metadata: authors: 0: author: De Melo,Jaime A. P.
count: World
docna: 0: docna: CGE models for the analysis of trade policy
            in developing countries
docty: Policy Research Working Paper
subtopic: Trade Policy,International Trade and Trade Rules,Rules of Origin,Inflation,Macroeconomic Management,Trade and Multilateral Issues
teratopic: International Economics and Trade,Environment
abstracts: cdata!: The use of computable general
            equilibrium (CGE) simulation models for policy analysis has
            become widespread. However, such techniques are not well
            suited to economywide analysis in developing countries.
            Instead, simulation models relying on "borrowed"
            parameter estimates have been used for a wider range of
            applications in developing countries. This survey begins
            with a presentation of the core structure of simulation
            models for trade policy analysis. It shows that a few share
            parameters and elasticities, leading to a fourway sectoral
            classification: exportables, importables, nontradables, and
            import-dependent sectors. The rest of the survey deals with
            a range of applications relating to trade policy, internal
            and external balances, and intertemporal issues. These
            economywide simulation models are good tools for quantifying
            the tradeoffs in policy packages that the Bank discusses
            with its clients. Future modeling exercises would
            nevertheless benefit from direct econometric estimates
            rather than "borrowed" parameter estimates.
repnme: repnme: CGE models for the analysis of trade policy
            in developing countries
display_title: CGE models for the analysis of trade
            policy in developing countries
listing_relative_url: /research/1988/07/19875734/cge-models-analysis-trade-policy-developing-countries
topicv3: Current Account m1326278 1135,Inflation m1326709 0870F4727ACED1CF8525815C00471347,Trade m1326924 698,Trade Policy and Integration m1327407 775,Trade Policy m1327640 776
publishtoextweb_dt: 2014-07-22T00:00:00Z
historic_topic: International Economics and Trade,Environment
no_of_pages: 55
author_keys: 0: author_key: 91075
model_extractions: Polley, Planning, and Research

## Trade Polley

The use of computable general equilibrium (CGE) simulation models for policy analysis has become widespread. In the industrial countries they have generally had a microeconomic focus because economywide policy analysis can rely instead on econometric techniques. But such techniques are not well suited to economywide analysis in developing countries, for three reasons: (1) the lack of time series data, (2) the need to remove inconsistencies from data that are available, and (3) the short time that big changes in policy leave for testing hypothesis. So, simulation models relying.on "borrowed" parameter estimates have been used for a wider range of applications in developing countries.

This survey starts with a presentation of the core structure of simulation models for trade policy analysis. It shows that a few share parameters and elasticities, leading to a fourway sectoral classification: exportables, importabies, nontradables, and import-dependent sectors. The rest of the survey deals with a range of applications derived from this core model.

Applications to trade policy Three of the models are modifications of static one-period models: • _Modell._ Measuring the costs of protection in a regime of quantitative restrictions characterized by rent-seeking.

• _Model2._ Measuring the costs of protection when there are economies of scale in some sectors and a restrictive trade policy impedes entry by new firms and allows incumbents to price above average cost • _Model3._ Designing optimal trade policies when budgetary revenue is constrained and fiscal authorities cannot resort to direct taxation because of a weak fiscal system.

# . Applications to internal and external balances

Three others are modifications of dynamic models that treat intertemporallinkages recursively: • _Model4._ Decomposing the causes of a balance-of-payments crisis and comparing the results with purchasing power parity calculations. . .

• _ModelS._ Determining what an exchange rate in temporary disequilibrium means for the current account.

• _Model6._ Determining what alternative foreign trade strategies might mean for long-run growth.

Applications to intertemporal issues 'The seventh model is a modification that goes beyond intertemporally decomposable growth paths to show the determinants of intertemporal substitution in a two-period, two-sector dependent economy.

• _Model_ 7. Determining the optimal borrowing strategy for a country that faces external borrowing constraints linked to its fiscal position.

These economywide simulation models arc good tools for quantifying the tradeoffs in policy packages that the Bank discusses with its clients. Future modeling exercises would nevertheless benefit from direct econometric estimates rather than "borrowed" parameter estimates.

This paper is a product of the Trade Policy Division, Country Economics Department. For copies contact Carmen Hambidge, room NS-069, extension 61539.

The PPR Working Paper Series disseminates the findings of work under way in the Bank's Policy, Planning, and Research Complex. An objective of the series is 10 get these findings out quickly, even if presentations are less than fully polished. The fmdings, interpretations, and conclusions in these papers do not necessarily represent official policy of the Bank.
CGE MODELS FOR THE ANALYSIS OF TRADE POLICY IN DEVELOPING COUNTRIES .. ...

# Jaime de Melo (*)

# Table of Contents

|1.|**Intro**|**duction••••••••••••••••••••••••••••••••••••••••••••••••••••**|1|
|---|---|---|---|
|2.|**AOne**|**SectorModel••••••••••••••••••••••••••••••••••••••••••••••**|3|
|3.|TheD|omesticPriceSysteminMulti-SectorModels••••••••••••••••|8|
|4.|Appli|cationstoTradePolicY••••••••••••••••••••••••••••••••••••|11|
||4.1|The WelfareCostsofQRaand Rent-SeekingActivities•••••|11|
||4.2|InteractionsBetweenQRForeignTrade Regimes<br>andIndustrialOrganization••••••••••••••••••••••••••••••|16|
||4.3.|Optimal TradePolicyinthePresenceofa<br>Government Revenue .Constraint••••••••••••••••••••••••••••|20|
|_s._|Appli|cationstoInternal-ExternalBalance and Growth••••••••••••|23|
||5.1.|CausesofTurkey'sForeignExchangeCrisisin1977•••••••|27|
||5.2.|AbsorptionUnder aDisequilibriumReal ExchangeRate:<br>**Chile1977-81••••••••••••••••••••••••••••••••••••••••••••**|30|
||5.3.|SimulatingAlternativeDevelopmentStrategies••••••••••••|33|
|6.|Appli|cationstoIntertemporalIssues••••••••••~•••••••••••••••••|35|
||6.1.|OptimalForeignBorrowingStrategies:<br>A Case Study<br>ofThailand(1985-92)••••••••••••••••••••••••••••••••••••|38|
|7.|**Concl**|**usions•••••••••••••••••••••••••••••••••••••••••••••••••••••**|42|
||**Footn**|**otes**••••••••••••••••••••••••••••••••••••••••••••••••••••••|43|
||**Refer**|**ences**•••••••••••••••••••••••••••••••••••••••••••••••••••••|**47**|
|||Tables||
|Table|1:|AOneSectorSmall-CountryModelwith<br>DifferentiatedTrade•••••••••••••••••••••••••~••••••••••|_5_|
|Table|2:|WelfareBenefitsfrom Removing QuotasinTurkey•••••••••|15|
|Table|3:|A ComparisonoftheWelfareCostsofRationing<br>underAlternativeMarketStructures•••••••••••••••••••••|19|
|Table|4:|TariffRates••••••••••••••••••••••••••••••••••••••••••••|22|
|Table|5:|AOneSectorSmall-Country GrowthModel•••••••••••••••••|24|

- (*) An earlier version was present at the International Symposium on the Social Accounting M&trix Methods and Applications, June 17 - 19, 1987. I thank Bela Balassa and Sherman Robinson for comments and Jackson ·Hagargee and Julie Stanton for much appreciated support. The views are those of the author not those of the World Bank •

. -· . ., ' .
• ..

• '

# Tables (continued)

|Table_6:_|FactorsContributingtotheChangeinthe||
|---|---|---|
||EqutlibriuaReal Exchange Ratein1977••••••••••••••••••|29|
|Table7:|RepresentativeTradeStrategiesand||
||MacroeconomicIndicators••••••••••••••••••••••••••••••••|34|

||Figures||
|---|---|---|
|Ptpre1:|AOneSectorPull-Employment Hodel••••••••••••••••••••••|7|
|rtaure2:|WelfareCostofRationingandlentSeeking••••••••••••••|14|
|Ptpre3:|Internal-External.BalanceaDdGrowth••••••••••••••••••••|25|
|Pipre4:|ModelPredictedTradeoff•froaLover<br>**CapitalInflowa**•••••••••••••••••••••••••••••••••••••••••|32|
|Pipre_S:_|LoverTariffBates••••••••••••••••••••••••••••••••••••••|40|
.. .. · • eo_,utable Geaeral lqu1libri .. Models for Trade Policy Allalyaia in De~elopiag Countries: A Saney

# 1. Introduction

• · The use of computable general equilibrium (CGE) models for policy analysis has become widespread for both developed and developing economies. Por developed economies, with a few notable exceptions, applications have had a .tcroeconomic focus with the analysis concentrating on the estimation of the welfare impact of alternative tax structures or energy policies. _JJ_ In de•elopina countries, CGE models have been used for a wider range of issues, r&llliaa froa JHdiua- to lonr-tera ucroeconomic policy. analysis to the more traditional .tcroeconomic issues analyzed in developed countries as well. _lJ_ There are a nuaber of reasons for this wider range of applications, including the fact that notwithstanding the use of econometric models in the framework of LlNl, developing countries are usually not well suited for economywide policy analysis relying on econometric techniques. This is so for several reasons. Firat, and foremost, reliable time-series data for sufficiently long ct .. periods are usually not readily available. Second, when available, the data are often not appropriate for standard econometric analysis without considerable further preparation to remove inconsistencies. Last but not least, sigaificant changes in policy regimes often take place calling for different structural models, thereby reducing the time span available for hypothesis testing with a selected model.

CG! models have found much use for mediu.- to long-term policy analysis in developing countries. The policy applications have ranged from lona-run issues like the the impact of alternative development strategies on arowth and resource allocation or policy towards exhaustible resources, to .ediu.-run issues such aa rural-urban migration, labor markets and employment, ' - ··· . '.
2 the functional and size distribution of income and tax reform. Because foreign exchange has great scarcity value in most developing countries, the iesue of foreign trade policy has occupied centerplace in the majority of applications. Even in the applications which do not have a foreign trade focus, the way the foreign trade sector is modeled has a decisive influence on the outcome of policy simulations. For example, changes in the equilibrium value of the agricultural terms of trade in response to a change in policy in a aodel focussing· on income distribution will depend on assumptions about the behavior of exports and imports. The issue of foreign tra~e policy and the interaction between the domestic economy and the foreign trade sector is also particularly well-suited for general equilibrium rather than partial equilibriua policy analysis because of the sensitivity of domestic resource allocation to developments in the external sector. By how much the scarcity value of foreign exchange is affected by a change in policy cannot be easily estiaated in partial equilibrium because of the difficulty associated with estimating the excess demand functions for tradable& and nontradables without specifying the appropriate economywide budget constraint.

• The purpose of this survey is to review the contributions made in the area of modeling foreign trade with examples from numerical applications. Deliberately, the focus is on policy issues and how to model thea, rather than on an exhaustive review of contributions in each policy area. 2a/ Section 2 starts with a presentation of the simplest model. to deal with external-internal balance. This one sector model is then extended to a aulti-sector version in Section 3. The policy applications start in Section 4 where the impact of tariffs and QRs on welfare and resource allocation is examined, as well as the design of tariff policy when the government has a revenue constraint. Extensions to deal with a growing economy are surveyed in
3 .. .. Section 5 with applications to problems of external-internal balance in the medium-run. .economy faces an intertemporal budget constraint are raised in Section 6. Finally applications that deal with policy choice when the

# 2. A One Sector Hodel

> It is widely accepted that for medium-run issues, the Salter-Swan dependent economy model is the most appropriate specification to represent the

> external sector in a developing economy. prices are given and hence the external terms-of-trade are exogenous, and doaestically produced tradable goods are perfect substitutes for foreign

> produced goods.

> homogenous primary commodities, the implication of this specification -- goods. Indeed the empirical evidence at the most disaggregated levels [e.g. rate changes on domestic: prices is small. _11_ In addition, trade statistics

> indicate significant cross-hauling even at a very disaggregated commodity level, also suggesting the inappropriateness of the perfect substitution

> assumption of the Salter-Swan framework.

> In that specification, foreign

> In applied work however, with the exception of a few

> naaely that changes in foreign prices or trade policy are entirely passed through t.o competing domestic traded goods -- is unrealistic: for most traded Isard 1977, Aspe and Giavazzi, 1982] shows that the pass through of exchange

use. This apecific:ation, which is used on the import side should also be Then domestically produced goods for export sale are imperfect substitutes for domestically produced goods for sale on the domestic market. appropriate for ec:onomywide models that are fairly aggregated is not without The alternative, now found in most CGE models, is to assume that foreign goods and domestic import-competing goods are imperfect substitutes in incorporated on the export side for similar reasons. This assumption, while ' --~ . ' .
4 drawbacks. ·As Dixon (1977) has convincingly argued, empirical estimates of the coats of protection that are not sufficiently diaaggregated to accommodate economies of scale at the product level and the appropriate degree of complementarity/substitutability in use are likely to seriously understate the coats of protection. This criticism thus applies to the models that use the product differentiation assumption presented here when the models. are used . to give welfare estimates of the coat of protection.

A one sector full employ.ent model with symmetric product differentiation is presented in table 1 .and analyzed in figure 1. 4/ Because of Walraa1 law, the econo~vide budget constraint is omitted. Because of hoaogeneity of the demand and supply functions, only relative prices are deterained. Let e • 1 be the nuaeraire. Then the model determines the f o 11 owing ten en ogenous d variab 1 es: X, E, D<sup>d</sup> • 0<sup>s</sup> , M 1<sup>p , p , p ,</sup> a e d Q • p • x In numerical applications, the functions G( ) and P( ) are usually given by constant elasticity of transformation (CET) and constant elasticity of substitution (CBS) functions. ~ The equilibrium in this stylized economy is represented in figure 1. The external constraint for B • 0 is given in quadrant 1, and the fulleaplo,.ent transforaation frontier represented by the CET in quadrant 4. By choice of units let<sup>-e</sup> ••• .... •1. Then the econoay#s consumption possibility frontier which is given by CC in quadrant 2 is symmetric with the production possibility frontier in quadrant 4. Finally, II represents the indifference aap. It is easy to see that equilibrium in the econom, is characterized by the following familiar condition: (1)
_5_ ... ....

<!-- Start of picture text --> tion<br>unction<br><!-- End of picture text --> Table 1

||AOneSectorSmall-CountryModelwithDifferentiatedTrade|
|---|---|
|(1)|Importaggregationfunction<br>Q •F(M,Dd)|
|(2)|X •G(E,Ds)<br>Exporttransformationfunction|
|(3)|Importprice|
|(4)|Exportprice|
|(5)|pq- fl(p•,pd)<br>Consumerprice|
|(6)|Px•gl(pe,pd)<br>Producerprice|
|(7)|! - f2(pm,pd)<br>Dd<br>Importdemandequation|
|(8)|! - g2(pe,pd)<br>o•<br>Export supplyequation|
|(9)|-<br>-e<br>-<br>wM-wE•B<br>Balanceoftradeconstraint|
|(10)|Dd- n•- o<br>Domesticdemand- supply<br>equilibri~|
|where:||
|M,B|-<br>iiiPorta,exports|
|nd,n•|-<br>deaand andsupplyofthedomesticgood.|
|Q|-<br>COIIPOSiteconauae r good|
|i|-<br>compositeproduction|
|-<br>,..|-<br>vorldpriceofi11porta|
|-e<br>,..|•<br>worldpriceofexports|
|e|•<br>nuaeraire|
|~|•<br>domesticpriceofi11ports,M|
|pe|•<br>doaesticpriceofexports,E|
|pd|•<br>do~~esticpriceofdomesticsales,D|
|pq|•<br>domesticpriceofcoapositeconsumer good,Q|
|pX|•<br>domesticpriceofcompositeoutput,X|
|i|•<br>exogenousbalanceoftrade,ornetforeigncapitalinflow<br>outflowfornegativei).<br>(or|

'- ~ '.
6 which states that the marginal rate of transformation in production is equal to the marginal rate of substitution in consumption at equilibrium. Furthermore, when there are no trade or consumption taxes, these marginal rates are equal to the foreign rate of transformation and Pareto efficiency occurs.

The equilibrium in figure 1 is given by A and B. This apparatus is useful to examine the effects of terms-of-trade shifts, changes in the - (exogenous) level of foreign transfers B and ad-valorem trade taxes (tariffs . and subsidies are not incorporated in the equation summary of table 1). Several characteristics of this model are worth noting. First. the sign of the slope of the domestic offer curve -- obtained by perturbing the terms-oftrade -- is determined by the value of the elasticity of substitution in use, ~ between imports and domestically produced goods. As shown in de Melo and Robinson (1986), the domestic offer curve is upward (backward) sloping where _a_ is greater (less than) one. This is an important point in numerical ·applications since it will determine whether a policy change will cause a real • exchange rate appreciation or depreciation.

Second, the model determines an equilibrium real exchange rate, er, which is the relative price of the foreign produced and the domestically produced good. Note that for the selected numeraire, e • 1, the real exchange is defined as er : 1/pd. However, depending on the choice of weights in defining the price in~ex for the domestically produced good, the computed value of er will be different. Thus results from multi-sector simulations computing the percentage change in the equilibrium real exchange rate from a policy scenario can be used to see how sensitive the values of er are to the
<!-- Start of picture text --> ..... , ..<br>t untu<br>- I. - If,•<br><!-- End of picture text -->
8 eelection of weights defining the price indices that enter into the definition of the real exchange rate. _!f_

# 3. The Do .. stic Price System in Multi-Sector Models

> The stylized model above is too simple in structure for policy analyeie, though it presents the necessary ingredients to expand the depeDdent-econoar model for policy analysis. The first extension that adds etructure to the model is to add sectors and intermediate goods. Now I develop the implications of this extension for the effects of trade policy cbaace• on resource allocation. Tbe analysis is partial equilibrium. _1J_ To etart out, consider first the problem of specialization in production in response to trade policy change when .the perfect substitution aeeu.ption (p• • pd • pe) is married with the small country assumption. Suppoee the econo.y hae n sectors, of which i,j • 1, ••• , mare traded and the r ... inder t • m + 1, ••• , n are non traded. Following most CGE application•, technology is described by a separable function between valueadded and intermediates. A Leontief production function describes the fixed input/output coefficients for value-added and the aggregate of intermediates, ae .. 11 ae the substitution possibilities within intermediates. To illustrate tbe epecialization problea, assuae that nontraded intermediates do not enter into traded goods production. As before, by choice of units ~ • ~ • 1. Suppoee there are 1 • 1, ••• , s intersectorally mobile factors of production with unit input coefficient• t 1 under cost ~inimization. Then the zero profit condition of perfect competition for traded sectors implies that unit valueadded price will just cover unit costs when production takes place. If ti denote• the ad-valorea tariff/subsidy rate, the zero profit condition is:

~ 1 -
9 ... _ ..

PHi< tkw 8 8 8 i ,j • 1, • • • , m (2) 8 - 1, • • • • 8

# where

It is tm.ediately evident that the system of equations described in (2) is underdetermined for a change in tariff/subsidy rates if m>s, i.e •. if there are more traded sectors than primary factors of production. This is of course the case in aoat empirical applications. Allowing for nontraded intermediate inputs to enter into traded goods production will help somewhat but not much, unless they weigh heavily and cross-price effects are strong within the nontraded sectors so that relative prices there change a lot when tariff/subsidy rates are altered. An obvious solution is to add priaary factors. However, this approach is not entirely satisfactory since quickly one runs out of information to disaggregate labor categories. The alternative is to assume decreasing re~urna to scale (e.g. land as a naturally lrixed factor or entrepreneurial talent that is sector specific). 8/ The alternative is to return to the product differentiation assumption presented in section 2 which baa the added advantages of allowiDC for erose-hauling and of leading to a characterization of sectors by their degree of tradability, as will be shown shortly. Define d • d e J!A ! dp• ~~ Ee ! dp e J7 , the elasticities of the domestic price response to dp p dp p a change in the domestic currency price of imports and exports respectively. (Sector subscripts are oaitted to save on notation.) It is clear that under the assumption of perfect substitution, Ee • _tD_ • 1, i.e. a 10 percent '- ~ ' .
10 increase in the domestic currency price of imports or exports -- due to a change in their world price, a change in the exchange rate, or a change in the trade tax -- will lead to a 10 percent increase in the price of the domestically traded sector. However, for the model introduced in section 2, it can be shown that: • e x Jl 11.., q q dQ Pq s Where e • p .E/P .X, e • P _•I'll_ P Q, & :-- < 0, & is the elastic! ty of dPq Q supply of X, and _a_ and n are the elasticities of substitution and transformation for the CBS and CBT trade aggregation functions introduced in Section 2. ~ Clearly, dropping the assumption of perfect substitution between imports and domestic goods solves the specialization problem noted above. Furthermore this formulation is well-suited to address empirically issues raised in the development literature between "structuralists" who aaintain that developing countries are characterized by low elasticities and "neoclassicists" who maintain that elasticities are high. 10/ When ~ Q + • the doaestic price system loses its independence and we are back to the traditional trade theoretic model. Once intermediates are included, the formulation acquires quite a degree of realisa for studying the impact of trade policy changes on resource allocation. A fo,trfold sectoral classification of sectors according to their degree of tradib1 :y follows naturally: (1) nontradables are sectors with low export <dl> and import <61> shares; (2) exportable& are sectors with
11 high export and low import shares; (3) importable& must be distinguished into two subgroups depending upon whether they are substitutes _(a>_ eq) or complements _(a<_ eq); (4) finally. import dependent sectors are those sectors, like construction, which may be nontradable on the final demand side but which have ~ high ratio of imported intermediate inputs in total intermediate inputs.

This formulation has a number of desirable attributes due to the relatively small number of parameters and elasticities that are required for its implementation. Furthermore, equations like (4) and (5), once augmented for oligopolistic pricing possibilities can be used for interpretation of microeconometric estimates of the link between exchange rate movements and producer prices. _11J_ However, when applied to simulations of changes in trade taxes on resource allocation, this formulation relying on constant elasticities may overestimate the degree of autonomy of the domestic price syst .. , especially when simulations involve large changes in relative incentives.

4. Applications to Trade Policy The model structure outlined in Sections 2 and 3 reflects the essential characteristics of the trade policy reform simulations carried out in practice. Below I give three examples of model-based simulations.

# 4.1. The Welfare Costs of QRs and Rent-Seeking Activities lla/

Many developing countries have foreign trade regimes ridden with quantitative restrictions (QRs). For example in Turkey, in the late seventies, import programs are issued semiannually with imported commodities

- .... '.
12 classified under three main lists: a liberalization list consisting essentially of raw materials and spare parts not competing with domestic production for which importation is free: a restricted list consisting of intermediary and final goods mostly manufactured in Turkey for which an import license is required; and a · quota list, with commodity-specific quotas further allocated between industrialists and importers.

Students of Turkey's foreign trade regime have noted that these extensive QRa have led to rent-seeking activity on the part of tnduatrtalista. 12/ Grais, de Melo and Urata (1985) draw on the concept of 11virtual11 prices introduced by Neary and Roberta (1980) to estimate the welfare coats of rationing in Turkey with an 8-sector CGE model calibrated to 1978 Turkish data. The use of virtual prices (i.e. those prices which would induce an unrationed household or firm, to behave in the same manner as when faced with a vector of ration constraints) allows reoptiaization over unrationed quantities, thereby allowing for spillover into other markets when adjuatment to the quota is by quantity rather than price.

In the simulations, consumers are rationed .in their purchases of i~orta of final goode and producers in their purchases of imports of interaediatea. ~ Furthermore, producers are assumed to engage in rentaeeking activity. The approach to implementing rent-seeking behavior· is to aaau.e that the production function for rent seeking is the same as the production function of what the authors refer to as "traditional" output. The producer, however, must purchase both the "traditional" and the "rent-seeking" ca..odities. Furthermore, we assume that the entire value of the rents, R, is apent ·on the production of the rent-seeking activity. Dropping sector aubacripta, at equilibriua the following will hold:

-~ ' .
13 where pd, pv, and pm are, respectively, the domestic, virtual, and import prices, M is the volume of rationed intermediate imports, x:. x:. are the deaand for "traditional" and rent-seeking output, and xs is short-run output supply given capital stock. Thus the effect of rent-seeking is to reduce the supply of the "traditional" output and to raise the price to the final user. In the spirit of the literature on directly unproductive activities, rentseeking creates income since more output is produced, but at the same time the output generated by rent-seeking, X:• does not enter the utility function since it does not appear as an element of final demand.

The loss to the economy from rationing and rent-seeking is su.aarized in figure 2, where the economy is conveniently aggregated into one sector. Because producers purchase imported intermediates, any rationing of these intermediates will raise marginal costs of production. This is shown in figure 2 by the leftward shift of ~ to ~ beyond xo• the point at which rationing becomes effective. As a result of rationing, there is a deadweight loss, AD!. The effect of rent-seeking is to push up further the supply curve - to x; • ~ X: because of the diversion of output toward rent-seeking. The result is to raise the price (in terms of the numeraire) to PD2• The area HBCI is equal to the value of the rents and the horizontal distance between X~ and x; shows the output of rent-seeking activity. The extra deadweight
-¢

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FASS Ivey pur SupUCTIey 3o 380) SISTTON Z e2n8z3 91
15 loss froa rent-seeking is given by ABO. At the new equilibriua. FG and BF are additional coats due to rationing and rent-seeking. respectively.

The welfare benefits from removing QRs are reported in table 2. Measured in terms of GDP. welfare costs of QRs in Turkey in 1978 were estimated at over 5% of GOP. Most of the costs come from quotas on intermediates since consumer imports had a small share in overall imports. Of course. the magnitude of the results is driven by the assumed rent-seeking behavior and by the estimated value of the premium rates incorporated in the calibrated solution for the base simulation. The results are thus only 1Dd1cat1ve. but can serve to focus on the costs in terms of foregone conauaption and. more importantly. foregone growth due to reduced real investment caused by QRs and rent-seeking behavior.

Table 2

> Welfare Benefits from Removi otas in Turke Ratio to Base Simulation Value)

Quotas on Intermediate Quotas on Intermediate Imports Removed and Consumer Imports Removed leal GDP 1.052 1.054 leal Household Consumption 1.038 1.042 Real Investment 1.112 1.110 Source: Grata. de Malo and Urata (1986. table 7) • ... , ' '
16

# 4.2. Interactions Between QR Foreign Trade Regimes and Industrial Organization.

Rent-seeking activity is only one aspect of the potential welfare coat• of QR foreign trade regimes that extend beyond the standard welfare coata of protection. Another and potentially more costly aspect of QR trade regiaea derives from the noncompetitive behavior made possible by the market atructure observed in many developing countries. In the following application, a QR trade regime does not give rise to rent seeking.

Students of industrial organization features in developing countries have often noted that concentration is high in the manufacturing sector and furtheraore that these high concent~ation ratios probably understate the extent of market power enjoyed by leading oligopolists. 14/ This is so bacauae entry ia restricted by industrial policies that regulate investment by co.plaz licenaing procedures and exhaust credit incentives among incumbent fir... Likewise weak capital markets imply that investment funds are internally generated which also restricts entry. Most importantly foreign trade regimes ridden by QRa eliminate foreign competition. Furthermore exit ia alao difficult because of the lack of bankruptcy legislation. As a result there ia often both market power and an ossified industrial structure. When reatrictiveness on investment licensing is not too great, too many firms ope~ate. This has become known as the excessive entry problem reflecting the obaervation that too many firms have typically co-existed behind protective walla despite official licensing policies. 15/ Condon and de Melo (1986), starting froa the analysis by Harris (1985) and Coz and Harris (1985) for Canada, illustrate the costs of QR protection in a semi-industrial economy using several variants of a model in which econa.ies of scale and oligopolist behavior interact when rationing of
17 coneuaer aDd intermediates takes place. Though expressed in dual rather than primal form, the model is similar in its specification of the foreign trade sector to the model presented in table 1 since the model assumes symmetric product differentiation on the import and export sides.

Before examining the welfare costs of rationing, it is instructive to indicate how the standard costs of protection are modified by the presence of economies of scale and the departure of pricing from average cost implied by nonc~etitive behavior. Let the consumer side be represented by a single consuaer with expenditure function E (P1, ••• Pn,W), where W is a welfare index, and let sectoral production take place in identical firms (Xi • nix1 ), with unit coet functions ci(w,Ji) where w is the vector of factor prices, xi ia firm output and \ • ci [ a(cixi)/3Ki] is the ratio of average to marginal coat (i.e. the inverse of the scale elasticity). Then, as shown by Rodrick (1986), the welfare effect of a change in trade policy can be decomposed into the following expression: where Pi ia the domestic price and wi * is<sup>thecorrespondingworldprice.</sup> bpresaion (8) decomposes the welfare change into three terms. The firat term ia the familiar consumption effect, which states that consumption ahould be expanded wherever marginal value exceeds marginal cost. The second term depart• from the traditional costs of production and states that output ahould contract whenever unit domestic price exceeds world price because of the effects of imperfect competition. The degree of monopoly is represented by the extent to which Pi > ci. Whenever Pi > ci, the correct policy goal
18 should be to expand output to remove monopoly power. In the end, the second term states that output should contract if ci > wi. Thus, * for a given degree of oligopoly, the production costs of protection are less than under perfect competition. Finally the third term states that, for a fixed number of firms, production should be expanded whenever there are unexploited economies of scale. Table 3 reports the welfare cost calculations obtained from a stylized three-sector model (primary, manufacturing, and nontraded activities) where only the manufacturing sector has economies of scale and noncompetitive behavior. The welfare costs of rationing are obtained by starting from a free trade situation and rationing consumer and intermediate imports, first by 20 . percent and then by 50 percent (that is reducing the volume of imports by 20 percent and 50 percent). Rationing is modeled as in the previous example but there is no rent-seeking.

Variant 1 gives the cost of rationing with constant returns to scale. Variant 2 gives the cost of rationing when there are economies of scale in manufacturing. Variant 3 captures the excessive-entry phenomenon observed in the manufacturing sector of developing countries by incorporating the asauaption that the nuaber of firms in a sector is an increasing function of rents in manufacturing arising from rationing. Variant 4 captures the fact that rationing provides opportunities for manufacturing firms to depart from average coat pricing in the domestic market. Rents accruing from rationing are used as the proxy for entry barriers (since imports are restricted), and the departure of unit domestic price, pd, from unit average cost is an increasing function of per unit rents conferred _'1_ rationing. 15a/ The figures in table 3 show that the welfare costs of excessive entry, or
19 'nlbl.e 3 A Cl!!prison of The Welfare <bits of Rationit¥ lbier Alternative Mlrlc:et Structures a/

||Bati~<br>|Variant1|Variant 2|Variant3|Variant 4|
|---|---|---|---|---|---|
||Rate(~1)|an'S|IRl'S|!Rl'S;Fim<br>entxy,no<br>collusive<br>behavior|mrs;<hllusive<br>behavior,<br>noentry|
|WelfareCoats:_Ef_||||||
|(%.ofbaeenatfcnal<br>tDcx.a)|.8<br>_.s_|1.7<br>13.0|6.1<br>16.0|6.5<br>16.7|6.5<br>17.1|
|Praf1ts(P/NJ-1)|.a|0|0|0|6.6|
||_.s_|0|0|0|25.7|
|bt.roffiu.|.8|1|1|107|1|
|(lltioto._.)|_.s_|1|1|124|1|

Saul:ce: ODblmi de Milo (1986, 'Dible 5).

1he c:al.ibmtioa of the parall!ters detemd.DiiW tiE extent of ecauaies of scale in IIIIII1f~ are fraa Cl:Jx mi Blrrie (1984). Profits m:l fim entry are calibrated so as to replicate the c:1awe 1D price-c:oet mugln ani tUBbers of fiDIII in tiE <lrl.lem IIBBlfacturirw sector after traie 11t.ral1zat1on. See de Milo mi Urata (1986). In the base sfntlatfon, foreign tra:fe is 4Q't of ~ td.tb _5%_ in ~r goodl

# arrs • Oxlatalt returne to ecale.

!/ Varimta are d18als ed 1D the text.

b/ C'bnpJtaf as the B1cb1a ~tfoo variatioo frcm t._ ~ imtrec:t utility fmctioa rep~

- CIQIWIIMI' ap-d1ture c:h:dc:e.
20 collusive pricing can be well in excess of 10 percent of national income. Theae calculation• are only suggestive because more disaggregation would be desirable to better distinguish sectors that are subject to economies of scale and non-competitive behavior. Nonetheless, the calculations are suggestive of the potential costs of QR regimes when interaction is specified between the trade regime and the industrial organization structure.

# 4.3. Optimal Trade Policy in the Presence of a

# Government Revenue Constraint

With limited administrative capacity to raise taxes, developing countriea often have a government revenue constraint. Some sectors in the econo.y (e.g. agriculture) or some categories of demand (e.g. consumption tasea) cannot be taxed, and rampant tax evasion for certain kinde of taxes (e.g. inco.e taxea) force the government to rely on trade and producer taxes aa their aain source of government revenue. The policy· issue then is how to raiae a given amount of government revenue at minimum distortionary cost, given the presence of nonremovable distortionary taxes and the further conatraint that trade taxes need to be used to raise revenue. 16/ Dahl, Devarajan, and van Wijnbergen (1986) and Mitra (1986) derive condition• for optiaal tariff structures to raise government revenue at .tnimua diatortionary cost under the conditions specified above. They derive a nuaber of rules, analogous to those derived in the optimal taxation literature, for tariff policy. For example, they show that in the absence of croaa-price effects, the optimal tariff rate should .be inversely proportional to the import demand elasticity. Furthermore, when cross-elasticity of import d ... nd with respect to the export price is recognized, account must be taken

-~
21 • .,• of the fact that a tariff acts as an export tax, so that imports which are the closest substitutes for export goods should be taxed the least. These theoretical results thus imply that the uniform nominal (and hence effective) tariffs advocated in the literature on trade liberalization should be revised to take into account the inherent weaknesses of developing country fiscal systems.

Dahl, Devarajan, and van Wijnbergen (1986) incorporate these features in a CGE model similar to the one outlined in table 1 except that their 8-sector model for Cameroon also includes uniform less-than-infinitelyel .. tic demand for sectoral exports (~ • -20). Table 4 presents the results fro. using optimal tariffs to raise the same level of government revenues as **vaa** collected in Cameroon during 1979. Though similar in structure to the prevailing tariff structure (in column 1), the optimal tariff structures (in columna 2 and 3) are far from unifora. Note in particular the results in colu.n 2 for the case where the prevail~ng set of indirect taxes ia kept at ita existing level: the optimal tariff for the food and especially caah crops ia negative. With virtually all output of the cash crop sector exported, the production tax acts like an export tax. The negative optimal tariff dampens the effect of this tax, which is excessive given the high elaaticity of demand for exports.

Of course, aa with the other empirical exercises, ·greater disaggregation would help in the design of trade reform packages but the eaaential message of this analysis would remain, namely that unifora protection is not optimal in the presence of fiscal (or other) constraints.
22

## Table 4

# Tariff Rates (Indirect Tax Rates in Parentheses)

|||<br>Actual|Optimal Revenue-C<br>|onstrainedRates|
|---|---|---|---|---|
|||TariffRates|Ind Taxes>0|Ind Tax • 0|
|Food Crops|(0.02)a/|0.22|-0.06|0.09|
|<br>Cash Crops|(0.19)-|0.23|-0.28<br>|0.13|
|<br>Fore•try|(0.06)|0.28|9.31_E.!_|0.12|
|<br>FoodProcessing|(0.04)|0.35|0.27|0.11|
|Con•waer Good•|(0.10)|0.38|0.28|0.11|
|Intera.Goods|(0.03)|0.18|0.22|0.15|
|Services|(0.00)|o.oo|0.04|0.19|
|UNIFORM|RATE||0.16|0.15|

### ROTIS

Source: Dahl, Devarajan, van Wijnbergen (1986, table 2) The •i.ulations assume zero export taxes.

a/ Indirect production tax rates in parenthesis. _]t_ The 931 percent tariff on for~stry is due to the fact that imports in this •ector are ainu•cule.

I •• '.
23 ··-5. Applications to Internal-External Balance and Growth I now turn to issues of internal-external balance in a growing economy. Table _5_ augments the skeleton model presented in table 1 so as to deal with a growing economy. Neither the process of growth nor the interaction between growth and policy is addressed in the model, except in a very limited sense discussed further below.

The distinguishing feature of the augmented model is the presence of a more complete production side which includes factor allocation and factor accumulation equations. Here the ~apital stock is not assumed to be mobile across sectors, whereas labor migrates to equate value marginal ' products across sectors. This specification is common in many applications where liadted within-period factor mobility is handled in this manner. For example,. rural and urban labor are often distinguished, with limited rural-urban aigration .in response to wage differences. The model also assumes that all of resource gap (ei) is invested and that investment includes a domestic and an imported component so, therefore, any change in the equilibrium value of relative prices will have an impact on the amount of real investment forthcoming from a given savings effort.

To see better how external-internal balance and factor accumulation interact to determine growth in this augmented model, consider the simple case where there is no difference in factor intensities across sectors, but technical progress is higher in tradables than nontradables (perhaps because of learning-by-doing). In this case, the contribution of technical progress to growth can be related to the structure of production, as shown by the line LL' in figure 3 quadrant 2. Internal-external balance for a given level of - exogenous capital inflow (B0 ) is given by F0 F0 in quadrant 1. The internal
24

# Table _5_

|AOneSectorSmall-Country Growth Model|
|---|

|(1)||Import AggregationFunction|
|---|---|---|
|(2)||ExportTransformationFunction|
|(J)*|X<br>•A(t)H(Lt;It)|ProductionFunction|
|(4)*|w -<br>pX'IJ/CLt|LaborDemand|
|(S)*|it• Kt-1+It-1|CapitalAccumulation|
|(6)*|Lt•Lt-1(l+gL).|L_,JrAccumulation|
|(7)||.... , >rtPrice|
|(8)||ExportPrice|
|(9)|pq.fl(p•,pd)|ConsumerPrice|
|(10)|px • g1(pe,pd)|ProducerPrice|
|(11)*|PI•k1(p•,pd)|InvestmentPrice|
|(12)|M<br>(IId)<br>:cr•f2p,p<br>D|ImportDemand|
||Id<br>m d<br>-<br>• k(p,p)<br>I•<br>2|InvestmentDemand|
|(14)|~.g2(pe,pd)<br>D|Export Supply|
|(15)|-mII<br>-m..<br>-e<br>-<br>wI+wl'l- wE•B|BalanceofTradeconstraint|
|(16)*|Y • pXx+ei|Income|
|( 17)+|pqQ•pdDd+p~+PII|Absorption|
|(18)*|pqC•PXxd- S(Y)|Consumption|
|(19)*|PII• S(Y)+ei|Investment|

tbtes: _In_ asterisk(*) next to an equation indicates an equation that ~ mt incluied in table 1. - + • 'lhe absorption equation (17) replaces equation (10) in table 1.

A time subacript is ODly inclu:ted for the factor acct.lllllation and factor dauand equations to sare on notatico. A (t) ia the excgelD18 rate of disaabodied technical progress mi ~ the~ rate of growth of the labor force. Also to save on mtation, it is 888\D!d ttat dcmestic am foreign investment goods have the saae prices as their final dEI'II8Ili cnmterparts.
<!-- Start of picture text --> •<br>l<br>~<br>..<br>-------·--- -·--- ---<br>... it~<br>~·w:»~<br>10 Mttl<br>,,<br>0<br>•t~CCO.U·UON 10 •~IJc!<br>•tQCCICJl 10 ·~~e<br><!-- End of picture text -->
26 balance is downward sloping because, if starting from an equilibrium position, expenditure exceeds income, and the relative price of home produced goods must rise to eliminate excess demand. By the same line of reasoning, the external balance schedule is upward sloping because an excess demand for tradable& caused by an excess of expenditure over income requires an increase in the relative price of tradable& (i.e. a depreciation of the real exchange rate) to eliminate the excess demand. 17/ The model is closed in quadrant 4 by the assumption that a constant fraction of income is invested. The rate of growth is measured by the vector ~GO in quadrant 3. The model closure assumes that investment is determined by savings. As Dewatripont and Michel (1987) shaw, other closures are possible. One such example is the application reported in section 5.2. The apparatus can be used to examine the effects of a change in the teras-of-trade, in the exogenous level of foreign transfers (i.e. a shift in the F0 P0 schedule) or in the relative price of investment goods (a shift in the investment schedule 10 10 ) on growth. The simulations reported below involve applications that amount to either exogenous or policy-ind~ced shifts in the schedules of quadrants 1 and 4. A typical exercise with a model of the type described in table 5 starts with a validation of the model from historical data where the modeler chooses a plausible set of parameters and elasticities that produce a base run scenario close to the observed aggregate and sectoral growth rates. No formal econometric procedures are used to test the validity of the chosen model structure. 18/ After satisfactory validation, counterfactual simulations are undertaken to examine the likely evolution of equilibrium values of relative prices and medium-term adjustments under different policy scenarios.
27

# 5.1. Causes of Turkey's Foreign Exchange Crisis in 1977

The modern theory of exchange rate determination recognizes that the equilibrium exchange rate is determined by the combination of monetary and real factors, going beyond differences in inflation rates of the economy and the rest-of-the-world as advocated by the strictest version of purchasing power parity (PPP). To see this, following Dornbusch (1976), assume there is goods arbitrage so that for tradable&

> where subscript T refers to a tradable sector. Letting P denote the price level and ~ a * the equilibrium relative price of traded goods, one has

p • fiR ; PT • * a * * P T (10) where an asterisk denotes a variable for the rest-of-the-world. To introduce the monetary sector assume monetary equilibrium where L and L * denote domestic and foreign demand for real balances M/P • L( ) ; M * * /P • L ( ) * (11) Coabining equations (9) - (11) and taking log differentials it can be shown that the detersinants of the equilibrium exchange rate combine real and monetary aspects according to the following: ... ... ... ... "* ... ... e • (M - M ) + (L - L ) + ( a - a ) (12)
28 where the first term captures the effect of different rates of monetary growth and the second and third terms capture the respective effects of real money demand and changes in relative price structure. In the exercise to be described, the monetary sector is treated rudimentarily, as it is assumed that the monetary authorities effectively control the domestic price level, which is set exogenously in the model and the analysis concentrates on decomposing the role of the various real factors which contribute to the equilibrium value of the real exchange rate. 19/ Following a successful devaluation in 1970 accompanied by a set of macro policies to correct imbalances, Turkey achieved a half-billion dollar current account surplus in 1973, only to reach a three billion dollar deficit in 1978, at which time the deficit reached nine percent of GDP. With foreign reserves exhausted, the crisis was only postponed by massive foreign borrowing. As is often the case in such circumstances, during the post-1973 period, Turkey did not devalue sufficiently to correct for the differential in inflation and the real exchange rate was back to its pre-1970 value by 1976 (the differential in inflation between Turkey and OECD was 8 to 10 percentage points while devaluations averaged 5 percent).

The issue then is what were the causes of this foreign exchange crisis. More specifically, what was the contribution of the inflation differential, the rise in oil prices of 1973, the massive foreign borrowing in 1976 and 1977, the rise in the index of OECD export prices, the unexpected fall in workers remittances (which were financing half of imports by 1973) as the number of workers abroad stagnated? Dervis and Robinson (1982) used a fifteen sector CGE model quite similar to the one described in table 3 to assess the relative impact of each of these effects. 20/

- ~
29 .

Having validated their model over the period 1973-77, Dervis and Robinson go on to ask in a set of cumulative experiments (where each new factor is added on to the previous one) what would have been the equilibrium real exchange rate, had Turkish inflation equaled OECD inflation, had external borrowing been equal to GDP growth, had there been no rise in oil prices or OECD export prices beyond the rise on world prices in Turkey's export markets, and had workers remittances grown at the same rate as GDP.

The results of the contribution of each element of this counterfactual history are reported in table 6. The exercise shows that differential inflation was only a small part of the story. Of course the mo~el structure

# Table 6

Factors Contributing to the Change in the Equilibrium Real Exchange Rate in 1977 (%)

|Differentialinflation|37|
|---|---|
|Oilpricerise|21<br>|
|HigherOECDexportprices|11|
|Lowerremittances|18|
|Otherfactors(residual)|13|
|100||

Source: Dervis and Robinson (1982, table 5) is imposed rather than tested and there certainly was interaction among some of the variables that were treated exogenously or feedback mechanisms from endogenous to exogenous variables. But it remains that in a world where economies undergo multiple exogenous shocks, partial equilibrium analysis or simplistic calculations are likely to be misleading.

> - ~ '.
30

# 5.2. Absorption Under Disequilibrium Exchange Rates: Chile 1979-81

> The. second application which also deals with internal-external balance illustrates the difficulty in model.ing age~ts' expectations and incorporates · a practical-- albeit not e~tirely satisfactory-- way of overcoming the difficulty. The model follows the recent contributions to the analysis of the current account that have emphasized the role of expectations and the usefulness of modeling the adjustments in savings and investment behavior (e~g. Sacha 1981, Svensson and Razin 1983). Implications for the . current account of exchange rates temporarily in disequilibrium have also focussed on savings and investment behavior (Dornbusch 1985). In great part, these contributions have been inspired by country experiences, some involving unsustainable current account deficits fostered by protracted periods of low real exchange rates resulting from "excessive" capital inflows. These con.tributiona drawn from intertemporal models show that expenditure smoothing takes place to offset temporary changes in purchasing power.

A vivid example of this smoothing effect is the consumption increase that followed the Chilean real exchange rate appreciation of 25 .percent between 1979 and 1981. The problem was exacerbated by the pegging of the peso to the dollar in mid-1979 while the wage was fully indexed on past inflation and domestic inflation exceeded world inflation. Capital inflows averaged 5 percent of GDP between 1977 and 1979 and jumped to an average of 9 percent during 1979-81, with the current .account deficit reaching 15 percent of GDP in 1981. With no public sector deficit, this increase in capital inflows (induced by the fixing of the exchange rate while domestic interest rates were free) resulted in an expenditure boom. Private consumption grew by 1
31 <!-- Start of picture text --> by 11<br>The<br><!-- End of picture text --> percentage point less than GDP during 1977-79, but grew, on average, by 11 percent during 1979-81, while GDP was growing at the rate of 7 percent. The crisis emerged when capital inflows necessary to finance the deficit ceased. Condon, Corbo, and de Melo (1985) use a simulation model similar to the one presented in table 3 to ask what might have happened had Chile not followed the fixed exchange rate policy that led to the surge in capital inflows described above. The mechanism leading to capital inflows is not modeled explicitly and the exercise consists in asking what would have been the absorption and real exchange rate trajectories had capital inflows been leas during 1979-81. Their model departs from the one described in table 3 to allow for a rising real consumption wage that reflects the wage indexation mechanisa then prevailing in Chile and private savings behavior is modified to incorporate expenditure smoothing by stating that savings is a positive function of real income and a negative function of (exogenously determined) real capital inflows, eB, with coefficients drawn from econometric estimation with Chilean data. _J:ll_ This model closure applied to a 5-sector model for Chile during 1977-81 fits well the adjustment patterns in production, relative price, and expenditure patterns of Chile during 1977-81. The authors then use the model to ask how the -Chilean economy would have adjusted to lower capital inflows during the 1979-81, taking as given the wage indexation mechanism prevailing in Chile. The model is used to trace the combination of real exchange rate depreciation and increases in unemployment caused by real wage rigidity. The model also captures the effect on GDP of compositional shifts in demand induced by expenditure switching by taking into account different factor intensities across sectors. Figure 4 shows the predicted trade-off between

- ::'\

'
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33 _:_ . ... .. ..

lower capital inflows during 1979-81 and reductions in capital inflows of 10 percent, 25 percent and 50 percent (E-1, E-2, E-3) during both 1980 and 1981. Elasticities of the real exchange rate with respect to the equilibrium expenditure levels range between -0.6 and -0.8 for 1980, and -0.5 and -0.7 for 1981. In addition, the model shows that much of the adjustment to lower capital inflows could have been achieved by expenditure switching, in spite the institutionally determined real wage rigidity, because of the positive. effect on employment of compositional shifts in demand. Again, these counterfactual history simulations are only indicative, but as in the preceding exercises, the addition of structure (here in the labor market and in the composition of demand) to an otherwise standard dependent-economy aodel, provides an enhanced tool for policy analysis.

5.3. Simulating Alternative Development Strategies 22/ The last application is a long-run exercise where CGE simulation analysis is used to distill the growth implications of alternative foreign trade strategies. The results of the exercise, consisting of 20-year simulation runs, are sensitive to the linkages built into the (mostly) exogenous determinants of growth. Again, the model structure corresponds quite closely to that described in table 3 and figure 3. Three new features, however, deserve attention. First, exogenous trends have to be imposed on the paraaeters describing the response of imports and exports to relative price shifts (see table 7), otherwise the model is not capable of reproducing the development patterns that result froa the selection of alternative trade strategies (described below). 22a/ This is a serious shortcoming of the functional forma advocated in section 2, at least for long-run applications,
34

## 'Dable 7

!epri!Sentative 'lmle Strategl.ea and Mlcroec:orxDic IMicators

||Balanced<br>(IS)|Export<br>PraiDtion<br>(B)|(l!P)|
|---|---|---|---|
|TrarJepolicy/Trends<br>Sectonltread~(i.e.exogenass<br>vu1at1oo1ntradeshares)|Lar/falliJw|<bnstant|RI.SillJ|
|Mlcmecoroltcpol1cy<br>imtl\llllmt8|'lUiffs/iqJort<br>ratimirwa/|Realexchqe<br>rateadjustb/|RealE!ICChlqe<br>rateadjustb/|
||1Dif/1nterned1ate|Intenned1ate|High|
|~c<br>lDdic:ators_sf_||||
|IDcr<br>a:-alcapital~<br>put_nt1o,teadnal,pedod|3.26|3.02|2.95|
|!lportgrollthrate|.7.9|10.3|14.1|
|lllportgrartbrata|4.5|6.4|9.3|
|~<br>graNthrate|5.7|6.2|6.5|
|Bt•ofthetraded/reg1JII<br>intmd.nal..,.Ar_!f_|200|100|95|
|Belatiwpriceofcapital<br>aooaintmd.nal,_r~|120|_lOS_|95|

# TrarJe policy/Trends

Source: a__, ... al (1986, Cllp. 4) _!I_ Illport rationlrw 1apli• that a-ante ex.c:ees d8I8Dd for foreigll excbqe is el.Jminated by eOWI'..,.lY cletemhrl'll the prad.\a 011 fore:f.Iw ~e.

t../ lb ntfordJW of illlports ~ x..l of a•!latiw c:apitaliDflCJf 1s 1,900 lllllion 1964 dollars.

dJ IDda - 100 1n 1Dit1al. ,...

,... !/ 'lbe blaB of thl trade regime :h deff.necl as B • !EF -::~ where EER. is the effective exchqe rate (1nc:l••ive of tariffs, 91die& and prald.a Cl :-Sign ~e) md subscripts refer to illlporta aad aporta rMpeet1~ . _·' ._
35 ~ ...

and suggests that the foreign trade specifications adopted in ~pplied general equilibrium analysis need improvement. Second, as indicated in table 7, the inward-looking (IS) strategy is modeled by assuming that macroeconomic adjustment comes entirely on the import aide via rationing of imports when there is excess demand for imports, rather than by a real exchange rate devaluation which would also relieve the foreign exchange constraint by stimulating exports. The implication of this adjustment mechanism is that a pr..tua on imports develops in the IS strategy resulting in the strong bias against exporting in the trade regime shown in table 7. Third, is the significant effect on the relative price of capital goods~ This effect, equivalent .to an upward ah~ft of the I 0 t 0 schedule in figure 3, results in leas real investment froa a given savings rate. · Thus, policy choices affect growth via the bias in the trade regime and the cost of capital goods. Table 7 reports the results of simulations designed to provide rough bounds on the extent to which the choice of development strategy is likely to affect growth. Though not reported here, the ~odel was also used to examine the aarginal productivity of foreign aid under different trade strategies. Based upon extensive sensitivity analysis to key parameters in the model, the exercise suggests that up to one percentage point in average annual growth (over a 20 year period) can be explained by the mechanisms describing alternative trade strategies that were incorporated in the model.

# 6. Applications to tntertemporal Issues ~

Even though allueion was made to the role of forward-looking decisions in the application to Chile on absorption under a disequilibrium real exchange rate (see section 5.2), all the models considered so far have
36 • ..

been intertemporally decomposable. That is, the solution values for endogenous variables in period t only depended on the solution values of endogenous variables in previous periods. For the problems examined, this assumption was adequate, although the Chile example points out that such an assumption is not tenable when the economy is in a strong macroeconomic disequilibriu.. The assumption of intertemporally decomposable growth paths is also inadequate for inherently forward~looking policy issues such as optimal extraction of an exhaustible resource, or decisions about external borrowing strategy. In such circumstances a forward-looking intertemporal model is the appropriate framework. · In this section, I review briefly the equilibrium properties of the two-sector tradable nontradable dependent econo111 mod.el in a two-period framework, then illustrate results from an application to optiaal borrowing ~trategies for Thailand derived from a fivesector seven-period model. The interta.poral aspects of the two-period model carry over to the multi-period model.

/ Following Glick and lharaa (1986), consider a small op ~~ economy that can borrow any amount, D, in the first p ~ tiod at a fixed world interest rate, r. Then, the country~& welfare maximization problem consists of choosing consumption and investment levels for traded and nontraded goods that maximize discounted utility: 2 w- · c~-b/CC1-b)(1 +<sup>) t-1)</sup> . (13) • t•1 1-a where ct<sup>-</sup> =<sup>ca</sup> Tt C Nt b>O •<sup>O<a<1</sup>
37 Subject to the intertemporal budget constraint PNt Where Pt ! - is the relative price of nontraded goods or the inverse of the PTt real exchange rate. Subscripts T and N are used to distinguish tradables from nontradablea and Q refers to output. Note that investment, I, is all in tradable&. In this formulation, ~ is the pure rate of time preference, and the utility function is assumed to be intertemporally separable with a constant intertemporal elasticity of substitution 1/b, as in the simulation exercise below. As b + •greater smoothing of consumption is desired. Let ~ ! ~T2/ Ck2 + P2 ~N2 / Ck2 represent the return on capital in period 2. Then the first order conditions to the maximization problem are: <!-- Start of picture text --> from<br><!-- End of picture text --> Thi• faailiar condition from intertemporal models states ·that the real social discount rate in equilibrium is set equal to the real cost of foreign borrowing and the real rate of return on capital, all rates and costs being expressed in terms of the aggregate consumption bundle. The real cost of foreign borrowing and the real return on capital depend on two factors: (a) the coat (return) in terms of traded goods; (b) changes in the aggregate eonauaer price index over time. Thus changes in relative prices over time are an iaportant determinant of intertemporal substitution.
38 With no investment, given supply functions, borrowing (lending) will occur for ~r ( ~r) because there is a fall (a rise) in consumption of tradablea and nontradablea in t~e second period. With positive investment the ease relevant to the CGE applications -- Glick and Kharas show that borrowing not only affects production and consumption through relative prices, but also through factor intensities in each sector. Only for the ease of b • o (that is when consumption is perfectly substitutable across time periods) are relative· price movements independent of inveataent. Otherwise, the relative factor intensity in production will influence the outcome. Thus While it ie poaaible to isolate the factors that determine whether borrowing (lending) will take place, it is difficult to derive analytical results, even in the eiaple ease where all investment goods are .produeed in the tradable sector. Also the outeoae is quite sensitive to the value assumed by the interteaporal elasticity of substitution, a parameter difficult to give an intuitively eo.torting 9alue to. 23/ 6.1. Optimal Foreign Borrowing Strategies: A Case Study of Thailand (1985-92) Aa the recent debt repayaent difficulties of developing countries have ahown, it is critical to conduct external borrowing within overall eon•istent .. eroeeonomde policies, lest capital flight occur when credibility wanes. The debt crisis of the early eighties also taught creditors the fraaility of sovereign borrowing and debtors the realities o~ credit rationing. For example, the eapirieal evidence shows that lenders~ willingness to lend is positively related to the borrowers~ fiscal positions (lharae and Shishido, 1984). This suggests that borrowers will find it

-~ ' ..
39 ·· ... · appropriate to reduce the probability of credit being cut off by having high fiscal savings.

Kharas and Shishido (1986) use a model similar to the one described above to examine optimal borrowing strategies for Thailand over the period 1985-92. In addition to the intertemporal equilibrium conditions described in equation (15), their multi-sector model captures some aspects of uncertainty insofar as the expected terminal year fiscal surplus is a parameter that depends on the weight attached by the borrower to the possibility of losing creditworthiness. To ensure smooth investment and borrowing paths, the model postulates an absorptive capacity constraint in each period on investment so that there is a diminishing marginal efficiency of investment within any period. Likewise, the more the country borrows relative to outstanding loans in each period, the more costly the loans become, reflecting the assumption that the borrower must shift to new lenders and more expensive financial instruments. Finally, as in the applications discussed in Section 5, technology is putty-clay with new investment directed to sectors with highest profit rates and, once in place, capital can only be removed from a sector through depreciation. 24/ The model is solved numerically by resorting to the turnpike theorem (Burmeister and Dobell 1970) so that a balanced growth state is reached by the end of the simulation, with all real values growing at the same rate in the post-terminal period. ~ This implies that the model ~valuates the penalty for the outstanding debt and the premium for the existing capital stocks in the terminal year through calculating the impact of these on future consumption. 26/ <!-- Start of picture text --> in<br><!-- End of picture text --> <!-- Start of picture text --> l<br>so<br><!-- End of picture text --> Having calibrated on historical data for the period 1975-85, Kharas and Shishido, go on to use their model to determine optimal borrowing and
40 investment strategies when the economy undertakes policy changes or is subjected to external or internal shocks. As in the other simulation exercises, the model determines the equilibrium real exchange rate and other relative prices and quantities. But in these dynamic simulations, the model also determines the borrowing and investment path which maximizes welfare subject to the constraints discussed above.

As an example, consider the implications of a tariff reform which would reduce the average tariff on manufactured imports from 16 percent to 10 percent. The dashed and solid line simulation paths in figure 5 show the si.ulated ·valuea under the experiment and the base simulation. 27/ In the absence of a. lending constraint, lower tariffs would generate positive effects on growth because of reduced distortions. With a lending constraint, however, the situation is quite different since the loss in public revenue (24 percent) increases the risk of debt repudiation so that lenders reduce credit lines and borrowing is only 18 percent of what is possible without the policy change. A8 shovn in figure 5, consumption must fall and the real exchange rate depreciate so as to achieve the required reduction in the current account deficit forced by the borrowing constraint. Investment, however, rises because of the improved returns in the economy associated with the real ezchauge rate depreciation. Of course, the results here are even more suggestive than those drawn from the simulations reported in Section 5 since they rely on parameters even harder to obtain values for, such as the intensity of the lending constraint or the interteaporal elasticity of substitution.
. ~-' <!-- Start of picture text --> I<br>I<br>I<br>,<br>-- -- -<br>•OJ,•~s<br>••<br>.-----~--~--------~-.~<br>.. .<br>•'<br>~-'fl<br>•'<br>•<br>'IJI;<br>•<br>I<br>• ' I<br>I<br>' '<br>'<br>'<br>12Wi ;;1:•1 :~<br>1IIU .... ----<br>• t - · ... . ,<br>., ., a -· •••<br>•<br>•• • '<br>I ~ •• • .. '<br>•<br>••<br>,•<br>,<br>I<br>, •<br>•<br>•<br>, •<br>•<br>, •<br>,<br>...<br>_________________________ _.<br>~ I<br>' •<br>tCJIWI'aiiO<br>.1<br>., .,<br>..... _<br>, .. ,_<br>, • ...<br>, ,• ,•' , .... , .. • .. -<br>, , ..<br>,<br>, . ~<br>• , .... ..<br>, • ..<br>, '<br>, , '<br>, , '<br>'<br>' '<br>•<br>.<br>·------- I I<br>..........<br>8Nif!QMJP<br>(~qeq UOTTTTq '!6l UT ••~niT. r--:)<br>•<br>:<br>.<br>•<br>••<br>••<br>•<br>•<br><!-- End of picture text -->

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• 42 It remains, however, that the simulations point out the need for goveraaent not to postpone adjustment in the face of an adverse change in external or internal conditions or to take macroeconomic considerations into account while undertaking microeconomic reforms.

# 7. Conclusions

This paper has surveyed recent contributions in applied general equilibrium analyses for developing countries with a foreign trade focus. The structure aDd properties of the models commonly employed have been analyzed and nuaerical exercises reviewed to show how simulation analyses can provide a useful tool for policy analysis. The strength and weaknesses of the models were clear fro. the theoretical properties and implementation methods. It is clear that there is roo• for much improvement especially in the area of par ... ter eetiaation aDd more formal methods of testing model validity. Ronetheless, it is hoped that the variety of applications illustrates the raage of foreigD trade policy issues in developing countries for which CGE models can be used.
43

## FOOTNOTES

<!-- Start of picture text --> Jj<br><!-- End of picture text --> <!-- Start of picture text --> y<br><!-- End of picture text --> Applications to international trade and taxation issues are surveyed in Shoven and Whalley (1984). For models with a focus on energy policies see Hudson and Joergenson (1978). An exception is Dixon et al (1982) where a CGE model for Australia is used for analyzing a wide range of macroeconomic and microeconomic issues.

Bobinson (1986) surveys CGE applications for developing countries. In that survey, the emphasis is on macroclosure and applications rather than on international trade. The two surveys are therefore coaplementary.

Devarajan, Lewis and Robinson (1986) and Decaluwe and Martens (1986) provide bibliographic surveys.

...

<!-- Start of picture text --> 3/<br>-<br><!-- End of picture text --> <!-- Start of picture text --> 4/<br>-<br><!-- End of picture text --> A recent example of pass-through, though for a developed economy, is the dollar appreciation during 1981-85. Dornbusch (1987) observes that a 20 percent appreciation in the dollar only resulted in a 5 percent increase in the index for manufactured imports. He goes on to show that this relative price behavior among traded goods is consistent with a number of competing hypotheses about firm behavior and product characteristics including the one presented here. Krugman (1986a) also develops other pricing models that are consistent with this observation.

The presentation here follows de Melo and Robinson (1986).

The CET and CBS formulations in this context were first introduced by Powell and Gruen (1967) and Armington (1969) respectively.

Edwards and Ng (1985) discusses alternative definitions of the real exchange rate and of the indices used in computing it.

# 7/ -

The analysis below draws on de Melo and Robinson (1985).

This is what was done by Taylor and Black (1974) in one of the first trade policy simulations with a CGE model.

de Helo and BDbinson derive these expressions and compute values of Ee and s• for different parameter configurations in equations (4) and (5). They also show that this formulation can easily be extended to accommodate a less than infinitely elastic foreign demand for exports, with or without product differentiation on the export side, thereby extending the analysis for homogenous primary commodities.

- 10/ Chenery (1975) reviews the structuralist debate.

Feinberg (1986a, b) uses the model presented here augmented by a tera that captures the presence of oligopolistic interactions on the pricecost margin in a Cournot model to estimate econometrically the pass

> ~' '.
44

- through of changes in the real value of the dollar on relative producer prices at the microeconoaic level.

- This application was formulated in the transactions value (TV) approach to modelling. See Drud, Graia, and Pyatt (1986), and Pyatt (1987). Krueger (1974) is the original work in this literature. Bhagwati and Srinivasan (1978) and Dervia, de Melo and Robinson (1982) give a further discussion. Lewis and Urata (1984), Ahmed et al. (1985), Robinson and Tyson (1985), Clarke and Whalley (1986), and Ahmed and Graia (1987) are other examples of estimates of the coats of QRs and rent-seeking activities. Tbe specification of foreign trade in this application is close to the one in table 1 although final demand is broken down into investment, public and private consumption.

- The evidence on market structure and performance in LDCs is surveyed in Kirkpatrick, Lee and Nixson (1984). Krugman (1986b,c) and Srivinvasan (1986) review the issues raised here along the same linea. Stewart (1984) takes an opposing view, claiming that the literature on trade and industrial organization provides new arguments for protection.

- The excessive entry problem was first noted by Eastman and Skybolt (1964) for Canada. A well known example of excessive entry is the automobile industry in developing countries.

- 1.5a/ Calibratrion procedures are described in table 3. As shown by Dixit (1985), in the absence of nondistortionary taxes, consumer taxes should be used to raise revenue.

- - 17/ assumption The slopes of of gross the internal substitutability and external between balance tradable& schedules and reflect nontradablea the in demand. See, e.g., Dornbusch (1980, chp. 6) for a fuller derivation. OGE models have been described so far as if it is always assumed that relative prices adjust to clear markets. In practice all models rely on a mix of price and quantity clearing assumptions in product and factor markets.

More precisely values for P and ... PT ""* are taken exogenously where P . .. is ""* Turkey's inflation rate and .PT is the O!CD'a rate of inflation. The exercise thus assumes equilibrium in the money market with the government having full control over the money supply. In terms of the · results in table 6 the effects of differential inflation are captured by the first two terms on the right-hand aide of (12).

The numerical results are from Dervia and Robinson (1982) where the full structure of the model and recent Turkish economic history are &WIIIIarized.

-~
45 · ....

The counterfactual is well visualized in terms of figure 3 since during 1977-81, total factor productivity growth patterns induced by the trade reforms corresponded to that shown in figure 3. Reducing capital inflows (with a fixed real wage) results in an upward shift of the F p 0 0 schedule, an inward shift of the D0D0 schedule and a leftward kink in the I 0 I 0 schedule for expenditure levels below the initial equilibrium.

The specifics of the model are reported in Chenery, et al (1986).

This led the authors to update exogenously the trade share parameters in the import demand and export supply equations. de Helo and Robinson (1985) provide analytical expressions that show such a procedure is necessary to diminish the degree of independence of the domestic price system from foreign prices.

22b/ See Devarajan (1987) who covers intertemporal issues in greater depth.

- 23/ economy no Glick and Kharas longer also faces study a perfectly the properties elastic of supply the model of foreign when the funds. They do so by incorporating an endogenous lending constraint where lenders limit the· extent of credit extended below the worth of the "collateral" given by the penalties of default proxied by a given loss of tradable goods production. In particular they show that the preaence of a lending constraint .providea a case for subsidizing tradable goods production.

Tbia implies that profit rates are not equalized within period, though there is a tendency towards equilization within period. Note that · these adjustment costa on investment amd borrowing and partial capital mobility are necessary in dynamic multi-period models to avoid extreme behavior (e.g.·. all investment or borrowing in one period).

The transversality condition requiring that the net present value of post-terminal debt service payments be equal to debt outstanding is incorporated in the model by insuring that the balance growth increase in the atock of debt is leas than the interest rate. The additional constraint (mentioned above) requiring that a predetermined fiscal surplus be maintained in the post-terminal year assures that funds will alwaya be available along the transition path during the simulation period.

The apecification of · the foreign trade sector is akin to what was discussed earlier although exports from the primary sector are modeled exogenously, and manufactures exports have a less than infinitely elaatic demand. Imports either have a zero elasticity of substitution (i.e. are noncompetitive) or a positive elasticity as in tables 1 and 2 • . ., '.
46 ,.

Siailar paths arise from an increase in the world interest rate or lover world demand for Thai exports. The relative position of the base . and simulation paths is reversed for simulations which raise the rate of technical progress or the domestic supply of natural gas.