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Working Paper Summaries (WP/94/77 - WP/94/147)
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Summary of WP/94/88: “External Shocks, the Real Exchange Rate, and Tax Policy”

Author(s):
International Monetary Fund
Published Date:
February 1995
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This paper uses a computable general equilibrium model of the economy of Trinidad and Tobago to assess the effects of two different external sector shocks (trade liberalization and terms-of-trade shocks) on the real exchange rate and the overall fiscal position of the government. The results of the model show that a policy of trade liberalization raises consumer welfare (although real wages would decline), induces a real exchange rate depreciation that increases trade flows, and leads to a more efficient allocation of resources. The simulations highlight the importance of price flexibility of nontraded goods in determining the ultimate effects of trade liberalization. If the price of nontraded goods is inflexible, many of the beneficial effects of trade liberalization will not be realized. In this case, there may be a role for a nominal exchange rate depreciation, in conjunction with trade reform, to help facilitate the necessary adjustment in relative prices. A policy of trade liberalization would also increase the central government’s budget deficit, and further strain the government’s ability to borrow. Simulations with the model show that it would be possible to replace the tax revenue lost from trade liberalization with increases in other taxes, and still generate an aggregate welfare gain.

The model was also used to assess the effects of a change in the terms of trade on trade flows, welfare, and the overall fiscal position of the government. A deterioration in the terms of trade lowers welfare, reduces trade flows, and worsens the fiscal deficit. In response to the terms-of-trade deterioration, a policy of trade liberalization would reverse many of these effects by inducing a real depreciation, but trade liberalization would lead to a widening of the fiscal deficit. Furthermore, the model shows that an increase in the value-added tax rate would be the most efficient means of replacing the revenue lost from a terms-of-trade deterioration.

These results have important implications for the appropriate policy response to a rise in the international price of a primary export good. A policy of trade liberalization would raise welfare, introduce a real depreciation, and increase trade flows. Conversely, more restrictive trade barriers would lower welfare and produce a real appreciation in addition to that already caused by the rise in the international price of the exportable good.

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