of imposing a capital loss on domestic currency holdings. Installation of a* dual exchange rate, with the financial rate .IgLr sZtad rolative to **the** unchanged commercial rate (61 - -0, 71 > 0) produces a capital loss for holders of foreign axsets but does not affect tho real value of wealth denominatod in domestic currency. A UTCS (kl - 1 - 0, 61 > 0) or devaluation of the commercial rate in a dual **system** _(61 -_ 01 - 71 > 0) **imposos an equal** percentage capital loss on *fl financial **wealth.** Since the capital losses above do not represent changes in the **economy's** trading opportunities with the rest of the world, and in the current model do not affect output (which is exogenous), they do not represent changes In 10
consumption possibilities for the economy **as** a whole. They will therefore have no effect on consumption levels **as** long **as** the private sector correctly foresees the accompanying **taxes** and faces **the sm** real interest **rate as the** public sector. Both of these conditions hold **here, the** first from perfect foresight, and the second from the fact that the policies **are** permanent. Effects on money demand, and therefore (given the path of domestic credit) on the balance of payments, vill depend on what happens to **the** nominal interest **rate.** Since interest parity holds, i 2 moves one-for-one with anticipated depreciation of the financial exchange rate. This means that permaAent policies have no effect on real money dmand, since they do not affect anticipations regarding changes in the financial exchange rate. Theme policies lover the real money supply on impact, however, thereby producing an ezcess demand for money and a corresponding balance of payments surplus. The rebuilding of money balances by **the** private sector happens instantly, however, and has no real effects given the frictionless environment and perfect capital mobility. To restore the initial lI-el of real money balances, the private sector simply sells foreign bonds to the central bank in return for domestic currency. These foreign exchange market interventions by the central bank change the istributfni of domestic holdings of foreign bonds, but not the overall amount held. Since **the** private sector internalizes the goverment budget constraint, the desired increase in liquidity is achieved with no loss in real wealth.<sup>7</sup> 7 The result that devaluations are neutral even in the short run under perfect capital nobility and Ricardian equivalence is due to Obstfeld (1981, 1986a). It is important for this neutrality result that central bank **reserves** earn interest, that prices are flexible, and that the prlvate sector has **the sme** planning horizon as the government.

11
# Temporary policie

Equation (5) sakes three things clear. Firxt, as long as tsere is some prospect that tariff/subsidy levels will change over time (i.e., *2 ' 0), a UTCS alters **the** real interest rate facing **the** private sector. A UTCS that is announced today but belioved to be temporary ('1 > 0 and *2 - 0, *° _62_ < 0) **makes** consumption today expensive relative to consumption in **the** future; if substitution effects dominate wealth effects, this rise in the real interest rate will **man an** improvemnt in the current account.

Second, a temporary UTCS is equivalent in its effects on the real interest rate to an anticipated change in the gap between **the** comercial and the financial exchange rates in a dual exchange rate system. This is apparent from the interchangeability of S and i in (5): any time pattern of wedges (gl.g2) between the co mercial and financial rate can be reproduced by a combination (51a92) of uniform trade **taxes.** A temporary UTCS therefore works just like an expected depreciation of the financial rate (with the comnercial rate fixed) or an xpected appreciation of the coiercial **rate** (with the financial rate held fixed).

Finally, a temporary UTCS and a variable dual exchange rate system are equivalent in their effect on the real interest rate to a subsidy to foreign lending. To **see** this, simply rewrite (5) **as** (l+r2) - (l+r1)(l162/(1+62)1)(1-172/(1+72)1); setting 72 - 0 (for example), a subsidy at rate s on principal and interest income from International londing has exactly the **same** effect on **the** real Interest **rate as** a temporary UTCS satisfying - 62/(1+62) - 8,9 8 The equivalence of a dual exchange rate systeo to a tax on principal and Interest on foreign bonds is eophasized by Adams and Greenwood (1985).

12
A temporary UTCS will thercfore tend to raise **the** real interest rate **and** produce a current account improvemnt (the opposite would occur if the tariff/subsidy level were expected to JZa). What about effects on **the** balance of payments? Again, by **interest** parity, **the** domestic nominal interest **rate** is governed by antieLpated novesents in the exchange rate applied to financial transactions. A UTCS will therofore have portfolio implications only if it changes expectations regarding future changes in **the** financial **exchange rate.** In **the** absence of such effects, **real** money demand will be unchanged, and the balance of payments improvement (given the path of nominal doinstic credit) will be identical to the improvement under a peranent UTCS. 10

# Potential **S** port **ac** of portfolio effects

The balance of payments effects of temporary and permanent UTCS policies depend crucially on how **these** policies affect oxpectations regarding **the** financial **exchange** rate. Although our model is too stylized to address this Issue formally, it **is** worth noting here that Important portfolio issues may arise if implementation of a UICS erves **as** a signal of an underlying balance of payments problem. The mechanism **is** simple: to the degree that the tax policy **raises** subjective probabilities of devaluation of **the** financial rate, (either alone or **as** pert of an across-the-board devaluation), it will raise 9 Note that the effect of S on the real interest rate can be circumvented by increaing the lag **between** delivery and payment for imports and exports. **A** UTCS, on the other hand, can only be circumvented by smuggling or faked invoicing (see Sections 3 and 4 below).

10 The **change** In the private capital account, however, will depend on how large a current account improvement is produced by the higher **real** interest rate; if the current account improves sufficiently, the private capital account may **even** improve, in contrat to the permanent UTCS case.

13
**the dosestic interest rate** and **cause a** portfolio shift away **from domestic** currency towards foreign bonds. If the interest elasticity of money dmnd is high enough _(in_ **the** current model, this depends on the curvature of v( )), **the** overall balance of payments may wvel deteriorate. If there is a limit on international borrowing by the central bank, it may be impossible (without other policy action) for the authorities to rule out an equilibrium in which implementation of **the** UTCS leads to self-fulfilling expectations of a balance of paymnt. crisis and devaluation of the financial rate.

2. ontreded goods and the ral exchange rate Suppose now that the economy receives an endowment ln each period of a second, nontraded consumption good. The real exchange rate is given by the price of **the** rntraded good relative to the price of the iportable: (14) qt nL Budget constraints **are** identical to before, except that current real consumption is now at - _4_ + qtcf and real Income at international prLeos is Yt - (P.t/Pt)Xt + qtNt where Nt is the endowment of the nontraded good. FLrst-order conditions are as given in (6), along with the conditions UNt - qtUrt characterizing the optimal within-period allocation of consumption (Ujt ls the partial derivative of **the** within-perLod utility function U(cN,cT) with respect to cj).

Consider usLng the three alternative policies (across-the-board devaluation, devaluation of the commercial rate relative to the financial rate In a dual system, or UTCS) to achieve a given depreciation In the real 14
**exchange rate** on Impact. As before, If **these** policies are regarded an permannt, there will be no effect on **the real rate** of **interest expressed** in terms of Imports. A variable UTCS, however, or an anticipated change in the **wedge** betweon **the** com_ercial and finncall rates N M **zhange** the rel **Interest rate.** As In **the earlier** case, an anticipated depreciation (appreciation) of the financial rate relative to **the** coercial rate or **an** anticipated decrese (increase) in **the** tariff/subsidy rate will raise the **real** intere,ut rate expressed in terms of imports. As * phasixed by Dornbusch (1983), what happens to the current account as a result of **these** pollcies will depend on what happens to the price of nontraded goods. An increase in the rate of appreciation of the _real_ **exchang** rate will tend to reduce the real consumption rate of interest and worsen **the** cui rnt account, while a fall in the rate of approciation will tend to Increase the reel interest rate and improve the current account.

3. llegal Trade and UTCS Schmens, I: Smugglin Any tax scheom sets up incentives for evasion. The possibility of evasion satters for at least three reasons: (1) evasion may **use** up real resources both in the attempt to evade and in enforcemnt; (2) successful evasion may alter the income distribution between the prlvate and public sector; (3) successful evasion may affent the relative prices facing **agents** at the margin, and thus underminr the resource allocation objectives of the original policy.<sup>1 1</sup> There **are** many possible forms that illegal transactions ight take, given the gcvernent interventions that we are studying. In **the** dual exchange rate 11 Note that (2) and (3) do not necessarily represent socLal costs.

15
systm, for exanple, although the budget constraints (2) **are** written under **the** assumption that foreign bonds can only be accumulated by first acquiring foreign exchange at the financLal rate from **the** central bank, It may be possible for iuporters or exportert to borrow and lend internationally at a different real intorest rate simply by Increasing the lag between shipment and paymAnt.<sup>12</sup> Moreover, the coexistence of two s*parate exchange rates In a dual 13 **system may even nct** up opportunitios for pure arbitrage.

With respect to trade taxes, **the** key casumption in equation (2) is that smaggling and customs fraud **are** ruled out. In this section and the next, we ask how the possibility of illogal transactions alters the conclusions of Sections 1 and 2. To focus on the impact of illegal trade, we do the analysis in flexible-price, full-employment models in which the various policies have no real effects In **the** absence of illegal trade. Our key result ls that the possibility of illegal trade breaks the equivalence we have been emphasizing **between** UTCS schemes and changes in **the** commercial exchange rate. When wages and prices are flexible, exchange rate changes may well have Dt impact on smuggling incentives; in contrast, the level of illegal trade is a nondecreasing function of the uniform trade tax/subsidy rate, and is strictly increasing above some minimum UTCS rate.

This lack of equivalence survives when prices or **wages** are sticky, as 12 Suppose, for example, that the financial rate were expected to appreciate relative to the commercial rate (7 < 1 in equation (5)). An exporter could avoid the implied lower real interest rate by retaining export earnings from period 1 abroad and repatriating them In period 2, with interest, at the comercial rate.

13 Suppose that unilateral transfers from abroad take place **at the** co mercial rate, and that the financial rate is appreciated relative to the co ercial rate. Individuals can then collect the difference between the two exchange rates by smuggling out exports and receiving payment in the form of an (apparently) unrelated unilateral transfer.

16
long **as the costs** of illegal activity are denominated in traded goods. Uhen costs are denominated partially in nontraded goods, however (as they would be, for example, if smuggling used domestic labor), price and wag, stickiness provides a channel through which a devaluation can affect the incentives for illegal trade. This restores a partial equivalenco between exchange rate changes and UTCS schmes. We show that equivalence is not complete, however, since a devaluation that achieves a given real depreciation on impact will have a smaller effect on muggling incentives than the corresponding uTCS schem.

Since intertemporal issues are secondary here, we look at one-period models of illegal trade. We also demphbasize monetary issues, since the existence of illegal trade does not add Important new monetary dimensions as long as completely free convertibility is maintained (as we will assumo). 1 4 The remainder of this section is devoted to a model of pure" sm"uggling ln which illegal trade is carried out wlthout the cloak of legal trad. In Section 4, we study a model of customs fraud, in hich legal and illegal trade are inextricably linked. The two sections together glve a fairly complete vLew of the effects of UTCS schemes and exchange rate changes ln the presence of illegal trade.1<sup>5</sup> 14 Pltt (1984) and Macedo (1987) analyze models in which tariffs and export taxes give rise to a black market. This does not occur as long as convertibility is maintained with "no questions asked' about the source or destination of foreign exchange obtained by private individuals.

15 In the classic bhagwati and Hansen (1973) analysis, the costs of illegal trade are independent of the magnitude of legal trade. Pitt (1981) pointed out that this assumption determines some key features of the resulting equilibrium. Our first nodel follows the classic Jhagwati and Hansen (1973) analysis in this rospect. The custems fraud model of Section 4 follows Pitt (1981) In giving a central role to the linkages between illegal and legal activity.

17
# A Model of **Sm%gglqng**

In the model of this section, **a** competitive smuggling Industry uses domestic rvsources to bring goods past the customs authorities. **We** follow Ihagwati and Hansen (1973) in assuming that illegal trade i a co plotely separate activity from legal trade. The key iuplication of this separation is that swuggling does not affect the domestic prices of traded goods **urless the** marginal costs of smuggling **are so** low that **legal trade** is driven out completely. This allows us to focus on the real resourco costs of illegal activity and on the income redistribution from the public to the private **sector.** The addition of smuggling **mans** that **there are** potentially five activities or sectors: production of the exportable and importable, production of **the** nontraded good, and suggling of **the** xportable and importable. Since **the** domestic relative prico of tradeablem is unaffected by smuggling, however, we can consolidate tradeables into a single composite good. This **leaves** us with three sectors: production of tradeables and nontradeables, and smuggling of tradea:los. Each sector uses domestic labor along with a sector-specific factor whose supply is fixed in the short run. Labor is perfectly mobilo between sectors, so there is a single economy-vide nominal wage.

Production and smuling Letting the subscripts T, N and a denote the traded, nontraded and s*uggling sectors, respectively, we will **assume** that **the** production functions Qj(Lj) have the properties Q(O) - 0, Q' > 0 and QU < 0. Qg is the number of units of traded goode s uggled into the economy. We are modeling smuggling as 18
simply another domestic activity operating under docreasing returns to scale. 16 The price received for a unit of smuggled goods Ls the wedge between the domestic aid the world price of **the** good; **as** long an sauggling ,ccurs under increasing marginal costs and legal trade is not driven out in equilibrium, **the** marginal source of supply of tradeables will be legal trode, and the domestic price will simply be the UTCS-inclusive world pricea17 ivt revenue from a unit of *uuggling is therefore **1(l+s)4** - XF*r - st4 18 If all activities are purely comptitive, labor will be allocated so to maifize net domestic revenue from the three activities. Denoting the maimized value of nat revenues by R, we have R - Max (U1+s)IQT + + +NQ laQO subject to LT + I L+ s L, where 4 and QT **are the Zoreign** price **and** domstic production of tradeables, Q5 is the quantity of tradeables smuggled into **the** country, and Lj is the quantity of labor **used** ln sector 3 **Since** R is homogeneous of degree one in all prices, **we** can **deflate** by **the** domestic price of tradeables, U(1+s)4, to gst real not revenue, r(lq,s/(l+s);L), where q - PN/(l+s)1 4 is tho real exchange rate. The revenue function r has **the** property that its partial derivatives **are** the 16 By assumLng that the smuggling activity uses domestLc resources, **we** are departing from the traditional approach ln which the costs of smuggling **are** denominated in traded goods (Bhagwati and Hamaen (1973), Pitt (1981), Martin and Panagariya (1984)). Our approach is equivalen **t** o Sheikh's (1974) assumptLon that smuggling requires a domestically produced nontraded good s input.

17 Since world prices of tradeables are fixed, this justifies our consolidation of imports and exports Into a single composite tradeablo good (it **is** also **essontial** for this that the UTCS schea itsolf has no direct effect on the relatlve price of tradeablos). 18 We **are** proceeding **as** if there were a dometic market for both tradeable goods. In this case, all the sauggler has to do is to get the good into **the** country. Uhen exportables **are** not consumed domestically, there is a separate probleu of collecting the subsidy, which requlres re-exporting the good. This cost would be included ln the form of Qs(La).

19
# supply functions for **the three sectors.**

# Consu ttom -nd taxes

Since illegal trade leaves the price of domestic tradeablos unaffected, expenditure on consumption is simply 2(1+*)P cT + _PNcN._ **We** denote the minisixed value of experditure for any utility level U by Z(Z(l+s)14,1P;U).1 9 Since Z is homogeneous of **degree** one in all prices, we can write the xpendituro function In terms of tradeables as Z/3(14s)P4 - t(l,q;U); the partial derivatives of c are the compensate **d** emand functions. The representative consumer has disposable income Y - R - T, here T Is lump-sum **taxes.** Although snuggling Is privately profitablo, it does not contribute to mocial disposable income. This is clear when we consider **the** goverment budget constraint. Assuming that the goverment's only role is to collect trade taxes and rebate them **as** lump-sun transfers to the conumer, we have T - a[EPx(Qx + Ks - Cx) - E* (cx - - HM)], where Xs, Qx. and ex are productlon, consumption, and smuggling of exports, all measured in term of the composite tradeable good (and similarly for **the** importable). This implies T - **sc P[QT** + Q. - cTJ, which can be further simplified by noticing that the balance of trade is zero (QT - cT). Deflating by the domestic price of tradeables, and noting that Qg - r3, we have r v [s/(1+s)lr 3<sup>: lump-sum taxes</sup> aro exactly equal to net revenues from illegal trade. 2 0 From the social point 19 We are ssuming the existence of a representative consumr, which requires that preferences be Identical and houothetic or that **there** be a benevolent govern cnt controlling the Income distribution through lump-sun taxes. 20 Notice that by homogeneity of degree 1 of i. the consumer's disposable Income,y, is given by y - r - r - rl + qrq + [s/(l+s)1r3 - [s/(14s)1r3 - rl + qrq. Only directly productive activitios contribute to social disposable income.

20
of view, snuggling is nothing more than a costly way of generating a rodistribution of income within the private **sector.**

# Iquilibril

The following two equations completely characterize equilibrium: (15) C(l,q;U) r(l **.** q. 2;L) - (l+)(+s) 3 (16) **a** (l,q;U) - (l,qo L) qq

**The** first of these states that the labor market clears, **the** economy is on its overall budget constraint, and the government budget constraint is satisfied; the second is the uark.t-clearing condition for nontraded goods. Equations (15) and (16) jointly determine q and U **as** functions of L and s (the third equilibrium condition, that the trade balance be zero, is implied by these two). Notice that the nominal exchange rate, S, does not appear in the equations. This means that changes in E have no real **effects** in this economy: any devaluatior is immediately oro&dd by an equiproportional rise in wages and the price of nontraded goods.<sup>21</sup> 1otice also that when r30, **i.e.,** when **the** smuggling activity is prohibitivAly costly, the modal reduces to the standard dependent economy model; in particular, g and U ar determined independenelv of A. In the absence of smuggling, therefore, a

21 This would be true under price flexibility and perfect capital mobility even if money and international lending were in the model (as in Section 1).

21
(pormanont) UTCS has no real effects, **as** in our previous analysis.22 **Whon** smuggling **iL** present, however, changes in a (in contrast to changes in 3) do **have real** effects. Totally differentiating (15) **end** (16), **we** get (17) ~c:)l3]~ [IqU] [qq[ qq (l+s) q3 ]3

**whore the** subscripts to c and r denote **partial derivatives, and where A** - Is/(l+)lrq3cqU + cu(rqq - eqq) > O.21 After **some algebra, we** got the following expression for **the** change **in the real** exchange **rate as a** result of changing the UTCS **level:**

**du (1+- )** 2 **A** (qUrl3 £lurq3)

(19) Consider first the change in overall welfare due to **the** UTCS **schew.** By convexity of the revenue functlon, **the** term in square brackoet in (19) is nonpositlve; this Implies that the entire exptession is negative, except at s - 0, where it is zero.<sup>2 4</sup> UTCS schmes are unamblguously welfare-worsening in 22 All UTCS policLes are permanent here since the economy lasts only a single period.

23 one can show that A - rqqelu - rqlcqU - cUcqq. which is unambiguously positive.

24 Under the assumption that the marginal product of labor in smuggling goes to infinity as Q. goes to zero, **one** can show that rjs - 0 for a - 0. An infinitesimal change in s starting at s - 0 therefore has no effect on U (or 22
this **model: any** finite **Increase** in **the** UTCS rate **In the** presence of **swaggling**

**draws** resources out of productive activities and **lowers** welfare..25

Consider next the **effect** of **a** change in the UTCS rate on **the** real exchange **rate.** By equation (18), q appreciates or **depreciates** according to whether eqU/1lU is less than or greater than rq3/r13 **(recall** that rij < 0). Defining the **income** elasticity of **demand** for good j as j and **the** cros0elasticity of supply In sector j with respect to [s/(l+s)j **as** ej3, **the** condition can be written in the form<sup>2 6</sup> (20) *gn I - agn **(!I** - **I)** ds C~T3 PT The effect on q is illustrated In Figure 1. where **the real** exchange **rate is** determined by equating relative demand to relative supply of nontradeables and tradeables. A rise In a drives up the economy-wLde **wage** and **draws** labor into **the** smugling activity. The effect on relative supply of nontradeable. and tradeables depends on the relative cross-elasticities of supply in these on q). For s > 0, rj5 is strictly less than zero.

25 A related question is whether the smuggling is itself welfareworsening, i.e., whether for a given UTCS rate welfare is **higher** or lower in the presence of smuggling. In this model, smuggling is unambiguously welfereworsening (as in Bhagwati and Hansen (1973) when legal trade is not fully displaced). The reason is that the UTCS scheme is itself not a distortion, so that the loss of productive resources due to smuggling occurs in an undistorted economy. Sheikh (1974) analyzed the tariff case in **a** nodel similar to ours and found that the elimination of smuggling might be imiserizing -- i.e., that welfare could be higher in the presence of smuggling. This possibility would clearly extend to any non-uniform (and therefore distorting) tariff-subsidy scheme.

26 The elasticities are given by p - cjuetUc and e - rj3[s/(l+s)I/rjj - N,T. In deriving (a0), we use e fact that in equilibrium, t q - rq and el - rl.

23
sectors with respect to a rise s/(l+s); at the original real exchange rate, this amounts to asking which sector has a larger elasticity of supply with respect to its own product wage. The RS curve shifts to the left if the supply response **is** higher In nontradeables, **and** to the right if the response is higher in tradeables. RS is unchanged if eq3/E13 - 1.

On the demand side, the movement of labor into smuggling produces a fall in disposable income. The effect of this on the RD curve depends on relative income elasticities. RD shifts to the right if Aq/0l < 1; in this case, a fall in income produces a shift in demand towards nontradeables. RD shifts to the left if nontradeables have the higher Income elasticity; if Pq - 1 (tho case of homothetic preferences), there is no effect on RD, A rise in a therefore has effects on both the supply and demand **sides.** It **Is** quite possible that the final result for the real exchange **rate** will be the oprosite of what **was** lntended. **WV** tend to get a real appreciation if (a) the -.....ome elasticity of demand for nontradeables is relatively low or (b) the cross-elasticity of supply of nontradeables with respect to the UTCS rate is relatively high In nontradeables as compared to tradeables.

# Two Remarks

Remark _1._ We have assumed that the marginal product of labor in the smuggling activity is infinite at Ls - 0. With this assumption, any finite s, regardless of how small, will call forth a movement of labor into the smuggling activity.<sup>27</sup> There are a number of cases, however, in which a small 27 It is not true, however, that an infinitesimal change in s will produce a flrst-order shift of labor into smtggling starting at a - 0. An infinitesimal rise in s starting at s - 0 will produce a first-order increase in smuggling services, Qs. but it will do so without drawing more than an infinitesimal amount of labor from productive sectors (and therefore without 24
UTCS may not provide sufficient incentives for smuggling. This would be true in our model, for example, if the marginal product of labor were (positive but) finite at Lx - 0, or if there were fixed costs to initiating the smuggling activity. In either of these cases, we would have r3 - r3j - 0 for * < i, i.e., a would have to reach some critical minimum level ; > 0 before there would be any snuggling response. One would also get no real effects 28 from a UTCS scheme in the short run if labor were immobile. Of course, even in the presence of fixed costs or a finite warginal product of labor **at** v - 0, a sufficiently large UTCS, or a rise in the level of * from a positive base level with smuggling, will produce a supply shift towards s*uugling.

Remark_2. The results in (18) and (19J establish **an** important asyeo-try between uniform trade **taxes and** exchange rate changes in the pr*sence of smu"gling: only trade taxes have real effects. This **asymmetry** becomes less clear when prices or wages are sticky, since then changes in the exchange rate are capable of altering the relative return to legal and illegal activities (provided that the costs of smuggling are not denominated completely in traded goods). For example, suplose that there is unemployment due to a sticky economy-wide nominal wage, but the nontradeables price is flexible, so **that** the nontradeds ma:ket always clears (i.e., we are on the border of the Keynesian and Classical unemployment regions in a disequilibrium framework). Total labor demand is Ld **<** L: affecting overall income or utility to first order).

28 With imobile labor, (18) and (19) no longer hold. One can see, however, what must happen in equilibrium; nominal wages in all sectors must adjust to maintain real product wages at their original levels, and the price of nontradeds must rise in direct proportion to the increase in tradeables prices. There are no real effects.

25
(20) Ld ( + LN(<sup>1</sup> + _Ls(E )_ < _L._ Now consider a rise in s or E that achieves a given increase in the domestic price of tradeables, PT - E(l+s)Pj on impact. Since these policies lower the product wage in the tradeablas mector by the same amount, they lead to the _smae_ increase in the demand for labor there. The JTCS, however, has **a** greater effect on overall labor demand mince .t lowers the product wages in the smuggling sector by a larger amount. Denoting the elasticity of labor demand in the snuggling sector by qT < 0, we have the following expressions for the change in employment in smuggling: The employment response **Is** therefore larger when the chang in traded goods prices is achieved through a UTCS than when it is achieved through devaluation. Both policies produce an increas, in employment and income, together with expenditure switching towards nontradeds, at the initial price of nontradeds. There will therefore be a rise in the price of nontradeds to clear that market, leading to a further increase in the demand for labor **as** the nontradeds product wage falls. The final increase in employment and rise in the price of nontradeds will be larger for the UTCS, however, given the 26
stronger Impact on employment in snagling. 29

# Income distribution effects

The final topic worth discussing in this iMple model iL the effect of smuggling on incom distribution. We have already noted that smuggling in this nodel is nothing more than a costly way of Influencing the inco c distribution within the private soctor. Since resources devoted to smugglLng **are** *Sply being used to engineer a transfer of trade tax revenuse from the public sector to mugglers -- a transfer that the private sector would hav received in any case, through **rebates** of **tax** revenues -- **there is** no net social benefit to offset the loss of resources. 30,31

**The assumption** of lump-sNm **taxes is** important in interpreting smuggling **as simply a** costly **way** of nflnuencing the Income distrLbution within the privat, sector. In a world with lump-sum **taxes,** the net revenue impact [s/(l+s)]r3 of the UTCS schoem is irrelevant, *Ince It can always be unravelled at zoro social cost by lump-mm taxes. In practic, however, the goverment may not have nondLitortionary tax instruments available, so that the income distribution kJtUg the private nd public sectors may matter. In

29 The overall welfare comparison of the two alternatives is unclear: the UTCS creates more employment, but it has more smugling and therefore a higher resource cost. 30 We noted earlier that illegal trade cannot deliver berefLts in terms of alleviating policy-induced distortions, since a UICS does not affect the relatlve prices of traded goods.

31 The argunmt that smuggllg **is** welfare-worsoning **relies** on the action of a benevolent govern et with **access** to lump-uam **taxes.** If this assumption **fails,** then lncome redistributions within the private sector or **between** the private and public sectors may affect welfare, *and it is no longer clear that the smuggling equilibrium li Parsto lnferior to the equilibrium without mugling.

27
**_this_** case **the adverse** impact of muggling on public sector revenues placo an additional welfare burden on the *conomy

There will also be additional effects on the real exchange rate and other variables in the **absence** of lump-sum taxes. Suppose, for example, that trade taxes are the only tax instruent available to the govermnnt. The government budget constr&int would then imply that either current government expenditure or (in a dynamic setting) future trdet tax rates or *xpenditure must beccue *ndogenous. Effects on tho real exchang rate and other variables will depend on where in the budget the required adjustmnt takes place. If current government expenditure bears the burden of adjusting to changes in current trade tax receipts, for example, there will be an additional effect on the real exchange rate depending on the relative consumption pattorns of the private and public sectors.32

# 4. Illegal Trade and UTCS Schemes II: Fraudulent Involcing

A channel for tariff avoidance that is important in a number of developing countries Is underinvoicLug of lmports. While the use of official referonce prices or specific tariffs would seem an easy solution to this problem, implementation of realistic reference price systems may be very costly for nonhomogeneous imports.33 In addition, solving the underinvoicing 32 In this case, if the government had a higher marginal propensity to spend on nontraded goods, an incroese in souggling would draw demand away from the nontraded goods sector and put downward pressure on the real exchange rate.

33 Cote d'Ivoire is a recent case of fraudulent Invoicing in response to trade taxes **(see** footnote 1). As an indication of the policy tradeoffe, it is worth notLig that **at** the time of introduction of the UTCS scheme, Cot. d'Ivoire was already gettlng rid of spocific tariffs due to their inefficiencies.

28
problm will Lncreaso the lnecetlv, for muglLng. What are the lipllcatLon of thLs form of illegal trade?

Although underinvoicing and smuggling are both responses tax-induced divergences **between** the int.rnatLoaal and domestic prices of traded goods, the analysis of **the** previous section does not carry over directly to the undcrinvoiLing **case. There are** two key **differences** in the structure of costs. FLrst, while lt **was reasonable** to thlnk of **smuggling as** using up **real** resources **(e.g.,** in utllizing inefficient transport routes), underinvoLeing sisply involves producing a fraudulont record of a transactlon. The private cost of thLs activity may lnclude brLbes to dishonest officials, or penalties (if the underinvoicng is discovered by an honest official), but lt **seems** appropriate to a first approximation to assum that the activity absorbs no real resources. The supply- and demand-side reallocations that we **emphasized** ln the previous section will therefore not play **a** role **bore. The second** dlfference **is** that it **soes** less natural in **the** underiuvoicLig case to think of legal and illegal trade as separate activities. In the suggling model, the aount of muggling could be determined Independently of the extent of legal trade, because smuggling costs were independent of **the** amount of legal trade. No such separation is possible in the customs fraud **case,** aineo individuals engaged ln customs fraud mst use (the appearance of) legal trade as a cover" for their illegal activity. This neans that in contrast to the earlier analysis, a competitiv **e** quilibrlum with underLnvoicLng will be characterized by what Pitt (1981) called "price dieparity": **the donestie** prieo of the imported (exported) good will fall 34 We **are** ignoring, **as** ln **the** previous section, the costs of enforcemnt. We also ignore bribes to foreLgners; unlike domestic brLbes, whiLch are simply transfers, these amount to social costs.

29
below (above) **the** full tariff-inclusive (subsidy-inclusive) price. **These relatlv,** price effects **are** ln fact **the** key channal through which customs fraud affects **the** real equilibrium.

We formlize **_these_** points below ln a veraion of. the static modl of **the** previous section. To keep things syLple, **we** abstract from smuggling and focus only on fraudulent involcing. Since the analysis for overinvoLcing of exports la syuwetric to that for undarinvoicing of imports, **we** do the full analysis only for **the** latter case.

For Liporter J, let us denote the amount of imports by Hj and tho degre of underinvoLiing by Aj, where (1 - Aj) is **the** ratio of the reported prlce to **the** true world prieo. By definition of Aj, **the** importer choosing N and Xi deprives the government of tariff revenue of e - SAJEP*Mj. In general, the (expected) cost of underinvoicLng should be **some** functlon of **the** three variables A, V and M. **Ue** choose the followLng simple form: C(A,WN) - p(A)(bW + *W), b,a k 0, p' > 0, p" 2 0. One possible literpretatLon, consLitent wLth liporters being rLsk-neutral, is that p(.) is the probabliLty of being "caught" (we require p(.) **6** [O,1 j and bM **+ aW is the** penalty condltional on being caught.<sup>3 5</sup> An iLporter who is caught therefore loses the illegally approprlated tarlff revenues W plus an addltlonal amount 35 In a smuggllng context, (1-Aj)/Aj can be lnterpreted **as** the ratio of illegal to legal iLports brought ln bsy Lmporter J. **The** smuggler in this **case** ts using legal trade **as** a 'cloakw tc avoid detectLon of smuggling. The analy ss here is therefore closely rAlated to that of Pitt (1981) and Martln and PanagarLya (1984) and Macedo (1987), who speclfy the probabilLty of detectlon of sauggling **as** a functlon of thLs ratio.

30
b* + (a-l)V that is proportional to the volume of affected importe36 Total expected proflt for importer j is given by

## (22)

I-pB *_ N - (I- A)sP * - p()(b)K + SW where PF is the domestic pric, of the Imported good. We *samu that individual importers **are** Small relative to the domestLi market end therefore take Ps as parametric.

Given NJ. the optimal choice of A satlfios the first-order condition

# (23) 1 - ap(A) s (ak 4 ,X,)P (A)

with equality if A > 0 (we can guaranteo A < 1 by assuming that p(l) - 1) For an interior cholce of A, (23) **requires** that the marglnal expected benefit of an increoe in A (which is an iucrease in profits with probability 1 - p(A)) equal the marginal expected cost (due to the increase ln p). Figure 2 shows the determination of A gIven a, b and s. **The** curve LL is the left hand side (lhs) of equation (22); RR is the rho. Ro31o is the rhs when bp (0)1s31* - 0. The diagram can be used to derive **the** followLng conclusions, whLch **we** will state and then dLscuss: Proposition **1** (Optimal underinvoicing) (1) A is a continuous YunctLon of a.

36 a, b, and the parmaeters of p(.) are presumably functlons of the government enforcement effort.

31
(11) lf b - 0 and > 0, A - > 0. **a** constant (this implies A/ds - 0).

_(ili)_ if bp'(O) > 0, A - 0 for **a** s **i, where** ; > 0. (iv) if bp'0O) > 0, dA/do > 0 for s x ; (v) **liA-_.** We now discuss (ii)-(v) in turn. Property (ii) **states** that if b Il zero, the optiml degree of underinvoicing **ts some** positive level **regardless** of the level of **s* A rise** In **a** increases **the** return to underinvoicing, but it also **lncreases the expcted** penalty by raising **a. Uhen** b - 0, these **effects cancel** out exactly, and there is no net effect on incontives for underinvoicing. Property (iLL) states that **whenever** bp'(O) exceeds zero, there will be **em** cutoff lovel of a (denoted i) such that **only** a UTCS above i will have n effect on unoerinvoicing incentives. A positive value for bp'(0) therefore **acts** like a fixed cost in the underinvoicing activity: **as** long **as** bp'(O) > 0, **a** mall UTCS will have no real effects. Property (iv) states that once the UTCS rate reaches its critical level a, ny further increases in s will raise the degree of underinvoicing. **The** degree of underinvoicing is therefore a monotonically increasing function of s for a : i. By property (i), this Increase happens smoothly, starting (by (1ii)) at A - 0.

Property (v) states that the degree of underinvoicing reaches an upper limit that is strictly below 1 as **s** goes to infinity. ThiL limit Is equal to the degree of underinvoicing that would prevail **(see** (il)) if b **were zero.** Before turning to the determination of Mj, it is worth noticing the relationship between A and the exchange rate. As Proposition 2 **states,** this 32
Ls *imply a matter of what happens to b/I as l changes: Proposition 2 (UnderinvoicLng and the Ixchange Rate) (i) if bp'(O) > 0 and a X i, dA/di > (C) 0 lff dlogb/dlogg C (>) 1.

(Li) if bp'(O) - 0, * < i, or dlog b/dlogl - 1, dA/dZ - 0.

The proposition states that **a** deprecLation will raise the optioal degree of underimnoicing only if (1) **s is at** least equal to its critical levl, and (2) the elasticity of b with respect to E _is_ **less** than one. **The** first of **these** conditions follows directly fron Proposition 1. The second cams from **the** first-order condition (23): a **chAnge** in E will **raise** A only if lt lowers b/sgP* The elast **city** condition **bere** is **simllar** to our result in the smuggling **case** that a depreclation had no effect on smuggling incentives if smuggling costs were **a** proportional loss of the *suggled shipment. The **asme** result arises here when b is denominated ln traded goods; rise in e would then lead to a proportional rise in b (elasticity - 1), with no change ln **the** optLmal degree of underinvoicing.

The Domestic **Price** of lmportables Given the optimal choice of A, it remains to solve for the jth iLporter's optimal scale, Nj, and the total supply of imports, IjMj. The first of **these is** solved by setting _BUj/OMj_ equal to zero, **and** the second by **Imposing the** *free entry' conditlon Ii - 0.

Since profLts **are** linear In N (cf. (22)), the importer will wish to expand or contract without bound unless the domestic price of **the** import 33
adjust. to brinS marginal coat and marginal revenu exactly into balance. Tho first-order conditLon BHJ/8Ej - 0 therefore determines the dometic price that must prevail lf i s to be posltive and finite in equLlibrium. Once this condltlon **is satisfied,** however, the importer iL indifferen **t** o **the s*ale** of **operations.** Entry **is therefore** no longer an **issue; the free** entry" condition Nj - 0 is automatically satlifLed when OUj/SMj - 0, and imports are demand determined.37 The domestic price level satisfying #Uj/%a - Nj - 0, which we call the **'break even price, Pb. is** given by: (24) p - 11 + (l-(l-ap(A))A)s + p(A)gpeJZP Since no underinvoicing is done if the **break-even prlce** is above **the** tarlff-inclusive price (1+s)EPm, **the** equilibrium **domestic price** will be **the** minimum of **the** two. This allows us to define **the** effective tariff rate, on, as the wedge between the international and domestic price of **the** importable: (25) _P;_ (1 _+ %)EP_ m m - Min[(l + s)EP* (l + (l-(l-ap(A))A) + _p(A)p*E_ p',~~~~~~~~~EP*) P It is **easy** to show that O < _n s_ a and that O < dtv/dss 1.38 The effective tariff is therefore between zero and **a,** and rises monotonically with s. It **is** everywhere a smooth, differentiable function of s.39 37 This gets us around the difficult problem of modellng entry and **exit.** 38 do./do - 1 - (1 **Ip(A))** 39 Differentiability is useful since lt implies that the expnditure and revenue functions **are** differentiable functions of s.

34
Figure 3 shows the effective tariff an as a function of a. When b Is uero, the effective tariff starts at sero and rises linearly with *, with slope 11 - (1 - sp(i))Is a (0,1). When b > 0, no underinvolcing occurs for a S i, **0o** an - a up to that point. At a - *, doWds - 1, but any further rise In a causes an to fall below s. As a gets large, the cost parmtor b becomes less end less important, and an approaches the value it would have had if b Vero z ro.40 Tbs Doesstic Pric of Uportables A siailar analysis applios on tho export side, where the incontive is to overinoice export good4 in order to collect a higher subsidy per unit. The equilibrium price of the exportable satisfies (26) P_ - (I + ay) **X** - Esxl(l + *)4ty,(1 + (l+(l-%p(A))s + p(A)-p1U **)** zpx UT~~~~~~~~~ Without loss of generality, have assumd in (26) that a and b **are** the **am as** - - they w*re n the import case (this implies that Ax(s) AM(s) and * 4) Figure 3 shows the effectiv **e** xport subsidy, whLch equals a for s S ; and then rises monotonically towards an asymptote of [1 **+** (1 - sp(A))Ia.

# Iquilibrium

In thhe smugling case, illegal trade did not affect the domestic relatiLv pricos of the traded goods as long as there was **some** legal trade in 40 It is interesting to notice that 8UWOA - 0 in equilibriuo. Increases in A do not get passed on to the domestic prlce because importers wN4t be compensated for the increasod expected costs associated with the higher degree of underinvoicing.

35
equilibrium. This made it **possible** for us to consolidate into **a** single traded good. This consolidation is impossible in the customs fraud **case, since** illegal invoicing in response to a UTCS leads to a rise in the domestic relative prLce of the exportable. To keep things **simple,** we return to the basic structure of Sections 1 and 2, with exports and nontraded goods produced and imports and nontradeds conumod. **We** will denote the offectiv e terms of trade resulting from a UTCS at rate a by _4x:_ pOx [(l- x)/(l um)Ix 2 _Px._ Slnce fraudulent invoicing does not use real resources, the production side of the model simply involves the allocation of labor between the two production sectors (exports and nontraded.). The value-added function R gives the maxiized value of output at domestic prices: R - Kax(E(l+ax)PQx _*+_ PNQN) st. LX + LN S L. Deflating by the domestic price of imports, we havo r(4,q;L). The demand slde is equally simple: asuoing that traders h-ve identical **preferences** to all other consumers, the minimimmu real expenditure **required** to reach utility level U is just e(l.q;U).

The economy-wide budgoet constraint is a bit more complicated then in the smuggling case, because we must keep track of net profits from fraudulent involcing. To incorporate invoicing profits, denote by xD and xx the actual, raMAIM& penaltios on traders engaged in Importing and exporting, respectively, measured in terms of imports at the domestic price.41 Replacing the expected penalty by the actual penalty in (22), realized profits are given by 4 - N - [(l+(l-A)s)/(l+8, jN - Xm and w - ((l+(l+A)s)/(l+ao)JpxX - 0 _sX-_ Xx Rearranging, we have 4 - (l+u*)'(e3 - s)M + wv - Xm and _4X_ - (1+vn)'s (- vx)PxX _+_ **wx** - _Xx_ where w and wx are the real amounts of underand over-invoicing, respectively. It follows that total realized profits from 41 The expected value of _EPCe._ is p(A)(bM + aZ).

36
> customs fraud **are** wr m (1+PM)'<sup>1</sup> ( - o) exX) where - v + wx and X - _XS_ **+** Xx **&re** th, total amounts of fraudulent invoicing and penalties, respectively, and **where** va have used **the** fact that **the** balance of trade, S - **IPxX** - I? **N,** is zero. Domestic expenditure therefore satisfies Z - R - Tr + jp*wr, where Tr **is the realized** value of not **lump-sum taxes.**

**The** governent budget constraint **states** that net **trade** subsidies **are** paid for by lump-sum taxes **and the** realized value of penalties: Tr - s(l+Ax)1P - _*(1 Am)RPe_ - p(Ax)(dX + Vx) - p(0 3 )(d( + Va). In real terms, vr - w - _X$_ **where we** have again used the fact that 3 - 0. In terms of its effect on income the amount v X can be thought of an a transfer to traders that is financed by lump-sum **taxes** on all consumers.

**V*** can now characterize equilibrium completoly using the following throe equations:

(27) &(l,q:U) - r(P,q;L) **+**

- (28) **cq** (lq;U) rq(x,q;L)

(29) _PX-_ ie _Px_ Equations (27)-(29) jointly determine q and U **as** functions of L, ***,** Px, and the penalty paramters b and a.

Uhat are **the general equilibrium effects** of **changes** in the UTCS **level?** ConsLder first the effect on welfare. The welfare results **are** in fact qualitatively identical to those of Section 3. Totally differentiating (27)(29), it **is** easy to show that dU/ds - 0 if **the** initial UTCS lovel **does** not 37
exceed **;.** It **the** UTCS rate **Ls** above **the** critical **level a,** however, **increases** in the UTCS rate are unambiguously welfare-woreening. Moreover, the illegal trade is itself welfare-worsening in the sense that for **a** given UTCS level, welfare is lower in the presence of customs fraud.

The result that illegal trade is unambiguously welfare-worsening is In contrast to Pitt (1981), who showed that illegal trade of the type analyzed here could be welfare-improving in the presence of a combination of tariffs and export taxes. As in tho Section 3, however, the explanation is that unlike any combLnation of tariffs and export **taxes,** or any non-uniform taxcum-aubsidy scheme, the UTCS by itself is not a distortion. Illegal trade therefore has no role to play ln alleviating the distorting effects of policy. In the customs fraud case, in fact, Illegal trade actually _introducas_ a diLtortion In tho form of an "inadvertento comercial policy. This explains why customs fraud is welfare-worsening ln the UTCS context even though the activLty does not absorb domestLc resources.

Now consider what happens to the real exchange rate. For simpliclty, consider the case where b - 0, so that ; - 0 and even a very small uTCS scheme will provide incentives for illegal trade. StartLng at **a** - 0, lncreases ln a raise ox more than one-for-one and an loss than one-for-one (Flgure 3). We therefore get a rLse in the effectlve terms of trade. The demand effects of this Inadvertent co mme rcial policy wash out when there is initlally no lllegal trade, and the overall effect on q is determined on the supply side. Slnce the effective terms of trade improvemnt produces a reellocation of domestic resources towards exportables, the supply of nontradeables falls and there must be a real appreciation ln terms uf importables: 38
(30) <!-- Start of picture text -->
- )dql(_d  ) ><br>ds s.,u.  r  ae  ds  de'~)>  ~<br>s-O,b-0qq  qq<br><!-- End of picture text -->

_Whlel_ the real exchange rate in terus of lmportabls, q, *ust **appreciate,** one can show that **the** prLco of the nontradeable does not rise by enough to fully offset **the** terms of trade improvemsnt. The real exchange rate in terms of exportables therefore depreciates.

**These** points are illustrated in Flgure 4, **where** we compare the UTCS (which Improves the effectiv terms of trade) with an exogenous improvemnt ln **tho terms** of trade. The initial equilLbrius iL at points 1 in the dLagram, where in quadrant I, £ - r at **the** initial reel exchange rate ql and utility leil U1 . Introduction of a UTCS schemo **does** not affect the external **terms** of trade, and therefore leaves the balanced trade locus (quadrant III, and the economy's consumption poseLbility locus (quadrant I), unchanged. **The** consumption point moves from 1 to 3, however, as the real exchange rate ln terms of importables apprecLates from ql to q3. The real exchange rate ln terms of exportables depreciates, naking possible the shift of resources out of nontradeables in quadrant II. Accounting for invoicLng profits and lump- **sum taxes,** real expenditure at the domestic price of lmportables is C3 - r3 + sr - wrr Small changes in q cause no change in welfaro, by the Envelop theorem.

It is instructlve to compare the UTCS equilibriums with what happens when the **sme** effectlve trms of trade improvement occurs as a result of an exogenous change in the external terms of trade. In this case, the balance trade locus rotates downward, and the consumption possibillties locus shifts out, reflectLng the economy's lncreased comand over imports. As long **as** both 39
goods **are** normal, **the real** exchange **rate** in terms of Lportables maSt appreciate; what happens to **the real** exchange rate In terms of exportables 42 depends on incom and substitution effects. Utility is higher at U2, even for a small change in **the** terms of trade.

S. Trmitional Unsploymnt Up to this point, we have done our analysis in flexible-price, fullemployment models in which purely nominal changes like devaluations had no real effects. While models of this type help bring out the analytical issues, they **are** Incauplote for some policy purposes. In partLcular, there is no **sense** in which the exchange rate (real or nominal) is ever "overvaluedm in this kind of model. There is therefore no reason for polLeymakers to want to **change the** parLty or alter the price of tradbd goods in any other way. In rias s*ction, **we** extend the comparison of devaluations and UTCS schemes to one Important caso in which the nominal exchange rate li overvalued in a welldefined sense before the policy chcnge.

**We** focus on a world in which the price of nontradeables is floxible, but the nominal wage is fixed in period 1 as a result of explicit or implicit wage 43 bargaining. With **a** given world price of tradeables, fixlty of the nominal

42 See Gavin (1988). If the income effect dominates, consumption of the nontraded rises, and the real exchange rate in terms of exportables mst depreciate. If the substitution effect dominates, consumptLon and production of the nontradbable fall, and the real exchange rate in terms of exportables appreciates. 43 **This** could be due to nominal contracts or to unwillinnoss of workers to accopt the fall in their real wages relative to other workers implied by a nominal **wage** cut. Efficiency wages are another possible source of uneployment, but **these** constitute a real, rather than nominal wage stLekLness, and It Is not clear that efficiency wages would adjust under prossure of unemployment **(as** would seem likely in the first two **cexs).** 40
wage meamn fixity of **the** product wage in tradeabls. This has two important implications. First, for **given** sottings of the nominal exchange **rate** and taxes, the tradeables soctor will have a fixed demand for labor and will therefore be unable to absorb changes in labor demand in the nontradeables sector. The labor market therefore need not clear in the short run. In particular, a contractionary e;hock that drives down **the** price of nontradeables will lead to a rise in unemployment.

Second, with w and AT fixed in the short run, the tradeables product wage becomes a policy variable: policymakers can Shoose the short-run demand for labor in tradeables by setting **the** level of the exchange rate and/or trade taxes. These polLcies may therefore play **a** role in maintaining full employmnot in the face of contractionary shocks.

Figure 5 illustrates this role for parity changes or UTCS **schmes. The** initial equilibrium is at points , vith **a** current account deflcit of b > 0 and real exchange rate qo. Now suppose that the country is cut off from foreign borrowing, so that it must reduce its current account to zero in the current period (b - 0). This borrowing limit acts like a rise in the international interest rate, depressing domand for current consumption. The price of nontraded goods must fall, leading to a fall in labor demand in nontrad4ables at the initial nominal wage. With flexible wages, the nominal wage would fall, and labor would be reabsorbed in the tradeables sector **as** the product wage there fell. Equilibrium would be at point 2, with a rLse in the nontradeables product **wage, a** fall In the tradeables product **wage,** and a depreciation of the real exchange rate (to ql < qo).

With fixed nominal wages, however, the short-run equilibrium is at a poitnt like 3, with uneployment. Labor released from the nontradeables sector 41
cam¢ot be reabsorbed in the tradeablss **sector, since the** coublnation of **a** fixed world prlce and **flxed** nominal wages prevents **the** product wag. from falling." The role for a parity **change** or UTCS is clear: *ither pollcy can be used to reduce **the** tradeableo product wage directly and (in **the absence** of illegal trade 45 ) achieve the optimal allocation at point 2.

# Cavts

WLth flexible goods prices, perfect capital mobility and forward-lookLng consumers, a devaluation or UTCS **Is** unambiguously expansionary from an Initial posLtion of unemployment. If any of **these** assumptions fail, however, **a** devaluation **may** have contractionary effects in the short run that offset the bensfits from falling product **wages** in the tradeables sector. Figure 5 may therefore give an overly optimistic picture of the role of a permanent parity chang or UTCS as a device for alleviating transitional unemployment. 46 A Assuming homotheticity of preferences, the equilibrium must fall somewhere between points I and 4. Notice that whle one can **say** that the nominal exchange rate ib overvalued at point 3 (given trade taxes), the real **exchange** rate, q, has adjusted fully to the fall in demand for nontradeables, and **say** not **be *misaligned" at all relative** to its full employment equLlibrium level (i.e., the equilibrlum may be at point 4). **This shws** that when there Lo unemployment due to sticky wages, the familiar prlce-index **based real** exchange rates may give a misleading indication of Incentives for resource allocation.

4.5 In the presence of smuggling or customs fraud, our analysis of Soctions 3 and 4 indicates that the UTCS is second-best, since it will lead to **some** combination of a wastage of resources and an unintended commercial policy.

46 There are other reasons why Figure 4 may be overly optimistic. As Buiter (1988) points out, the impact of a devaluation on resource allocation depends a great deal on the &QQ of underlying wage (or price) rigidities. If real **wages** were sticky due to lndexation, for exmple, then the ability of the authorities to reduce the product wage in tradeables would be limited by **the** implied reduction in the real **wage** index. If workers consumed only tradeables, for example, the authorities might find It Lmpossible to ralse the price of tradeables wLthout causing an offsetting rLse in the economy-wide 42
On the demand side, a major potentially contractionary influence of a devaluation is its *ffect on **the** real value of wealth denominated in domeatic currency. As we eWphasidzd in Section 2 below, UTCS scheme (or devaluations of the coo ercial rte lin a dual rate **system)** have **oven** larger potential real balance effects since they reduce the real value of A1U financial wealth on impact, regardless of currency of dnonmination. On the supply side, devaluations exert contractionary **pressure** by raising the price of imported intermediate goods.

Since these contractionary effects are particularly important in **the** short run (see, e.g., Obstfeld (1966)), they are serious potential liabilities for a policy designed to reduce transitional unemploymnt. At **the least, the** existence of **these** effects liplies that **the** adjustment path under a devaluation or UTCS **may** not be sonotonically superior over time to th* adjustment path ln the absenco of such a pollcy.

# **6.** Conclusions

This paper has examined the similarities and dlfferences between unifom trade **taxes** and exchange rate changes in **a** representative consumer setting. We reached the following concluaions, In the absence of illegal trade and under perfect capital mobility: (1) A UTCS is equivalent in all real respects to a devaluation of the coimercial exchange rate in a dual rate system. (2) In terms of theIr effect on the real value of liitial wealth, both policies mentioned in (1) are more contractionary than an across-the-board noinal wage.

43
devaluation or a rovuluation of the financial rate in a dual rate system, snec the lattor alternatives only affect wealth denominated in domestlc currency.

(3) In terus of effects on the real interest rate, a temporary UTCS is identLeal to a variable dual exchange rate regime, where only movoemnts in the gap between the comercial and financial rates matter. Antieipated **_across-_** the-board exchange rate sovements, in contrast, do not affect incentlves for intertemporal trade.

(4) UTCS policies do not affect the opportunity cost of domestic currency, end therefore have no portfolio implications, unless they chang. expectations regardLng the exchange rate applied to financial transactions.

It is not surprLsing that when the posslbility of illegal trade is taken lnto account, the equivalence between uniform trade taxes and exchange rate changes is broken. go examined both smuggling and customs fraud in a oneperiod, three-sector nodel in which devaluations had no real effects when trade taxes were zero, and showed that with both types of illogal trade, introduction of a UTCS schemo wa capable of changing the real exchange rate. It ls strikLig, however, that in tho muggling case, using a UTCS to raise the domestlc relative price of traded goods say backfilre and end up actually mni.ezlzag the real exchange rate In terms of importables. In the customs fraud **case,** the we get an appreclatlon of the real exchange rate in terms of lportables, but the real exchange rate in torm of cxportables will depreciate.

Three extensions of this paper **are** important before we have a reasonably full understandLng of the macroeconomLis of UTCS schemes. The fLrst is to 44
Incorporate distortionary **wmeai** of goverrdnt financo into the illogal trade analysis. Sections 3 and 4 emphasisz that one of the priLary results of a UTCS scheme Ln **the** presence of Illegal trade is a trans&*r of Lncomo from the publlc to the private sector. This revenue shock is likely to add to **the** welfare burden of the UTCS **scheoe** in the absence of lump-sum taxes.

The second extension is to add lnvestmont to the model and investiate tho relationship between investment response, the rel exchange rat., and fiscal rovenues under a UTCS whon the government does not have lump-sun **taxes.** The key Issue here is that while the tariff component of a UTCS satisfies both the relative price end the revenue objectives of **the** governuent simultaneously, the export subsidy component bringa out a confliet betweon **these** two objectives. The goverment may therefore have an incentive to reneg on the export subsidy component of the package. Finally, our assuuption of price and wage floxibllity severely limits the **real** balance and relative price effects that are the traditional channels for **real** effects of devaluations and UTCS schmes. **We** indicated ln Section 5 how a parity change or UTCS could bo used to alleviate a tranaLtional unamploymentO problem due to sticky nominal wages in the short run. It would **be** useful to work through this mnalysis in detail in a two-sector production version of the intertemporal model of Section 2. This wrvrld make it possible to examine **the** tradooffs between **the** direct contractionary effects of the alternative polleL s and their expansionary effect through the tradeables product wage.

45
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**Adams,** Charles **and Jeremy Oreenwood** (1985), 'Dual **Exchange Rate System and** Capital Controls: An Instigation,' Journal oi18 43-63.

**Shagwati,** J&gdish and Sent Hansen (1973), **'A** Theoretical Analysis of Smuggling,' Omst.ly Jounal2 o Eonomi, & may, reprinted in **Shagwati, ad.** (1974), Illegal Trstions in 04tLanal TrAde (Amterdam, NorthHolland).

uilter, Will.s (1988), "Some Thoughts en **the** Role of Fiscal Policy In Stabilization and Structural Adjustment in Developing Countries," *lmo. Devaraj an, Shantayanan and Jaim de Melo (1987), "Adjustment With a Fixed Exchang Rate: Camroon, Coto d'Ivoire, and Senegal," World Bank EcoLi Rtviex 1, 1o. 3: 47-487.

Dornbusch, Rudiger (1983), **"Real Interest Rates,** Home Goods, and Optimal External Borrowing,' JoU=r allo PoliticLal egon 91, No. 1, February: 141153.

Gavin, Michael (1988), -Structural Adjustmen **t** o a Terms of **Trade** Dicturbanco: **The** Real Exchange **Rate,** Stock **Prices** and the Current Account,' mlmeo, Coluwbia **UnLversity.** Krui, Kathie (1987), -Adjustment in the Franc Zone: Focus on **the Real** Exchange nate,' World Sank, CPD DiLcussion Paper No. 1987-7, April.

- ----------- (1985), 'Adjustment Policies in the Ivory Coast in **the** Fromwork of UMOA,' World Bank, CPD DiscuseLon Paper No. 1985-6, January.

Macedo, Jorge Braga de (1987), 'Curreacy Inconvertibility, **Trade** Taxes and Smuggling,' Journal of International Economic 27: 109-125. MartLn, Lawrence and Arvlnd Panagariya (1984), 'Smuggling, Trade, and Prieo Dlsparity: A Crime-Theorotic Approach,' Journal of Interainl Z&onomic 17: 201-217. Obstfeld, Maurice (1986a), 'Capital Controls, the Dual **Exchange** Rate, **and** Devaluation," Journal gf International Economics Vol. 20: 1-20.

--- -- (1986b), 'Capital Flown, the Current Account, and **the Real** Exchange Rate: Some Consequencos of Liboralization and Stabilization,' in Edwards and Ahmed, *ds, Economic dustmnt d Ercanga **Rates** in D oIg f&mz=;aa (Chicago, University of Chicago Press). ......----..----- (1981), 'Capital Mobility and Devaluation in an Optimizing Model With Rational Expectations,' rican Economic Review, Papers _nd 1r;J.gdUnga Vol. 71: 217-221.

46
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