metadata: authors: 0: author: Bourguignon,Francois J.
1: author: Branson, William H.
2: author: De M
docna: 0: docna: Adjustment and income distribution : a
            counterfactual analysis
docty: Policy Research Working Paper
subtopic: Health Care Services Industry,International Trade and Trade Rules,Inflation,Macroeconomic Management,Financial Sector Policy
teratopic: Poverty Reduction
abstracts: cdata!: This paper presents model simulations to
            quantify the effects of different stabilization packages in
            the distribution of income and wealth. The simulations
            suggest that a sharply contractionary stabilization package
            has a major adverse impact on the distribution of income.
            The shifts in distribution are likely to make the package
            less sustainable. The simulations support the view that
            stabilization packages which do not have specific components
            targeted to the poor will redistribute income in a way that,
            although transitory, is likely to permanently harm those
            below the poverty line - in terms of things like nutrition,
            health, and education. The sharp redistributive effects of
            stabilization packages that omit specific targeted policies
            to alleviate poverty are also likely to endanger the
            sustainability of the adjustment package.
repnme: repnme: Adjustment and income distribution : a
            counterfactual analysis
display_title: Adjustment and income distribution :
            a counterfactual analysis
listing_relative_url: /research/1989/05/700523/adjustment-income-distribution-counterfactual-analysis
topicv3: Current Account m1326278 1135,Inflation m1326709 0870F4727ACED1CF8525815C00471347,Trade m1326924 698,Financial Sector Development m1327681 1920,Health m1504661 3480
publishtoextweb_dt: 2010-07-01T00:00:00Z
historic_topic: Poverty Reduction
origu: Policy Plan & Prog Review Dept
no_of_pages: 53
model_extractions: **Policy, Planning, and Research**

**Trade Policy**

Bourguignon, Branson, and de Melo carried out model simulations to quantify the effects of different stabilization packages on the distribution of income and wealth. They did so for a representative economy subject to the interest rate and terms-of-trade shocks of the early 1980s.

Their simulations suggest that a sharply contractionary stabilization package has a major adverse impact on the distribution of income. The resulting shifts in distribution are likely to make the package less sustainable, even though income distribution becomes more equal when normal policies are resumed.

Contrast this with the model results for the targeted expenditure cuts advocated by critics of contractionary packages. These result in a more equal distribution of income during adjustment, but the distributional improvements of the targeted package are mostly reversed in the postadjustment period.

The authors' simulations support the view that stabilization packages that do not have specific components targeted to the poor will redistribute income in a way that, although transitory, is likely to permnanently harm those - below the poveny line in terms of things like nutrition, health, and education. The sharp redistributive effects of stabilization packages that omit specific targeted policies to alleviate poverty are also likely to endanger the sustainability of the adjustrnent package.

This paperis a product of theTrade Policy Division, Country Economics Department. Copies are available free from the World Bank, 1818 H Street NW, Washington DC 20433. Please contact Maria Ameal, room N8-073, extension 61466 (48 pages with charts and tables).

The PPR Working Paper Series disserninates the findings of work under way in the Bank's Policy, Planning, and Research Complex. An objective of the series is to get these findings out quickly, even if presentations are less than fully polished. The findings, interpretations, and conclusions in these papers do not necessarily represent official policy of the Bank.

Produced at the PPR Dissemination Center
# Adjustment and Income Distortion: A Counterfactual Analysis

by Frangois Bourguignon, William H. Branson, amd Jaime de Melo

## Table of Contents

|1.|Introduction|1|
|---|---|---|
|2.<br>|Model Outline<br> <br>|3|
|2.1|Determination<br>of Income and Wealth Distribution<br>|5|
|2.2|The Financial Sector<br>|10|
|2.3|The Govemment<br>Sector|1 0|
|2.4|Goods and Factor Markets|12|
|3.|Sectoral and Household<br>Disaggregatio**n**<br>a d Elasticity Specificatio<br> <br>|n 1 4|
|3.1<br>|<br>Sectoral and Household<br>Disaggregation<br> <br>|<br>1 4|
|3.2|<br>Elasticity Specification<br>and Calibration|1 7|
|4.|Description<br>of External Shocks and Adjustment<br>Packages|1 7|
|5.|Simulation Results<br>|23|
|5.1|Macro Outcomes|2 3|
|5.2|Income Distribution<br>Outcomes|27|
|6.|Conclusions|31|
|Foot|notes|33|
|Refe|rences|3 5|
|App|endix: Description<br>of the Model|3 7|

This paper builds on work financed by the OECD Development Center in the context of the project "Adjustment Programmes and Equitable Growth." Support from the OECD Development Center and the World Bank is gratefully acknowledged. We thank Akiko Suwa for very helpful research assistance and Maria D. Ameal for logistic support. We also thank seminar participants at Berkeley, EHESS, and the Federal Bank of Govemors for helpful comments.
1

# 1. Introduction

Declining terms-of-trade, rising real interest rates on external debt and a virtual halt of adjustment lending were the major contributors to the crisis environment under which weze executed many adjustment programs supported by the World Bank and IMF. A characteristic of these programs has been the joint participation of the institutions and hence the simultaneous emphasis on stabilization and structural adjustment. Stabilization policies placed emphasis on demand management, while structural adjustment programs placed emphasis on supply-side effects. The two concepts, however, are not easily defined and separated: for example, exchange rate policies are a fundamental element of both Fund-supported stabilization packages and of Bank-supported structural adjustment packages.

Recently, distributional implications of these adjustment packages have received increasing scrutiny. In particular, they have been criticized for their lack of focus on the welfare of the poor. These adjustment packages have been criticized for seeking excessive reduction in aggregate demand, thus resulting in an unwarranted contraction of output, employment, and living standards of the poor. These adjustment programs have also been criticized Zor their lack of emphasis on mitigating the adverse distributional implications of external shocks on the poor. _l/_ The most thorough critique is in Cornia, Jolly, and Stewart (1987) where a strong argument is also made for an activist role for adjustment programs. In their outline proposal for "Adjustment with a Human Face,' Cornia et al. suggest a combination of expansionary macro policies and sectoral (and micro) policies that are targeted towards the poor and designed to increase equity and efficiency. In support of their targetting
2 approach, they cite evidence showing that increases in nutrition, education and health raise productivity and that small farms where the landless poor are located have higher productivity than large farms. They further offer suggestive time paths of adjustment and incomes of the poor under their proposed package in contrast with the standard adjustment packages they criticize (ch. 6).

While very informative and thoroughly researched, this approach offers no framework which ties the macro and micro policies they suggest. Neither is there a coherent analytical framework underlying the studies undertaken by the IMF and World Bank in response to this rising concern. 2/ For example, the sensible methodology proposed by Heller et al. (1988, ch. 3) is tot classify the poor across economically meaningful socioeconomic groups; describe how the policies included in a typical adjustment package are likely to affect these groupst then to speculate on how the poor fared during adjustment, usually without attempting to impute whether any change in their status was due to the effects of the adjustment program or to the (unsustainable?) preprogram situation (Heller et al., p. 8).

The purpose of this paper is to go a step beyond these earlier efforts by using counterfactual simulation analysis to derive orders of magnitude about the likely distributive implications of alternative adjustment strategies for-the poor. Our analysis relies on the socioeconomic classifications proposed in the studies cited above. The paper also relies on previous estimates of the magnitude of adjustment that was required during the period when the adjustment programs supported by the Bank and the Fund were in effect. These previous efforts allow us to build sensible base scenarios and counterfactuals as well as a representative classification of the poor by meaningful socieconomic groups.
3 The distinctive characteristic of our simulation model is that it links the short-run impact of macroeconomic policies that affect the distribution of income through inflation, the interest rate and other price changes, with the more-often emphasized medium-run impacts of adjustment policies (i.e. incentive reforms) that affect the distribution of income through relative commodity and factor price changes. We are therefore able to address many of the criticisms that have been raised against the recent adjustment packages (e.g. their lack of emphasis on supply response and their excessive use of demand management policies).

The remainder of the paper is organized as follows: Section 2 outlines the model which is described in fuller detail in the appendix. Section 3 discusses the stylized sectoral disaggregation, the socioeconomic classification and the initial income and asset distribution among socioeconomic groups. The selection of counterfactuals is presented in section 4 and the simulation results in section 5.

# 2. Model Outline

The distinguishing characteristic of the model used for our counterfactual simulation analysis is its ability to capture the short and medium to long-run effects of stabilization and structural adjustment policies on the distribution of income. A full description of the model end of its various closures is in Bourguignon, Branson, aad de Melo (1988). Functional forms and equations of a one sector model are in the appendix. Here we focus only on how we model income and asset distribution and the linkages between the macro and micro elements in the model.
4 Analytically, one can distinguish two interacting channels through which these adjustment packages may have adversely affected income distribution. The first, and more easily quantifiable channel, has to do with the medium to long-run effects of cuts in government expenditures and changes in production incentives brought about by changes in relative prices following changes in tariffs, other tares, and the exchange rate. For a given mix of expenditure reduction, the extent of relative price rigidities (e.g. fixed real wages or mark-up pricing), the extent of factor mobility (e.g. supply elasticities), and differences in consumption expenditure patterns across socioeconomic groups will determine the medium to long run distributional impacts of the resulting structural adjustment. De Melo and Robinson (1982) give a numerical exercise quantifying these various effects.

In addition to changes in the level of activity, the second, and more difficult to quantify channel, comes from the short-run effects that stabilization programs have on the distribution of wealth (and income) via portfolio shifts operating in increasingly integrated capital markets. In these integrated markets, foreign exchange controls are ineffective in preventing capital flight when expectations mount that a stabilization program will soon be abandoned. First noted by Diaz-Alejandro (1979, 1985) and further elaborated by others (Foxley 1983, Corbo, de Melo, and Tybout, 1986). unsuccessful stabilization programs with relatively high capital mobility have often allowed the holders of financial assets to shift their portfolios from domestic to foreign assets prior to a major devaluation, thereby realizing a capital gain. So far this short-run channel by which stabilization programs may affect the distribution of income and wealth has not been quantified. Though the emphasis is not on short-run dynamics and
5 expectations, the simulation model developed here quantifies the interaction of these two channels through which the distribution of income and wealth is affected by adjustment packages. The first channel is captured by the multi-sector computable general equilibrium (CGE) models where distributional shifts mostly occur through relative price shifts. The second channel is conveniently captured by the standard IS-LM macro framework for an open economy (e.g. Tobin, 1969; Branson, 1979) where asset prices are endogenously determined. The model described here incorporates features from these two traditions. 3/ We start with the mapping of the functional distribution of income into socieconomic groups at the microeconomic level, then we show how macro and sectoral policies affect the distribution of income and wealth. Next we discuss our treatment of the financial and government sectors, and close with a description of goods and factor markets.

# 2.1 Determination of Income and Wealth Distribution

Sectors are indexed over i, factors over j and socioeconomic classes over k. The description of sectors, factors and households is described in Table 3. Let Pkji denote the share of class k in factor j employed in sector i. Then non-labor income of class k is given by: (2.1) k i j £ kji V"ji Fji where VMPji is the marginal revenue product of factor j in sector i,Fji. The same mapping is used to determine physical wealth allocation by class:

- (2.2) **VI'm E** P jqji **Fi** k kj
_6_ where qji is the price of factor j in sector i. (The number of factors qectors and households is discussed in section 3).

Households also hold financial assets. Aggregating over socieoconomic classes, the household sector (denoted by subscript h) holds the following financial assets: money, Hh, domestic bonds, Bh, and bonds denominated in foreign currency, Fh. The total wealth constraint is:

# (2.3) Wh _- Vh_ + Hh + _Bhi_ + eFh/i*

where i* is an exogenous foreign interest rate and i is an endogenously determined domestic interest rate in the model.

The mechanisms by which policy changes affect the distribution of income and wealth are threefold. First, changes in factor rewards and employment affect directly income distribution by socioeconomic class (or household since the two are equivalekLt here). Household real incomes are further affected by changes in returns on financial assets since household incomes include income from financial holdings. Second, changes in relative product prices affect households' real incomes differentially because consumption expenditures are specified at the household level. Third, household wealth distribution is affected by capital gains and losses and by portfolio decisions.

Now turn to a more specific description of how adjustment policies affect the distribution of income and wealth along the channels described above. The linkages are summarized in figure 1 which shows the determination of a *period* equilibrium. The distribution of income, Yk, and wealth, Wk, at the household (socioeconomic group) level is affected by
7

# Figure 1: MACRO-MICRO LINKAGES AND INCOME DISTRIBUTION

<!-- Start of picture text --> Exogenous Policy and Foreign Variables<br>Tax<br>H, 9, G (e: AB*), (w; L), Rates; P*, i*<br>w m<br>Endogenous Macro Variables<br>P P, i. (AB*, e), CA, KA, I, (L ,W) -i Income (y)<br>e V u and<br>Wealth (v)<br>Distribution<br>Yk<br>Endogeneous Micro Variables wk<br>Change in Asset Holdings<br>Xi, Vi, (pd; Ui) Firms and Households<br>i<br><!-- End of picture text -->

## Initial Conditions and Exogenous Structural Parameters

Initial Level Elasticities; and Distribution Demand and. Supply; e ^e of Liabilities Asset Choice; p , e , (mi; Ui), K . g , g by Issuer and Migration -1 A **s** Holder Elasticities Notation: See text particularly tables 0 and 2; h is a subscript indexed over households; i is a subscript indexed over sectors. Other subscripts do not represent indexes. Superscript e represents an expectation, an asterisk superscript a variable denoted in foreign currency units.
8 the endogenously determined values for macroeconomic and microeconomic variables. In turn, the joint'y determined values of macroeconomic and microeconomic variables depend on the exogenously given values of policy variables and exogenous structural variables (elasticities, expectations, and initial conditions). Typically, the values of exogenous structural variables are invariant across simulations while the values of policy variables depend on the selected policy choices in the adjustment package.

The exogenous policy variables in the maquette are: the level (G) and composition of nominal government expenditures; the money supply and the degree of control of the money supply by the Central Bank (9); the nominal exchange rate (e) or government borrowing abroad (AB4); tax rates. Additional exogenou- wariables include: the foreign interest rate (i*); import prices (Pm); and the level of foreign export demand. This menu of policy variables thus allows the maquette to capture the major policy instruments applied in a typical adjustment package.

The endogenous macroeconomic variables determined in the maquette ares the foreign currency price of exports (Pe); inflation (P); government foreign borrowing or the nominal exchange rate; the current (CA) and capital (KA) accounts; investment (I); unemployment (Lu) or the nominal/real wage (w). The microeconomic variables ares sectoral outputs (Xi); sectoral intermediate demands (Vi): relative prices (Pi) or sectoral capacity utilization rates (Ui) if exogenously specified mark-up rates (mi) are in effect; and asset holdings.

The dynamics of the maquette are simple in the sense that the equilibrium solution values in any given period only depend on current and past values of endogenous and exogenous variables. The next three sections describe the assumptions and functional form specifications which determine the 'periodu equilibrium described in Figure 1.
9 Table 1: MONETARY SECTOR BALANCE SHEET <!-- Start of picture text --> Assets Liabilities<br>Rest of the World<br>* * 1* * *<br>eLv + eBw eFh +eR<br>Government<br>- I ~~~~~~~~Bb + Bh + eBw<br>Monetary Survey<br>e3 + B + L Hh + Hf + Net Worth a/<br>Private Sector<br>Firms Hf eL + L<br>* ~ ~~~ b<br>Households Hh + h + Bh<br><!-- End of picture text --> a/ Changes in Central Bank Net Worth are assumed to absorb chanIes in the home-currency value of foreign exchange reserves given by R Ae. Thus the latter do not affect the money supply.
10

# 2.2 The Financial Sector

To capture the distributional implications of adjustment programs, we distinguish five financial units: government, households, firms, the consolidated banking system, and the foreign sector. We assume that governments do not lend and that households do not borrow. Because of thin or nonexistant equity markets in most developing countries, it is not included here, and the endogenously determined proportion of household savings allocated to physical capital is made directly available to firms. Household savings is first allocated to cash balances, the remainder being allocated in a first stage between bonds and physical assets. In a second stage, expenditure on bonds is allocated between domestic and foreign bonds. Firms' financial requirements are for investment expenditures, working capital, and interest payments on their stock of domestic and foreign debt. The distinction between firms and households allows us to separate productive and distributional implications of adjustment packages. However, to avoid modeling the details of the process of creating inside money, we integrate the commercial banks and the Central Bank into an aggregate monetary survey, following IMF practice. The resulting simplified Zinancial structure is shown in Table 1.

# 2.3 The Government Sector

Critics of Bank-Fund supported programs point out that excessive reductions in government expenditures fall disproportionately on capital expenditures, and within current expenditures, disproportionately on health and education expenditures. In an analysis with a macroeconomic focus, it is not possible to capture meaningfully a direct link between type of government expenditure, productivity, and income distribution. Thus, we
11 treat sectoral productivity growth rates, gA, as exogenous and invariant between simulations (although it would be easy to link productivity growth with say public and/or private investment if sufficient evidence were available at the aggregate level).

The government collects taxes, and disburses subsidies, on commodities. The government also employs government workers, paying these workers an exogenous wage. Changes in public sector employment and changes in public sector wages are part of aggregate demand management common to stabilization programs. The government also has exogenously determined investment and current expenditures. Both components of government expenditures are also part of expenditure reductions in the counterfactuals. Finally, the government deficit is financed by a mix of foreign borrowing (eAB*w), borrowing from the private sector (ABh), and borrowing from the Central Bank (Aib) (see table 1). The government's budget constraint is given by: (2.4) G7Pc +Iij, + i-Pc - (AB + AB* (Net indirect tax + Import tariff) - i_ (Bb + Bh) - (i1 (eB,) In (2.4), the first three terms on the LHS are the three components of government expenditures described above (a bar over a varible, or a product of variables, indicates that the variable, or product of variables, is exogenous,; the term in parenthesis on the LHS includes the three sources of financing of the fiscal deficit. The first two terms on the RBS are revenues from tax collection, and the last two terms are the payments on
12 the domestic and on the foreign issued components of the public sector's debt.

# 2.4 Goods and Factor Markets

Assumptions about goods and factor markets are summarized in table 2. The assumptions are familiar from the literature on CGE models. Because the model is short-run, capital once installed is fixed within the period: intersectoral capital mobility is achieved through time by capital stock depreciation. The technology for gross output assumes a separable production function for value-added and intermediates. For each sectoral demand, some substitution is allowed between the use of domestically produced goods in that sector and competitive imports to that sector. To save on parameter choice, the same elasticity of substitution between the domestic good and the competitive import is specified for all components of domestic final demand, hence expenditures are on a composite good with price pc. Imports are available in perfectly elastic supply but foreign export demand may be less than infinitely elastic, so that the terms of trade may be endogenous. Thus a devaluation or a change in protection gives some scope for import substitution, but export expansion involves some deterioration in the terms of trade.

In the simulations, two closures are adopted with respect to the foreign sector. In one closure, the exchange rate is fixed, in which case government borrowing abroad is endogenous and given bys (2.5) AB* **-CA** + **AF-** - AL* w **h** w
13

# Table 2: FACTOR AND COMMODITY MARKETS

# Factor Markets

Capital Stocks Fized Exogenous labor supply for each category (agricultural labor; modern sector labor; informal labor)

# Goods Markets

# Technology

- CES for Value Added

- * Leontief for Intermediate Non-Competitive Imports

# Final Demand

- CES between Imports and Domestically Produced Goods for all components of final demand

- LES for private consumption expenditures

- Exogenous Government Expenditures (see section 2.3)

- Export Demand: Constant foreign price elasticity of demand

- Investment Demand: function of the profit rate measured in terms of the opportunity costs of borrowed funds.

# Market Clearing Assumptions

- Labor Markets:

- Endogenous market clearing wage for agricultural employment Exogenous nominal wage for government sector labor. Exogeneus nominal wage for modern sector labor. Migration between informal labor and agricultural labor.

- Goods Market:

# Market Clearing Price Adjustment

## Dynamics

Price Expectations: Exogenous Exogenous labor force growth Exogenous productivity growth
14 where CA is the interest inclusive current account expressed in foreign currency. In the other, government borrowing abroad is exogenous and the exchange rate adjusts so that: In all simulations, we assume full sterilization so that the money supply is independent of the current account.

# 3. Sectoral and Household Disaggregation and Elasticity Specification 3.1 Sectoral and Household Disaggregation

The sectoral, socioeconomic, and factor market disaggregations reflect our focus on income distribution. The sectoral disaggregation and wealth ownership mapping according to equations 2.1-2.3 is described in Table 3. As suggested by Kanbur (1987), Heller et al. (1988), the poor are among the following socioeconomic groups: (1) landless rural labor who receive their income from the labor they supply to the primary export and agricultural sectors; (2) agricultural small holders (or small farmers) who receive their income from the land they own and from their supply of labor; (3) the urban informal sector here represented by informal workers who receive their income from their services in the informal non-agricultural sector where they are paid their average value product (no other factor is employed in that sector). In addition to these groups, the urban formal sector is represented here by the *modern labore socioeconomic group, a group which includes government workers as well as labor employed in the three manufacturing sectors and in the formal non-traded sector (see Table 3). The description of socioeconomic groups is completed by capitalists
15 who receive their non-financial income from several sourcess land and natural resources in the primary export sector (e.g. mining activity)s labor supply to the modern industrial sectorss and income from the capital they own in all sectors. 4/ The distribution of physical and human wealth by socieconomic group, though arbitrary, is meant to be representative of the fact that householdrj, when classified in such large socioeconomic groups, receive their income from several sources. 5/ Thls assumption that socioeconomic groups receive income from several sources mitigates the distributional effects of policy changes.

Initial distributions of financial assets and liabilities (see Table 3) are also made up but meant to be representative of an economy with a relatively low debt/equity ratio with private sector debt mostly concentrated in domestically issued debt. Only capitalists hold a fraction of their financial wealth abroad. Also capitalists and big farmers are the only socioeconomic groups holding domestic bonds. For the remaining socioeconomic groups, money is the only financial asset. Initial economywide financial ratios indicate an economy with a moderate initial stock of public foreign debt (13S of GDP or 60S of exports) and a small volume of internally held debt. Because firms' liabilities to the banking system are relatively low (about 10 of the value of the economy's capital stock), financial wealth is only about 10 of the value of physical wealth (land and capltal).

In sum, the economy portrayed here is representative of a low-tomiddle-income economy that splits its foreign exchange earnings from a primary export and light manufactures, with relatively large primary and informal sectors, and a simple financial sector. The initial distribution of income among socioeconomic groups is not too extreme since most socio.
# Table 3: PRIVATE SECTOR DISTRIBUTION OF ASSETS AND LIABILITIES

||I|Soeio-<br>economic<br> <br>|I<br>I<br>I|Phyc|al and I<br>bySol|..nan<br>WealthD<br>eloconomic**Cl**<br>I|istribution<br>**as**<br>e<br>|||<br>Firm<br>|IGroups||
|---|---|---|---|---|---|---|---|---|---|---|---|
|Sectors|I<br>I<br> <br>|**Factoru**of<br> Production<br>I<br>|I<br> <br>ICapi- <br>Itallet<br> <br>|I<br> <br> IBig <br>alFrma<br> <br>|I<br> <br>ISmall<br>eralFer<br> <br>|ILandleoeI<br>lAgricultur<br>s.rel<br>Workers I<br>|Modern<br>all Workers<br>(Incl.<br>Govt.|I<br><sup>lInfore</sup><br>)lWorke<br> <br> <br>|1Llabl-IWorkin<br><sup>slI1ltiesitn!</sup><br>rs<br>IseG<br>SItT<br>|ol<br>Foreign<br><sup>eil</sup><br>Debt<br>ol7Dt||
|Primary<br>Export|I<br>I<br>(1)I|<br> <br>Land<br>Agr. Labor|i<br>i<br>I100I<br>i<br>i|<br> <br> <br> <br> <br>I|I<br>-<br> <br>1<br>1<br> <br>I|-i<br><br> <br>100||I<br>|i-I<br>0 060|_<br>0S<br>a||
|Agriculture|(2)1|Land<br> <br>Agr. Labor|I<br>|es<br>8S<br>| 19<br>|i<br>l6<br> <br>0<br>e<br>|l<br>21<br>I||I<br>I<br>|1<br>T<br>0.06I0.80|0.I<br>0.30||
|Consuu_r<br>Goods<br>_<br>**_**<br>_<br>_<br>_<br>_ _<br>_ _1|(3)<br>_|<br>U<br>-__<br>_<br>_<br>_<br>_<br>_<br>_<br>_<br>_<br>_<br>_|,__|<br> <br>|I<br>I<br>I<br>j_|<br>1<br>_<br>_<br>_<br>_<br>I<br>j|<br>N<br>_<br>_<br>_ _<br>_<br>_|1<br> <br>I<br>|1aOoSO<br>I0 30<br>I<br>_<br>I<br>I|1030<br> _<br>_<br>_<br>_<br>_||
|Interoediste<br>**and**<br>Capital<br>Goods|I<br>(4)1|<br> <br>ModernLabor|I<br>t|||I<br>__<br>_<br>I<br>||<br> <br><br>4|I<br>1<br>|I<br>I<br>I<br>l030 10.801|<br>**0.80**||
|Non-Tred eiForm l|(6)1<br>|<br>Modern Labor<br>|87<br> <br> <br>|I<br> <br> <br>|1<br> <br> <br>|1<br>1<br> <br>|<br>68<br>|I<br> <br>|10.80 10.80<br> <br>li<br>|1 0.16<br>||
|Inform Il<br>Non-Agriculture<br>Intrma|<br>_(6)_|<br> <br>Inform Lbor<br>Labo|I<br> <br>I<br> <br>|<br> <br>I.....<br>|I<br> <br>..<br>|<br>I<br>T1<br>|<br>|i<br> <br>1<br>1100|I<br> <br> <br>0<br>10<br> <br>10|<br>10|e|
|All**Sectors**|(7)1|<br>Capital<br>_~ ~<br>~~~81|39 <br>|T8<br>|12<br>**112**|2<br> <br>**2**|T<br>0.|2<br>**12**<br>|y<br>I<br>Rol<br>1|||
||I<br> <br>|____________________<br>1.<br>|-I<br>I<br>|<br>|Financi<br>b<br>|al Wealth Dle<br>y Socleoncoom<br>|trlbutlon<br>ic Clas<br>||<br>|||
|Fors9<br>Imssets|<br>F7oneinST<br>WbIth|<br>(t)|I|I<br>I<br>10.5|i<br>i<br> <br> <br>|<br>i<br>I<br>I<br>I|I<br> <br> <br>I|<br>|<br>|i<br><br>I Debt Exports|I<br>I<br>0.60||
|_ _<br>_<br>_<br>_<br>_<br>_<br>_ _<br>_<br>_<br>_<br>Domestic Bonda<br>Non-Mon.Finsn.Aus*|_<br>_<br>_<br>I<br>I<br>ts_(9)_|_<br>_<br>_ _<br>_<br>_<br>_I__<br>_<br>_<br>_<br>_I_<br>_<br> <br>|l<br> <br>0.C|<br>l<br> <br>0.6|I<br>I<br>l<br>|<br>l<br>l<br>|1<br>j|**I**<br><br>|<br>!|.<br>_ _<br>_<br>_<br>_<br>_<br>_<br>_<br>moneySuD<br>I<br>u a|_<br>_<br>_<br>_<br>_<br>0.40||
|Money/Incom|(10)||0.05I|0.06|I0.10I|<br> <br>0.10<br>I|<br>______<br>_<br> <br>0.10|<br>_<br>_<br> <br> <br>I0.10|<br>! -_0|||
|Savings/Income|(11) i<br>I||<br> <br>||<br> <br>I<br>0.26 <br>i<br>|l<br> <br>1 01<br>I|{<br> <br>0 04<br>I<br>||-<br>|<br>1<br>0.08<br>I<br>l|<br> <br>.||<br>1<br>o004||<br>~~~~~~~<br><br>1<br>D0.04<br> Nov<br>I<br>|~~~~~~~~~<br>|0.10<br>.b0t<br>I-|~~~Bonds|
17 economic groups earn income from more than one source. Finally, nonmonetary financial wealth, concentrated in the hands of capitalists and big farmers is a small fraction of total wealth.

# 3.2 Elasticity Specification and Calibration

The selected elasticity specification is summarized in table 4. As is typical of such sxmulation exercises, the elasticities reflect a combination of averages of borrowed econometric estimates (e.g. for household consumption, technology, foreign trade) and guesstimates (e.g. portfolio response elasticitieS.) 6/ The calibration procedure follows that common to CGE application: initial prices and quantities are combined with parameters (e.g. tax, rates, etc.) and elasticities (essentially those in table 3) to calculate share parameters and exogenous constants that validate the read in quantities and prices. 7/ The presence of assets in our model complicates calibration since income flows (and hence consumption decisions) depend on incomes earned (or interest paid for firms) from assets. Our calibration procedure recognizes this complication. In the simulations reported below, we calibrate the model to the household ownership matrix described in table 3. We also calibrate portfolio holdings by firms and households to the figures in table 3 and the elasticitiee in table 4. 8/

# 4. Description of External Shocks and Adjustment Packages

The adjustment programs supported by the IHF and World Bank that were subject to the criticisms noted in the introduction took place in an unfavourable external environment. An indication of how unfavourable the
18

# Table 4: ELASTICITY SPECIFICATION

# Households

## Consumption

## Portfolio

0.40 c expenditure elas < 1.40 -1.25 < 0 (Frisch) < - 2.00 0.02 > Sh c 0.15 as (proportion of wealth change consumed) - 0.10 Money: 2 (semi interest elasticity) - 0.02 p (income elasticity) - 0.6 - Bond allocation (e2 1.0) Capitalist and farmers' population growth (0.01)

- Physical/Financial (el 1.0)

# Firms

## Technolo&Z

## Portfolio

Capital-Labor subtitution elasticity in value-added (0.7 < op < 1.1)

- Working Capital (7 1.0)

Bonds Re4 - 1.0)

- Depreciation **(5** 0.04)

Investment Labor force growth (0.03) Investment demand elasticity with respect to profits - (B/C) (0.1) Technical progress (0.02 < g8 < 0.03)

# Foreian Trade

Price elasticity of foreign export demand (2.0 < Z < 3.0) Price elasticity of import demand (0.6 < cc < 1.5)

# Expectations

po - so - 0.05

# Notes Intervals for elasticities refer to all sectors and all socioeconomic classes.

All variables refer to parameters defined by the functlonal forms in the appendix. All parameter values remain unchanged across simulations.
19 environment was, is given by the magnitude of external shocks for 93 developing countries estimated at a loas of 5-6 percentage points of average GDP during 1982-6 comparzd with 1978-81. For the same group of co.ntries, average GDP growth during the eighties **was** more than cut in half (to 2.3Z) compared with average GDP growth during the seventies. For a smaller group of 30 countries recipients of _IM?_ SAPs **and** World Bank SAL., average per capita consumption growth during 1982-5 was -0.62 compared with 1Z during 1978-81. In addition to a sharp fall in consumption growth, average investment/GDP for the same group of countries fell by 4 percentage points to an average of 18.8Z during 1982-S. _91_ This sharp deterioration in performance was greatly due to the limited access to foreign borrowing which would have helped cushion the effects of rising real interest rates and deteriorating terms-of-trade. Therefore we shall concentrate on the distributional implications of alternative packages taking as given this ilmited access to foreign borrowLng. However, it is of interest to get an estimate of the effect of terms-of-trade and interest rate shocks, even if foreign borrowing had been available to cushion the impact of the shock. We do this by first simulating the model with no external shocks (called base run (BR)), then with external shocks and available foreign funds (E-1). The subsequent simulations, (labelled E-2 to E-5 in table 5 where the specifics of the policy experiments are detalled) provide several adjustment scenarios when foreign financing is not available. To save on space we do not describe in detail the results of the BR and El simulation **s** ince they refer to options that were not available during the period of adjustment. However, to glve a feel of the magnitude of the shock we have simulated, and of what might
20 Table 5: DESCRIPTION OF POLICY EXPERIMENTS

|Base Run|(BR)|Yearly<br>Growth Rate|
|---|---|---|
||**A**<br>H|Money supply<br>102|
||**A**<br>LG|Government employment<br>5X|
||**A**<br>**A**<br>W,WG|Wages (Govt., modern labor)<br>102|
||**A**<br>GE|Government Expenditure (recurrent)<br>52|
||GI|Government Investment<br>102|
||ER|Rate of devaluation<br>52|
||A*<br>Pm|World prices of imports<br>0t|
||i|Foreign interest rate<br>82|
|External|Shock:|Foreign Borrowing, No Adjustment (El)|
||(El):|Same as (BR) but|
|||A*~~<br>PM =10Z; i -<br>16Z; d-<br>152<br>fort-<br>2,...<br>,5<br>(t-6,7: same as BR)|

Adiustment: External Borrowing Reduction (E2) (E2): Same as (El) but ALG = 5.62 a/ t - 2, ... , 7 (Exchange rate endogenous) Adjustment with Cut in Government Expenditures (E3) (E3): Same as (E2) but **A A ~~A** WG = GE - GI = 0 t - 2, ... , 5 (t=6,7: same as BR) Adiustment with Wage Freeze and Credit Squeeze (E4) (EM): Same as (E3) but H - 52; W - 02 t=2,...,5 (t-6,7: same as BR) Adjustment with Targeted Expenditure Cuts and Targeted Subsidies (ES)

- Public Works (WGLG constant); W-0; t-2,...,5 (E5) - (El) + 8I - 8E - 0 t-2,...,5 (ES) -(El) + Raise import tariffs by 5021 t - 2,...,5 Subsidy on sales of agricultural products of 202 t-2,... ,5 For t-6,7 variables have same values as in BR.

a/ Yearly borrowing expressed as a percentage of initial stock of foreign debt.
21 have happened had external borrowing not been foreclosed, the simulation results for BR and E-1 are summarized in tables 6 and 7.

In the absence of external shocks, average annual GDP growth over the seven simulation periods is 5.5Z with unemployment rising from 4.2Z to 5.5Z because of our assumption of a yearly labor force growth of 42 and a yearly real wage increase for modern labor of about 5Z. Under this scenario, external debt rises from 132 to 45Z of GDP with the current account and fiscal deficits remaining at about 9Z of GDP, estimates that are slightly higher than those prevailing before the outset of external shocks. In this favorable environment, the distribution of inkcome remains stable (table 7) with average per capita income rising by between 172 and 232 for all socioeconomic groups.

The effect of the external shock with foreign borrowing available (E-1), is to lower average yearly GDP growth by one percentage point and to nearly double the current account deficit because of the higher interest rate on external debt and the higher debt volume from having the fiscal deficit financed by foreign borrowing. Under this (unrealistic) scenario with no adjustment and with available foreign funds the terminal year debtto-GDP ratio rises to 722. It is noteworthy thet, by itself, the turn towards an unfavourable environment with little aA1)ustment effort has a relatively 4trong effect on the distribution of incoiie. Whereas in BR the relatively uniform expansion of real incomes in each socioeconomic group maintains a stable distribution of income, income inequality rises because of the external shock (see the values of the Theil inequality index in table 7). Furthermore, real income per capita which rose at an average yearly rate of 3.4Z now only rises at a rate of 0.08Z, much less than GDP because of the effect of the debt service burden.
22 Now we simulate the effects of four packages representative of the range of selected adjustment policies. In all simulations we allow for a small (and fixed) amount of foreign borrowing which implies that the economy must adjust by a mixture of expenditure switching (via a real exchange rate depreciation) and expenditure reducing policies (cuts in the various components of government expenditure). The amount of fixed foreign borrowing is determined so that the foreign debt to GDP ratio follows approximately the same trajectory as in the absence of external shocks (probably an understatement of how binding the external constraint was).

Of the four packages, the first three represent increasingly contractionary macropolicies of the type often pursued under adjustment packages approved by the IMF and World Bank. The fourth package is our interpretation of what might have been the main elements of a targeted adjustment package advocated by the authors of 'Adjustment with a Human Face.* As indicated in table 5, all packages last 3 years and start at the beginning of period 2, with exogenous variables thereafte **r** esuming their trend values in the no shock environment of the BR simulation. 10/ Also note that the first three packages are cumulative.

The first package (E2) consists simply of adjusting by devaluing the exchange rate without increasing government employee or modern sector wages. The next adjustment package (E3), adds a contractionary fiscal policy by freezing both components of government expenditures and public sector wages. Finally, the most contractionary adjustment package (E4) adds a wage freeze for modern labor and a sharp reduction in the growth of the money supply from lSS to 5S per year. By contrast, the adjustment program that seeks to minimize the adverse effects of adjustment on income
23 distribution (E5), combines the contractionary expenditure effects of E-^ with subsidies to the sale of agricultural products financed by a 50Z increase in tariffs. In this adjustment program with targeted expenditure cuts, the government mitigates the adverse impact on employment of contractionary expenditures by a public works program in which public sector wages are cut, and public employment is expanded in such a way that the public sector wage bill remains frozen at its first year value.

# 5. Simulation Results

The results of the various adjustment packages on macroeconomic indicators and the distribution of income appear in tables 6 and 7. Because of the complexity of the model, only a few indicators are reported in those tables, and to save on space, much of the detailed interpretation is left to the reader. For example, we do not dwell on the differences in the terminal year fiscal deficit ratios in E3 and E4 (2.9Z vs. 8.1Z) which can be understood by comparing growth rates and interest rates in the two simulations.

# 5.1 Macro Outcomes

Not allowing the economy to raise its debt-to-GDP ratio in response to the external shock essentially doubles the 'growth cost, of the external shock, ll/ as the average GDP growth is now 2 percentage points less than in BR, even though unemployment is at the same level as in E-1 (because the expansionary effect on employment of the fall in the real wage compensates for the lower output growth).

In the next two packages that include expenditure reducing policies, the contractionary effect is much stronger: with the most contractionary adjustment package including a wage freeze and a credit
24

# Table **6:** MACROECNOMIC ISNCAYS

|Experiment<br>Indlcator|End ot Initll_<br>**Year**(1)<br>Voluv|<br>_U_|**El**|U|_|**£4**|a|
|---|---|---|---|---|---|---|---|
|ODP Growth<br>!/||**F.5**|**4.5**|<br>**5.5**|<br>5.1|1.9|<br>**58.**|
|INVR/ODP<br>_k/_|21.1|**S**<br>_<br>**13.6**|**35.5**|**-**<br> **lOs**|**---**<br>**I'**<br>**#3.**|**10.0**|**16.6**|
|FiscalOeficit/GOPN /|**SO9**|10.2|1U.0|7.4|**_210_**|O.1|**0.1**|
|Trade Ialance/GPN_kI_|**6.5**<br>**E.6**||**9.1**|0.4|**1.5**|<br>**0.0**|<br>**0.7**|
|Current<br>Account/GOPN|W<br>**6.0 _.7**||**16.,**|**5.6**|**7.4**|**5.7**|6.1|
|Money<br>Growth||s1|**U.11**|**.8**<br>**18.5**|**1U.**|**0.0**|<br>**.11.1**|
|Intlatlon<br>!||_1.1_|**7.'**|**s.9**|**G.7**|**5.6**|0.4|
|RateofDevoluatlon_/_|**5.0**|**5.0**|**_5e_**<br>**0**|**10.6**|**7.5**|**5.6**|**0.4**|
|Interest<br>Rate_9/_|9.2|11.4|<br>**7.8**|**0.5**|**6.3**|**0.1**|**6.4**|
|Unemployment<br>Terminal<br>Year_g/_|4.2|**5.5**|**0.3**|**6.1**|**7.6**|10.6|**7.0**|
|Public<br>Foreign<br>D-bt/GDPN<br>_k./_|15.0|48.1|71.6|44.6|4.|**4**||

## Slulatlon.:

BR **a** base run (no external shook) El * external shocks foreign borrowing, me edU 1 -1 E2 ***** El ***** foroign borrowlng reductlen *oly ES * E2 ***** out In government *x_ lturea E4 **u** ES + odwern sector we free **and trdit sqeAz** ES **a** El + targeted expenditure cute ad targeoW oAeidie Notes CDP ***** real GO GODPN **a** current-price GDP INYR **_*_** real investmnt (public . private) f/ Average compounded annual growth rte. Terminal year ratio value /Termilnal yer percent value.
25 equeeze, unemployment doubles in spite of the lower real wage because of the contractionary effect on investment of higher real interest rates. Under this adjustment package, the economy expands so little that the fiscal deficit (expressed **as** a percent of nominal GDP) is hardly reduced because government tax collection is falling almost **as** rapidly **as** government expenditures. This simulation is **an** illustration, perhaps extreme, of thq 'overkill' criticism which IMP-type packages **are** often accused of (e.g. Dell i982). By contrast, the **less extreme** adjustment package, (12), sharply reduces the fiscal deficit vith a much lower rate of unemployment. In the moderate (E3) package, a much lower, yet positive **real** Interest rate results in a terminal year Lnvestment-to-GDP ratio that is **S** percentage points higher than in _(14)._ The macroeconomic results of the targeted expendlture cut package, 15, **are** similar to those with expenditure cuts without targettlAg (13)t the growth rate and the unemployment rate are close with a **somewhat** larger fiscal defLcit reduction in the targeted expenditure cut package. However, in the targeted package, protection results in **less** real **exchange** rate depreciation and hence less induped terms-of-trade loss throu export expansion. This raises growth. In contrast, the investment-to-GDP ratio is **as** low as in the most contractionary package in spite of a much lower real interest rate. This **is** due to the higher cost of imported capital equipment under the more restrictive trade policy vith higher protection. Whereas the lesser terms-of-trade **loss,** the lower real interest rate, and increased employment, all contribute to lessen the costs of protection on growth, the higher cost of imported capital equipment reduces growth. On balance, however, the targeted expenditure package yields macroeconomlc indLcators that are about as favorable as in the moderate package (E3),
26 Tb ILa 7: AVERACE PER CAPITA REAL INCOME BY SOCIOECONO#4IC GROUP (RATIOS TO YEAR 1)

|Experisent|||**Blas**Run<br>(BR)|E-1|E-2|E-S||E-|4|E|-S|
|---|---|---|---|---|---|---|---|---|---|---|---|
|Year||a/|5<br> a<br>7|5<br>7|7|o<br>a|7|a|7|a|7|
|Cnpital;sta|(6.3)<br>/|8.07<br>(42.7)|1.12<br>1.19|0.t40.90|0.76<br>0.90|0.77|0.91|0.72|0.61|0.76|0.94|
|Big Farwer'|(9.6)|1.08<br>(15.1)|1.11<br>1.17|0.94<br>1.08|0.94<br>0.97|0.91|O.94|0.88|0.68|1.13|0.94<br>.|
|Sol<br>Fuawro|(80.0)|0.83<br>(1.0)|1.12<br>1.21|1.00<br>1.06|1.03<br>1.08|1.00|1.00|0.97|0.94|1.24|1.00|
|Modern Worker. I/|(27.6)|1.48<br>(3.9)|1.18<br>1.21|0.96<br>1.09|0.78<br>0.91|0.66|0.82|0.67|0.73|0.62|0.92|
|Landles<br>Ag. Worke|rs(8.7)|0.80<br>(0.4)|1.17<br>1.23|1.00<br>1.10|1.07<br>1.08|<br>1.00|1.00|<br>1.00|0.93|<br>1.27|1.00|
|InformalWorkers|(17.8)|0.56<br>(0.6)|1.14<br>1.20|0.68<br>0.96|0.64<br>0.69|<br>0.59|0.68|<br>0.43|1.16|<br>0.69|0.77|
|Econony-Wide Averag<br>Real_P.r_Capita Inc|e<br>ome|0.91<br>(5.8)|1.14<br>1.22|0.9S<br>1.05|0.79<br>0.91|0.76|0.67|<br>0.67|0.66|<br>0.79|0.91|
|Thei<br>I/||22.87<br>26.86|22.07 22.2B<br>28.28 2t.66|22.67 23.91<br>31.8831.62|21.84 24.16<br>29.91 32.88|21.48<br>38.69|2S.44<br>36.02|26.85<br> 40.82|22.05<br>83.47|16.26<br> 24.09|24.29<br>38.92|
|HeadCountg/|S/|S8.78|86.04 87.79|38.15<br>87.07|56.52<br>54.87|6.40|86.11|67.67|39.68|56.67|66.19|
||_|6/<br>U3.92|S8.04<br>87.79|6E.71 64.74|66.1 65.48|68.76|67.71|70.52|69.08|65.67|66.80|
|Poverty**Gap**h/|_gi_|8.85|2.75<br>1.68|5.62<br>8.95|7.886.41|10.04|7.71|14.74|7.40|4.65|6.21|
||V|6.6|2.75<br>1.68|9.62<br>6.27|14.08 11.19|17.91|14.30|28.91|12.69|10.04|11.64|

I/ End of _year._ Year _I are_ luvel values (real wealth in parenthess); all other values are ratios to year 1.

- _hi_ Shares in total population in yoar I in parenthese.

- S/ Includes un_aloyed and government workers.

/ Theil inequality index; T - ln Cvi/wI **;** )I v* **s** are inco4 and population hare.

S/ Unemployed included * ong modern workers.

fr Uneaployed included among informl workers.

0/ Hoed-count ratio Ha E p / * **e** 0.44. Cost of living at calm i; p * population shares. y (a I i I is I i h/ Poverty gap i * E (a-i)p E y p **_;_ y** - per capital income of claos i.

Notes: i is diacentinuous becus **we** have aacoud a uniform distribution of income **among** socioeconomic groups. The value of 0 indicates the share of Ineme which ould have to be redistributed to brine thos below the poverty line up to the poverty line.
27

# i.e. a slightly higher growth (and less terminal year unemployment) but a higher fiscal deficit. 12/

# 5.2 Income Distribution Outcomes

The distributional shifts resulting from the different adjustment packages appear in table 7. In Table 7, per capita real incomes at the end of each adjustment package (year 5) are contrasted with per capita real incomes at the outset of the adjustment package (i.e. at the end of year 1 which is identical under all adjustment packages). We view these ratios as rough indicators of the sustainability of a package on the social front. Thus, for the lower income groups (rural labor, small farmers and informal labor all have below average per capita real incomes), ratios below unity would be an indication of pressure from those socioeconomic groups to abandon the adjustment package as their real incomes would be lower 3 years after the package started.

Because the unemployment rate varies much across adjustment packages, our estimates of the distributional impact of alternative adjustment packages will be sensitive to where we place the unemployed. In the main part of table 7, we have included the unemployed among the modern worker socioeconomic group. However, an alternative would be to assume that the unemployed are mostly among the informal worker socioeconomic group. For this reason, we have reported two sets of inequality estimates for each one of our inequality measures at the bottom of table 7. All estimates of inequality are more pronounced when the unemployed are placed among the informal workers group.

All the adjustment packages entail a large negative annual growth in per capita real income ranging from -42 for E2 and ES to -6.9Z for E4.
28 Even the less contractionary packages (E2 and E5) yield a negative average real income per capita growth of -1.42 for the entire simulation (including two years of growth without contractionary policies). Even if, for a typical developing country, the estimates exaggerate somewhat the extent of per capita income loss during the adjustment period, it remains that the costs of adjustment in terms of per capita income loss are large whatever package is adopted. It is also clear that the pressure to abandon the packages was great. 13/ A further indication of the pressure to abandon adjustment efforts is given by the *head count' ratio, H, i.e., the fraction of the economically active population below a threshold real income level taken as - a poverty line. Choosing the threshold line at Z 0.44 places the small farmers and landless agricultural worker groups below the poverty line at the outset. Depending upon whether the unemployed are distributed among modern workers (informal workers), 392 (64Z) of the population is below poverty at the end of year 1. 14/ Even in the less extreme case where the unemployed are distributed among modern workers, the share of population increases to over 50? of the population by year 5 at the end of each adjustment package. This increase in poverty comes from the informal workers who earn all their income in the non-traded informal sector. All adjustment packages involve a real exchange rate devaluation which lowers the real income earned by this group. The purchasing power of informal workers is further eroded by the increased cost of the traded goods that enter into their consumption basket. The position of modern workers deteriorates less than that of informal workers because their income is earned in both traded and non-traded sectors. If one reckons with the 43 percent fall in real income for modern workers by the end of the most
29 contractionary package, one can easily visualize why the contractionary packages advocated by the IMF are criticized for leading to socially unsustainable outcomes. Of course, the outcome is even worse if the unemployed belong mainly to the informal workers group. It is noteworthy that the most contractionary package is the only adjustment package in which the capitalists' relative position improves.

The distributional shifts during adjustment have some common patterns, regardless of the package. Informal workers always lose the most in relative terms for the reasons discussed above. The next group to lose the most is modern workers, mostly because we have arbitrarily distributed all the unemployed in that socioeconomic group. Small farmers and large farmers always improve in relative terms because their income is in traded sectors. Finally, capitalists usually lose during adjustment but make up their loss in the post-adjustment period.

In terms of income distribution, the targeted expenditure cut program dominates by far the other packages at the end of year 5. However, by the end of year 7, this improvement is eroded. indeed, it is the most contractionary package which yields the least unequal income distribution at the end of the seven year simulation. This reversal is due to the sharp relative improvement in the position of informal workers who recoup in the short-run from a resumption in more expansionary policies because there are no substitutes for what they produce when real incomes start growing again in response to the expansionary monetary and fiscal policies. This sharp swing is of course the reverse of the coin whereby informal workers suffer the most under contractionary policies. The reason for the sharp contrast between E4 and E5 when the unemployed are in the modern workers group is that in the contractionary package, the migration from the primary to the
30 informal sectors is much less (there are 4 percent fewer informal workers in year S under E4 than under E5). With fewer people, the informal sector gains even more from the resumption of more expansionary polLcies in E4 than in E5. The swing in inequality between years 5 and 7 is less sharp when the unemployed are included among the informal workers.

The head count ratio, H, ignores how poor the poor are.<sup>The</sup> poverty gap measure, G, also reported at the bottom<sup>of table 7, is</sup> sensitive to both the number of poor and to how poor they are. Also, unlike H, G is not discontinuous. The value of G indicates how much income as a percentage of the tot&i, would have to be given to those below the poverty line to eradicate poverty. The values for G in table 7 clearly show the superiority of the targeted expenditure cut adjustment program over the most contractionary package in terms of the amount of money that would have to be redistributed to eliminate poverty.

The distribution of wealth is also affected by the choice of adjustment package. Since the model does not include equLty and land markets, our calculations of the distribution of real wealth use the real interest rate as a deflator for land and replacement lost for capital. Given the concentration of wealth in the hands of capitalists and big farmers, the sharpest wealth distributional shifts occur between these two groups as a result of shifts in the ratio of the replacement cost of investment goods to the real interest rate. Farmers benefit from the targeted expenditure cut package which raises the rent on land<sup>and</sup> capitalists from the most contractionary package because of the higher real interest rate. The shift in financial portfolios have little impact on wealth distribution because of their small share in total wealth.
31 In conclusion the issue of uustainability is one of timing: can the contractionary policy survive three years of sharply deteriorating social indicators? If it can, then the simulations here suggest that the dlstrlbution of income would improve sufficiently in the years Lmnedlately following the end of the package. But the lower growth and sharper dlstributlonal shlfts of the severely contractlonary package suggest that it would face great pressures. It should also be stressed that the adverse distributLonal shift durlng adjustment, whlle transltory for those above the poverty line, can leave permanent damage (nutritLon, health, education, etc.) for those below the poverty llne.

# 6. Conclusions

**This** paper h's presented a macroeconomlc simulation framework to quantify the likely dlstrlbutional shifts that would occur under different packages. The distinguLshing feature of the model ls that lt lLnks the micro elements by which structural adjustment policLes affect income distribution through relatlve prlce shlfts wlth the macro elements of the stabilization components of adjustment packages that affect income dlstribution through the level of economic activLty. Because the model is faLrly dlsaggregated across sectors, markets, and socioeconomlc groups, expectations which may also affect lncome dlstrlbutlon are treated exogenously.

Simulations wlth the model were carried out for a representatlve economy subject to the lnterest rate and terms-of-trade shocks of the early elghties. The simulatlons suggest that the short-run effects on the distrlbution of income of a sharp contractLonary package are large. These shifts are likely to endanger the sustainabliLty of the package even though
32 the distribution of income becomes more equal when normal policies are resumed. (These reverse distributional shifts are not anticipated or discounted.) By contrast, the targeted expenditure cut programs advocated by the critics of contractionary packages result in a much less unequal distribution of income during the adjustment package, even though the distribution improvement is reversed in the post-adjustment period. Of course, the subsidy component of the targeted package could in principle be extended, but at the cost of continued distortion and/or future fiscal strain. In conclusion, insofar as the economy and simulation packages are representative, the paper supports the view that stabilization packages which do not have specific components targeted towards the poor, will have a noticeable adverse effect on the distribution of income, which is likely to result in some form of permanent damage for those below the poverty line.
33

# Footnotes

- 1I See Cornia, Jolly, and Stewart (1987), Taylor (1987).

- 2/ See World Bank (1986), Huang and Nicholas (1987), IMF (1986) and, more recently, Heller et al (1988). Kanbur (1987) is an exception. He develops practical measures to measure poverty at the household level using expenditure survey data.

- 3/ The financial sector is in the tradition of Tobin (1969), Branson (1979). The real sector is in the CGE tradition (Dervis et al, 1982) and income distribution is modelled as in Adelman and Robinson (1976) but in less detail. All markets are assumed to clear in the representative period and there are no lags. The model does not address the short-run dynamics of adjustment as in e.g. Khan and Zahler (1983).

- _41_ Note that all sectors except primary export and informal nonagriculture use capital and that the ownership of capital across socioeconomic groups is the same for all sectors (and does not exhaust non-labor income because of retained earnings). This distributive sssumption is the result of oar desire to calibrate the model so that capital ownership shares are consistent with the savings rates by socioeconomic groups at the bottom of table 3. (By consistent is meant that the distribution of capital across socioeconomic groups would remain constant if the share of savings allocated to capital remained equal to its base year value.)

- 5/ Figures for modern labor in table 3 refer to the case of full employment in the modern labor market. In case of unemployment of modern labor because of fixed wages, rationing falls on modern workers and not on capitalists. In that case, the correaponding shares in table 3 become endogenous.

- 6/ A desirable step in specific country applications would be to combine of the shelf parameter selection with econometric estimates for elasticities deemed crucial in that particular application.

- 7/ For a description of calibration procedures see Dervis et al. (1982) (appendix B).

- a/ The calibration is achieved by iterations involving at each step the recalculation of incomes inclusive of interest earned (paid) based on assumed values for prices, interest rates and expectations for the pre-simulation year. At each iteration, the calibrated parameter values and constants for technology and consumption behavior are maintained, but those for portfolios are recalculated until the desired portfolio holdings (given by the ratios in table 3) are the desired ones for the read in initial values for prices and quantities.
34

- 9/ All figures are from World Bank (1988). Also see Faini et al. (1988).

- 10/ In all packages, it is assumed that there is sufficient credibility in the monetary policy of the Central Bank (because money supply is kept from rising) so that the Central Bank has full control over the money supply and is therefore able to sterilize the effects of capital flows. Because our model is not well suited for adjustment under highly inflationary conditions -- no durable goods, portfolio decisions for incremental flows rather than for the total portfolio and exogenous expectations -- we do not consider an adjustment package that would rely heavily on the inflation tax.

- 11/ Of course, this does not account for the fact that the economy has a higher volume of debt than in BR.

- 12/ The slightly lower growth in E3 is also due to the shift towards consumption because of the strong wealth revaluation in that package. (Wealth changes are fairly similar for E2, E4 and E5.)

- 13/ Sachs (1986) contrasts the experience with adjustment of East Asian and Latin American countries, noting the pressures to abandon stabilization in Latin America because of the high income per capita loss during 1980-5 which he estimates at about 20S for 8 Latin American countries.

- 14/ Since the distribution of income is assumed to be uniform within each socioeconomic group, this is the only approach we can take to define poverty. It would be easy to postulate a lognormal distribution of income within each socioeconomic group as in de Helo and Robinson (1982). Such an approach, however, would not add much to the present discussion since within-group variance ls exogenous and there is little information on variances among the socioeconomic classes defined here.