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Working Paper Summaries (WP/94/1 - WP/94/76)
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Working Paper Summaries 94/45: Trade Reforms of Uncertain Duration and Real Uncertainty: A First Approximation

Author(s):
International Monetary Fund
Published Date:
August 1994
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In recent years, many developing countries have implemented far-reaching trade liberalization programs signaling a departure from the protectionist import-substitution philosophy that had dominated trade policy for decades. However, adjustment in response to trade reform, and the reforms that accompanied it, is complex. Economic agents, after years of suffering the consequences of policy slippages, question the credibility of new policies, and this complicates the dynamics of reform programs. Consumption booms, widening trade deficits, and real exchange rate appreciation have followed both successful and unsuccessful reform programs. Thus, it is difficult to interpret macroeconomic co-movements as signals of the program’s lack of credibility or weakness.

This paper examines the macroeconomic implications of trade reforms of uncertain duration in a framework in which policy credibility and real foreign and domestic shocks act as separate sources of uncertainty. Cases in which tariff revenue is rebated to consumers or used to finance unproductive government expenditure are studied, as are the effects of imperfect credibility and real shocks on deviations from trend consumption growth.

Noncredible trade reforms result in consumption booms and widening trade deficits, generally followed by recessions in the period when policy uncertainty is resolved. Contrary to findings in previous work, the results show that there is always a boom in response to an noncredible reform, regardless of the magnitude of the intertemporal elasticity of substitution, the duration of the reform, or whether tariff revenue is rebated. When revenue is rebated, the boom is always followed by a recession, and the higher the elasticity of substitution and the probability of policy reversal, the larger the amplitude of the cycle. If revenue is not rebated there are significant income effects, and the initial boom may be sustained or reversed into a recession at the date policy uncertainty is resolved. Similarly, the welfare implications of temporary trade reforms depend on whether tariff revenue is rebated or not, and, in the latter case, also depend on the elasticity of intertemporal substitution.

Real shocks induce consumption cycles through conventional transmission mechanisms. These cycles tend to be larger than those driven by a lack of credibility. In addition, the mean and risk characteristics of real asset returns affect the magnitude and direction of credibility effects--although this interaction is quantitatively small. Because of the noise introduced by real shocks, observed consumption booms cannot be uniquely attributed to credibility effects, and measures of credibility that do not separate components of the cycle driven by policy uncertainty from those driven by fundamentals are biased. If the probability of policy reversal is linked to real shocks, changes in the external economic environment may have an impact on credibility effects even if policymakers do not alter their behavior.

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