Public Disclosure Authorized Kemal Dervis, Jaime De Melo .
Public Disclosure AuthorizedWorld Bank Reprint Series: Number 248A General Equilibrium Analysisof Foreign Exchange Shortagesin a Developing EconomyPublic Disclosure AuthorizedPublic Disclosure AuthorizedPublic Disclosure AuthorizedKemal Dervis, Jaime de Melo, and Sherman RobinsonReprinted with permission from The Economic Journal, vol. 91 (December 1981),pp. 891-906.
World Bank ReprintsJaime de Melo and Sherman Robinson, "Trade Policy and ResourceAllocation in the Presence of Product Differentiation," Review ofEconomics and StatisticsNo. 215. Michael Cernea, "Modernization and Development Potential ofTraditional Grass Roots Peasant Organizations," Directions of Change:Modernization Theory, Research, and RealitiesNo. 216. Avishay Braverman and T. N. Srinivasan, "Credit arid Sharecroppingin Agrarian Societies," Journal of Development EconomicsNo. 217. Carl J. Dahlman and Larry E. Westphal, "The Meaning of Technological Mastery in Relation to Transfer of Technology," Annals of theAmerican Academy of Political and Social ScienceNo. 218. Marcelo Selowsky, "Nutrition, Health, and Education: The EconomicSignificance of Complementarities at Early Age," Journal of Development EconomicsNo. 219. Trent Bertrand and Lyn Squire, "The Relevance of the Dual EconomyModel: A Case Study of Thailand," Oxford Economic PapersNo. 220. Gershon Feder and Knud Ross, "Risk Assessments and Risk Premiumsin the Eurodollar Market," Journal of FinanceNo. 221. Bela Balassa, "Policy Responses to External Shocks in Selected LatinAmerican Countries," Quarterly Review of Economics and BusinessNo. 222. Choong Yong Ahn, Inderjit Singh, and Lyn Squire, "A Model of anAgricultural Household in a Multi-crop Economy: The Case of Korea,"Review of Economics and StatisticsNo. 223. Emmanuel Jimenez, "The Economics of Self-help Housing: Theoryand Some Evidence from a Developing Cotintry," Journial of UrbanEconomicsNo. 224. Thawat Watanatada and Clell G. Harral, "Determination of Economically Balanced Highway Expenditure Programs under Budget Constraints: A Practical Approach," Transport Research for Social andEconomic ProgressNo. 225. George Psacharopoulos, "The Economics of Higher Education inDeveloping Countries," Coinparative Education ReviewNo. 226. Katrine Anderson Saito and Delano P. Villanueva, "Transaction Costsof Credit to the Small-scale Sector in the Philippines," EconomicDevelopment and Cultural ChangeNo. 227. Johannes F. Linn, "The Costs of Urbanization in Developing Countries," Economic Development and Cultural ChangeNo. 228. Guy P. Pfeffermann, "Latin America and the Caribbean: EconomicPerformance and Policies," Southwestern Review of Management andEconomicsNo. 229. Avishay Braverman and Joseph E. Stiglitz, "Sharecropping and theInterlinking of Agrarian Markets," American Economic ReviewNo. 230. Abdun Noor, "Managing Adult Literacy Training," ProspectsNo. 231. Bela Balassa, "Shifting Patterns of World Trade and Competition,"Growth and Enitrepreneurship:Opportunities and Challenges in a ChangingWorldNo. 214.
The Economic Journal, 9I (December 1981), 89 l-906Printed in Great BritainA GENERAL EQUILIBRIUM ANALYSIS OFFOREIGN EXCHANGE SHORTAGES IN ADEVELOPING ECONOMY*Kemal Dervi., Jaime de Melo and Shlerman RobinsonAn acute shortage of foreign exchange has been a recurring problem for manydeveloping economies. In the development planning literature, the problemis usually discussed within the framework of the 'two-gap' or 'multi-gap'models developed and elaborated during the sixties. These models assumefixed input-output coefficients and limited possibilities for export expansion.As a result, a foreign exchange shortage becomes an almost absolute constrainton growth in that even if domestic savings were available in sufficient amountsto allow an increase in investment, the absence of the required complementaryforeign exchange makes such an increase impossible. The neoclassical answerto this 'structuralist' view has always been to stress the role of relative pricesand, in particular, exchange rate adjustment as a means of overcoming anyforeign exchange shortage.' Stated simply, this view treats the alleged foreignexchange gap as only reflecting an overvalued real exchange rate. If theexchange rate is allowed to clear the foreign exchange market, there can be noforeign exchange gap.However, the experience of developing countries indicates that it is extremely' difficult to achieve the necessary rise in the effective exchange rate torestore equilibrium in the foreign exchange market. As Krueger (1978) hasdocumented for a group of developing countries, the typical pattern of adjustment policies often involves an unsuccessful devaluation followed by a returnto various foims of foreign exchange rationing. The reasons why devaluationsare often unsuccessful are myriad and much discussed in the literature (seeKrueger (I978), Bruno (i979), Diaz-Alejandro et al. (I979)), but the mainpoint which we wish to pursue in this paper is that countries often rely onother policies whose quantitative impacts need to be systematically explored. Inunderstanding different adjustment mechanisms, all students of trade andexchange rate policy in developing countries agree that the elimination ofpersistent foreign exchange imbalances requires substantial adjustments in thereal sphere of the economy. While macroeconomic phenomena may be importtant, there must also be a reallocation of resources towards sectors where thereis scope for import substitution and/or where exports can be expanded. There-itionship between different policy regimes and these necessary structuraladjustments provides the major focus of our analysis.* We would like to thank Adrian Wood for helpful comments and criticisms. The views expressed inthis article are the authors' and do not necessarily reflect those of the World Bank.For a presentation of these contrasting views, see Findlay ( r973, Chapter ro) and Diamond (1978) .[ 891 1
892THE ECONOMIC JOURNAL[DECEMBERThis paper re-examines the foreign exchange gap issue and the debatebetween structuralists and neoclassicists by providing a quantitative assessmentof the role of different assumptions about the values of key trade elasticities.Perhaps more importantly, the paper also seeks to complement the existingdescriptive analysis of the consequences of alternative adjustment mechanismswith a quantitative analysis that indicates the relative importance of differentbehavioural assumptions and policy regimes. The empirical analysis is basedon a computable general equilibrium (CGE) model which is Walrasian inspirit and captures price mechanisms, market interactions and structuralinterdependence in a non-linear multi-sector framework.' The next sectiondescribes the main features of the model, concentrating on the specification offoreign trade. Section II describes the alternative adjustment mechanisms tobe considered and Sections III and IV present the empirical results. Finally,conclusions follow in Section V.I.OUTLINE OF THE MODELThe analysis is based on a nineteen-sector CGE model which endogenouslydetermines relative commodity and factor prices so as to equate demands andsupplies for commodities resulting from the independently pursued optimisingbehaviour of various actors in the economy: producers, consumers, and thegovernment (the latter not assumed to be a formal 'optimiser'). The parametervalues and initialisation of the model are based on Turkish data and theselection of adjustment mechanisms is inspired by the policies undertaken byTurkey and other developing countries during periods of foreign exchangeshortages. The model should, however, be viewed as a stylised one whichattempts to capture the main structural interactions between the internal andexternal sectors in a 'typical' semi-industrial economy.The equations of the flexible exchange rate version of the model are summarised in Table i. The adaptations to the model required to incorporate afixed exchange rate and alternative adjustment mechanisms are described inthe next section. The specification of foreign trade and its interaction with therest of the economy are the most important building blocks of the model. First,consider imports. Our fundamental assumption is that domestically producedand foreign goods of the same sector category are imperfect substitutes.2 Thistreatment is a compromise between the assumption of perfect substitutabilityfound in trade theory and the assumption of perfect complementarity found in'two-gap' models. More specifically, define for each commodity category a'composite' commodity which is a CES aggregation of imports and domesticgoods. Consumers and producers demand this composite commodity so thatthe demands for imports and domestic goods become derived demands just asthe demands for factors are derived demands in the traditional productionmodel. Assuming that demanders seek to minimise the cost of acquiring a given1 For a survey of CCE models, see Dervis el al. (I981). Chenery and Raduchel (I971 used a relatedsmall, non-linear model to analyse the foreign exchange gap issue, but did not explicitlv model marketmechanisms or focus on different policy regimes.2 See Armington (X969).
I98I]FOREIGN893EXCHANGE SHORTAGESTablcIEquations of the Flexible Exchange Rate ModelI. Prices(I) PMi PWi (I tmi) ER(2) PWEi PDi/[(i tee) ER](3) Pi (PDi PM2 M/Di)/f (MilDi, I)(4) PNi Pi -Z-Pjaji -tdiPDi(5) XQiPi PERexchange rate,tmjtariffrate,PWiworld price of imports,PMi domestic price of imports,export subsidy rate,teiPDidomestic price,PWEi world price of exports,Picomposite good price,indirect tax rate,tdiajiinput-output coefficients,PNiQ,Pnet price or value added,price index weights,exogenous level of aggregate priceindex,imports,domestic demand for domesticproduction.MiD,HiFexogenous world price of othercountry goods.exogenous net inflow of foreignexchange.IV. Income and Investment(I4) RL .- ikWkLki( -tk)(15) RK Z;(PNiXi- ;kWkLki) (I-tk)(i6) Ru EsiktkW Lei itki (PNii'kWkLki) 2tmiPWiERMlf-ZiteiPWEiER Ei itdiXi PDi FER( 7) TINV SLRL SKRX Sa Ra(i8) Yi Gi TINV(i9) Zi ZjbijY.tktax rate on labour income,category k,after-tax labour income,tax rate on non-wage incomein sector i,after-tax capital income,government revenue net ofRLrkiRRR export subsidies,II. Production andEmployment(6) XS - AiFi (Ki, Li)(7) Li Ai (Lij,. ., Lmi)(8) PNi (Xi/l aLki) WA-( )(g) LI ZiLki(lo) LD-Ls - oAi shares,L productivity parameter in produc-*SL,S, S0TINVYiexogenous savings rates,total investment,investment by sector of destina-oisectoral investment allocationbijcapital composition coefficents,investment by sector of origin.tion,V. ProductMarketstion,KiLkiexogenous sectoral capital stock,LiWklabour of category k in sector i,aggregate labour in sector i,average wage oflabour category k,LDktotal demand for labour category,exogenous labour supply for categoryk.III. Foreign Trade(ii) E2 Ei (IIi/PWE,)'7i(I2) Mi/Di gi (PDi/PM.)(I3) 2PJViMi - ZPWEiEi-F oRj, qh parameters of export demand function,(20) Ci CiL CiK Cio(2I) Ci1 q (i - Sy)R 1 /Pj j L, K, G(22) Vi E:a XI'(Zi Cf V,)(23) Di ((24) di ilfl (Ml/Di, i)(25) XD D2 Ei(26)CiiCiqijVidiX,0XI-Xis oconsumption, sector i, demanderj,consumption demand, sector i,expenditure share parameters,intermediate demand,domestic demand catio,total demand for domestic production.Notes:Endogenous variables are denoted by capital letters. Lower case letters (except d), Greek letters,and letters with a bar are exogenous variables or parameters.denotes the CES trade aggregation function. In equation (12),In equations (3) and (24), f(-)g(-) is derived from the associated first order conditions. F(-) and A(-) in equations (6) and (7)are CES functions.30Ecs 9I
894THE ECONOMIC JOURNAL[DECEMBERamount of the composite goods, the desired ratio of imports to domestic goodsis derived from the first-order conditions and is a function of the ratio of prices(to the demander) of domestic and imported goods (equation (12) in Table I).Solving the first-order conditions also yields the desired ratio of domestic tocomposite goods and, through the cost-function dual, the price of the compositegood.'Since imports are assumed to be in infinitely elastic foreign supply, worldprices, PWi, are fixed and the country is 'small' on the import side. Importprices to the domestic user are given in equation (i) and equal the world pricetimes the exchange rate times one plus the tariff rate.This treatment of imports conveys a certain autonomy to the domestic pricesystem not found in models where domestically produced and foreign goods areperfect substitutes. The specification also has the advantage of allowing two-waytrade. A pure non-traded sector whose relative price is entirely determined inthe domestic market is one for which there are no imports or exports. For othersectors, the relative price depends on commercial policy embodied in theexchange rate, tariffs and subsidies. The relative importance of each of thesefactors in determining domestic prices depends on the relative importance ofimports and exports in total domestic supply as well as on the trade substitutionelasticity in the CFES aggregation function.Turning to exports, we assume a downward-sloping foreign demand curvefor exports whose form is given in equation (i I), PWEi is the foreign currencyprice of exports and is obtained by dividing the domestic price, PDi, by theexchange rate multiplied by one plus the rate of export subsidy - equation (2).2On the export side, the country is not assumed to be 'small'.Built around this specification of foreign trade is a general equilibriumsystem with price-responsive demand functions and sectoral neoclassical production functions linked around an input-output core into a model thatsimultaneously determines quantities and prices. The core equations of thesystem are tne excess-demand equations for labour, commodities and foreignexchange (equations (io), (26) and (13)). Once solved, thle model determineswages, product prices and an exchange rate (in the flexible exchange rateversion) which yield zero excess demands and henct clear these threemarkets.3Equations (6) to (io) describe the labour market. The -production technologyis two-level CES in labour and capital, with intermediate goods required byfixed input-output coefficients (equation (22)). The labour markets always1 However, given linear homogeneity, thenf (M, D) D f (M/D, i), and these latter two magnitudes can be expressed in terms of the trade aggregation function,fi (,Mi, Di), evaluated at (A f/Di, i).Equations (3) and (24) show the relationships.2 The magnitude of the export demand elasticity depends not only on the country's market share,but also on the degree of product differentiation characterising products from other countries. Thus, thehigher the market share or the more differentiated the product in question, the lower the export demandelasticity. Other specifications of export markets are also feasible and would not change the essentialnature of the adjustment mechanisms we seek to capture. One could, for example, specify export supplyfunctions and allow an endogenous wedge between domestic and export prices.3 For a survey of different approaches to solving CGE models and a description of our approach, seeDervis et al, (198 1).
I98I]FOREIGN EXCHANGE SHORTAGES895clear, with no open unemployment.' Capital is assumed sectorally fixed.Investment - equations (I7), (i8) and (iy) - is zavings determined and itsallocation by sector of destination is given by exogenously specified shares.Equations (20) to (26) describe the product markets. The various demands(Zi, Vi and Ci) are all for composite goods, with the demands for domesticgoods being given by multiplying the composite good demand by the domesticdemand ratio (di). Since the various supply and demand functions, and the diratios themselves, are all price sensitive, the excess-demand equations can beseen as functions of domestic prices and the exchange rate. With the balanceof payments, equation (I3), there are as many excess-demand equations asthere are prices, wages and the exchange rate. However, by Walras' Law, theexcess-demand equations are not independent and we require some pricenormalisation rule to close the system. We have chosen to set an aggregateindex of composite prices exogenously - equation (5) - which represents anoverall index of prices to buyers in all markets, including imports and intermediate goods.In the flexible exchange rate model, the real variables depend only onrelative prices and hence the choice of price normalisation is only a matter of aconvenient choice of numeraire. However, as discussed in the next section,there are alternative specifications of adjustment mechanisms in which theexchange rate is fixed and balance of payments equilibrium is achieved bymeans of import rationing. In this case, the choice of the aggregate price indexmatters since it defines the 'no-inflation' benchmark against which the exchange rate is fixed and will affect real variables in the solution. Our choiceimplies that the monetary authorities are fixing an overall price index thatincludes transactions in all product markets in the economy including imports,intermediate goods and final demand. The actual monetary mechanisms atwork are not explicitly modelled in what is, after all, an essentially Walrasianmodel. 2II.ALTERNATIVE ADJUSTMENT MECHANISMS TO FOREIGNPAYMENTS IMBALANCESTo explore the role of alternative adjustment mechanisms, we assume a suddenshortfall in the 'normal' flow of foreign resources (Fin equation (I3)). Assurmiingthat the country can no longer borrow and that foreign exchange reserveshave run out, it faces a foreign exchange crisis and will somehow have to adjust1 Other specifications of the labour markets (e.g. rigid wages and open unemployment) are certainlyfeasible and have been used in other CGE models.2 A similar approach is used by Bruno (1976) and Jones and Corden (1976) who also assume thatappropriate fiscal and monetary policies are pursued to maintain price stability and full employment.The assumption of full employment could be easily relaxed and investigated in this framework. Explicitconsideration of monetary factors would be a considerably more difficult mat-ter which would be betterundertaken in a short-term mnacro model including asset behaviour and expectations. Note, however,that the assumption of price stability is not without empirical support. After reviewing the evidence ontwenty-two devaluations in developing countries Krueger (I978, p. 146) concludes that 'the net results ofdevaluation, import liberalisation, and monetary and fiscal policy were such that, on balance, thepercentage price increase in the several years following devaluation was no higher than before'.30-2
896THE ECONOMIC JOURNAL[DECEMBERto it. Three alternative adjustment mechanisms will be examined:valuation; (2) fixprice rationing; and (3) premium rationing.(i)de-Adjustment by DetaluationSuppose that the country is initially in a position of internal and externalequilibrium with the demands for all commodities and foreign exclhangeequal to their supplies. A shortfall in the inflow of foreign resources, F, generatesing excess supply of domestican excess demand for foreign exchange and a m.goods creating upward pressure on the exchange rate, ER.' Given the fixedoverall price level, this exerts downward pressure on domestic prices as awhole. However, as will be shown in Section IV, domestic prices do not falluniformly. At this stage, it is sufficient to note that the upward adjustment inthe real exchange rate is achieved by the combination of a fall in the price ofdomestically produced goods and a rise in the domestic currency price of bothexports and imports.Adjustment by Fixprice RationingIn spite of a movement towards greater exchange rate flexibility in the 1970s,trade regimes based on fixed exchan
Kemal Dervis, Jaime de Melo, and Sherman Robinson A General Equilibrium Analysis of Foreign Exchange Shortages in a Developing Economy Reprinted with permission from The Economic Journal, vol. 91 (December 1981), pp. 891-906. Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized
Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized . Bakker, Kemal Dervis, Olivier Godron, S. Ramachandran and Lawrence Summers of the World Bank, and Stefan Kawalec and Slavomir Sikora of the Ministry of . 1 See Dervis and Condon (1992) for a defense of this approach, which was
Public Disclosure Authorized 44986 Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized. Informe sobre el crecimiento . Kemal Dervis, administrador, United Nations Development Programme; ex ministro de Asun-tos Económicos y del Tesoro, Turquía.
Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized. I. WORLD BANK STAFF WORKING PAPERS Number 725 JUL, t, 1n . am grateful to Harinder Kohli and Kemal Dervis for supporting the extension of the previous work to include other East Asian countries, as well as to
Kemal Dervis Alejandro Foxley Goh Chok Tong . Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized. 57729 .
Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized. The Impact of Trade Policies on Income . fitted from other work undertaken jointly with Kemal Dervis, and we should also like to thank Martha de Melo for comments on an earlier draft Neither they, AID, nor the World Bank are .
Public Disclosure Authorized WPS4202 Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized. 2 INTRODUCTION Small arms are estimated to be responsible for between 200,000 - 400,000 deaths around the world each year. Approximately 20,000 – 100,000 of these firearm deaths occur in conflict
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