- Robert Gillingham
- Published Date:
- March 2008
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Typically, SAMs do not include separate asset accounts for various flows of funds related to activities of the monetary authorities. It is difficult to analyze the impact of monetary policy (money creation, credit, and interest rate) on the distribution of income within a SAM framework. However, there are examples of SAMs with financial sectors (Sadoulet and de Janvry, 1995) and the IMMPA model discussed below is an example of a SAM-based model that uses a SAM with a financial sector.
The closure rules of CGE models—which are a matter of contention in the CGE literature—are discussed further below.
See Cogneau and Robilliard (2000) and Cockburn (2001) who argue against the assumption of within-group homogeneity. According to the former, the contribution of intragroup distribution to total inequality can exceed 50 percent of the total variance.
There is a large body of literature on closure rules; for additional discussions see Sen (1963), Rattso (1982), Taylor (1990 and 2004), Robinson (1991), and Lofgren and others (2002). Also, Robinson and Lofgren (2005) discuss the theoretical underpinnings of closure rules.
For example, the exchange rate and foreign savings are two closure variables for equilibrating the external balance. Choosing foreign savings (fixing exchange rate) to equilibrate the external account would generate a set of equilibrating relative prices and imply a macroeconomic interpretation different from those generated from the same model with a flexible exchange rate (fixed foreign savings).
Compared with the alternative treatment of perfect substitutability and transformability, the assumptions of imperfect transformability (between exports and domestic sales of domestic goods) and imperfect substitutability (between imports and domestically sold domestic goods) permit the model to better reflect the empirical realities of most countries. The assumptions used give the domestic price system a degree of independence from international prices and prevent unrealistic export and import responses to economic shocks. Robinson and Lofgren (2005) note that introducing a degree of substitutability and transformability is theoretically consistent with the Salter-Sawn model, which assumes a rigid dichotomy between tradable and nontradable commodities.
For more information on the IMF FPM and its use in the IMF-supported programs, see Khan, Montiel, and Haque (1990).
Atkinson and Bourguignon (1991) provide a review of tax-benefit models as they draw lessons from their applications in developed countries for their adaptation in the context of developing countries. Davies (2004) lists some of the microsimulation models found in developed countries (STINMOD on Australia, SPSD/M in Canada, TRIM3 in the United States, TAXMOD and POLIMOD in the United Kingdom).
Savard (2003) describes the iteration procedure. First, the top CGE model generates a price vector (including factor payments) with household consumption held constant. Then with the new price vector, household consumption is computed at the bottom level, which is fed again in the CGE model to generate a new price vector, and so on. However, Savard does not explain how a convergent solution is guaranteed.
A SAM combines data from a variety of sources such as national accounts, supply and use tables or an existing 10 table, survey data—household, labor, and industrial surveys—and balance of payment data. Although compiling a SAM is a time-consuming task, recent development in SAM compilation and updating using the cross-entropy technique greatly facilitates the task of developing relatively disaggregated SAMs (see Robinson, Cattaneo, and El-Said, 2001; and Robinson and El-Said, 2000, for an introduction to the technique).
The appendix draws on Lofgren and others (2002).
The choice of either one of these two closures, as noted by Lofgren and others (2002), has different implications for changes in post-tax incomes. They provide an example with two institutions, an enterprise and a household, that, under base conditions, both have incomes of 200 and face direct tax rates of 20 percent and 10 percent, respectively, and show that if direct tax collection is to increase from 60 to 90 in order to reach a fixed level of government savings, an increase in the rates by 7.5 percentage points for both institutions (an increase in tax payments by 15 units in terms of absolute flows) is implied under the first closure. However, under the second closure, the new tax rates would be 30 percent and 15 percent, because the base rates are multiplied by 1.5, implying a different increase in the tax payments by each institution (20 for the enterprise and 10 for the household).
Robinson and Lofgren (2005) note that the real exchange rate as defined is not a financial variable that influences financial assets. For more discussion of the real exchange rate in neoclassical, trade-focused CGE models, see Devarajan, Lewis, and Robinson (1993).
This chapter is a revised version of a paper published in Coudouel and Paternostro (2006).
On the structure of taxation and tax reform in developing countries see Gemmell (1987), Tanzi (1987 and 2000), Gillis (1989), Bird (1992), Burgess and Stern (1993), Coady (1997b), Thirsk (1997), Heady (2001), Gemmell and Morrissey (2003 and 2005), and Keen and Simone (2004).
A more formal discussion of the welfare impact of tax and price reforms is presented in Appendix 3.1. A similar categorization is employed by Hertel and Reimer (2004) in the context of trade liberalization. Some of the issues discussed below are discussed in more detail in Dervis, de Melo, and Robinson (1982); Ahmad and Stern (1984 and 1991); Dréze and Stern (1987); Newbery and Stern (1987); Gunning and Keyzer (1995); Sadoulet and de Janvry (1995); Deaton (1997); Coady and Dréze (2002); and Coady and Harris (2004). An alternative approach to the simulation approaches discussed in this chapter would be to use the price data available in household surveys to estimate a reduced-form impact of price changes on household real incomes. However, because I am unaware of any such empirical studies, 1 do not discuss this approach here. The lack of empirical studies in this area may reflect econometric problems related to identifying price effects and separating these from, say, location fixed effects.
Note that with all these methodologies one can also distinguish between first-order welfare measures (i.e., where household net demand is assumed to be fixed) and exact welfare measures (i.e., those that incorporate demand changes). For example, in the case of increases in the consumer prices of final goods, first-order measures will in general overestimate the adverse welfare impact because they ignore the potential for
households to switch demand away from goods for which prices increase (Banks and others, 1996). Similarly, they will underestimate the benefits from consumer price decreases. The analysis of marginal reforms essentially assumes that price changes are sufficiently small, and that second- and higher-order welfare effects are also relatively small, so that first-order measures are accurate approximations. Note that although the focus here is on welfare impacts for marginal reforms, one simply needs to replace first-order welfare effects with exact welfare measures (e.g., equivalent variations) for large changes, and the discussion more or less goes through as in the text.
Typically, total household consumption (e.g., in per capita or per capita adult equivalent form) is used to categorize households by welfare level because it is perceived to be a more accurate reflection of household permanent income (Deaton, 1997).
Appendix 3.2 presents two examples of the types of price-shifting models that can be used for reforms of indirect taxes and price subsidies.
Note that such simulations of alternative expenditures can also be motivated by a desire to identify the relative distributional implications of alternative ways of, say, reducing a budget deficit.
In practice, the aggregate welfare loss can either increase or decrease depending on the existing structure of
taxes. For example, it could decrease if a higher tax leads to a switch of demand to other relatively highly taxed goods.
Note that this example implicitly assumes that the efficiency losses are "returned" to households via changes in the tax under consideration.
See Deaton (1995 and 1997) for discussion of alternative approaches to estimating elasticities and the inherent trade-offs between different approaches in terms of data and the restrictiveness of the underlying assumptions.
To the extent that producer prices (including commodity and factor prices) are truly fixed, such as because of the existence of perfectly competitive imports or government price controls, this assumption is obviously valid. More generally, this assumption would be valid if production technology were characterized by constant returns to scale with a single nonproduced factor of production and no joint products. Under these assumptions the socalled "nonsubstitution theorem" holds and producer prices are unaffected by the pattern of demand. See, for example, Mas-Colell, Whinston, and Green (1995, pp. 157-60) for further details on this issue.
For a discussion of these various resource costs for developing empirical CGE models, see Dahl and Mitra (1991). For examples of the importance of modeling assumptions, see Shah and Whalley (1991) and Clarete (1991).
For example, rationing in the labor market (e.g., unemployment) can be relatively easily incorporated by allowing increased production to draw on unemployed labor at a fixed wage, and imperfect competition can be captured through simple price-markup rules. How appealing these extensions are will depend on the policy context. Note also that the presence of rationing means that welfare effects come not only through price changes but also through changes in quantity allocations (e.g., reallocation of labor between segmented markets with differential labor returns and wage rates for otherwise identical labor types). This possibility has generated a related micro-simulation literature, which projects the new equilibrium (i.e., prices and quantities) from the CGE to household data and supplements the standard CGE analysis with an empirical reduced-form rationing model that allocates household labor to different sectors and generates a new distribution of income. For a more detailed discussion of these issues, see Bourguignon and Pereira da Silva (2003) and Kehoe, Srinivasan, and Whalley (2005).
See Warr (2001), which evaluates reform of Thailand’s rice export taxes, for an example of a CGE model that incorporates substantial country-specific estimates of the various parameters.
Appendix 3.2 presents some basic models that can be used to model the partial equilibrium effects of tax and price reforms. Appendix 3.3 presents a brief summary of the theoretical tax literature, the insights from which are often the motivating factors behind these reforms.
See Ebrill, Stotsky, and Gropp (1999) for empirical evidence on the revenue implications of trade tax reforms.
Many developing country governments directly control the price of petroleum and other energy products. For example, the determination of petroleum prices is fully liberalized (i.e., with the private sector determining prices without having to seek government permission) in only a few countries in sub-Saharan Africa (Chad, Kenya, Lesotho, South Africa, and Tanzania). In the majority of countries, prices are either fully controlled by the government without a functioning formula (11 countries) or government-determined with a functioning price formula (17 countries). In a smaller group of countries the government negotiates prices with the private sector using a formula (11 countries). For a discussion of the welfare and fiscal implications of alternative pricesmoothing rules, see Federico, Daniel, and Bingham (2001).
See, for example, Hughes (1986 and 1987, for studies on Indonesia, Thailand, and Tunisia); Chen, Matovu, and Reinikka (2001, for Uganda); Rajemison, Haggblade, and Younger (2003, for Madagascar); Coady and others (2006, for Bolivia, Ghana, and Jordan); and Baig and others (2007, for low/middle-income countries).
Their analysis adjusted for the fact that many households consume from their home production, especially food, and are not normally covered by the VAT system, so they pay the VAT only on their purchases from the market. In common with much of the earlier literature, the analysis also allowed for the existence of tax evasion through the use of implicit tax rates, that is, actual tax revenue divided by the tax base, as opposed to statutory rates, which assume perfect implementation. Because of data constraints, an IO table for Tanzania for 1992 was used. Note that this is unsatisfactory in two ways: using Tanzania data for Ethiopia and using 1992 data when the reforms took place in 2003. However, what matters here is not really that the economic structure of these countries may differ (e.g., greater reliance on agriculture or industry) but that the IO coefficients, which capture technologies and relative prices, may differ. But given the importance of intermediate good taxation, the alternative would be to focus only on the impact arising from the direct consumption of households, which would be even more unsatisfactory given that the impact arising from their indirect consumption can dominate. For example, over 50 percent of petroleum products are often consumed in the production and distribution of goods and services. Although results based on imperfect data need to be qualified, they can still provide a valuable input into the policy debate.
Real income effects were calculated using estimates of equivalent variation based on estimated demand elasticities. Note also that the analysis focused on total consumption and did not distinguish between households that were net producers and those that were net consumers of food grains. Refaqat (2003) uses household survey data for 2001 to evaluate the distributional impact of the VAT in Pakistan and finds that it is very slightly progressive. Chen, Matovu, and Reinikka (2001) find that the VAT introduced in Uganda in 1996 was no less progressive than the sales taxes it replaced.
For other examples of the distributional gains from introducing differential VAT rates, see Ahmad and Ludlow (1989) and Ahmad and Stern (1991, Chapter 7) in the context of Pakistan, and Gibson (1998) in the context of Papua New Guinea. The first two papers also find that the general distributional picture is unchanged when one adjusts for the fact that tax changes are not marginal by using equivalent variation measures of welfare impacts.
Many partial equilibrium studies evaluate such impacts: see, for example, Trairatvorakul (1984, Thailand); Krueger, Schiff, and Valdes (1988); Deaton (1989, Thailand); Budd (1993, Cote d’lvoire); Barrett and Dorosh (1996, Madagascar); Case (2000, South Africa); and Chen and Ravallion (2003, China). Reimer (2002) and Hertel and Reimer (2004) provide very good surveys of different trade reform studies and should be consulted for a more detailed and exhaustive summary of this literature. See Cornia, Jolly, and Stewart (1987) and Pinstrup-Andersen (1988) for a discussion of the motivation behind these policies. For an overview of alternative approaches to assessing the welfare impacts of trade policies, see McCulloch, Winters, and Cirera (2001).
Note that although a CGE model generated the price changes, factor price changes are not incorporated into the analysis. The likely implications of this are discussed in later sections. But note that Lofgren (2000) found that, in the short run, although domestic trade liberalization produced aggregate gains for the country, the rural poor lost out.
Ravallion (1990) discusses the importance of wage effects when evaluating reforms in rice pricing in Bangladesh, indicating that wage effects are likely to dominate commodity price effects over the long term, as would be expected from the well-known Stolper-Samuelson theorem. See also Porto (2003a and 2003b) and Nicita (2003) on trade liberalization in Argentina and Mexico, respectively. In the former case, trade liberalization was found to benefit the poor more than the rich. In the latter, although trade liberalization was found to decrease poverty, inequality increased.
A recent paper by Nicita (2004) is indicative of the detail that can be introduced on the efficiency side of the analysis. The paper evaluates the potential for welfare-improving marginal price reforms across different food groups in Mexico—abstracting from the issue of effective versus nominal taxation—and makes three interesting innovations. First, using a model developed by Deaton (1987,1988, and 1990) and Deaton and Grimard (1992), it estimates demand elasticities using a model that allows for quality differences in commodities. Second, separate sets of elasticities are estimated for income quintiles and rural and urban areas. Third, these elasticities are estimated using a series of six household surveys covering a period of 12 years from 1989 to 2000. The results show that income and price elasticities varied substantially across households, with lower-income households tending to have significantly larger income and price elasticities. The results also indicate that, even within these smaller subgroups of consumption, there is potential for welfare-improving price reforms and that there is a trade-off between efficiency and distributional concerns. An interesting extension of this work would be to evaluate separately the importance of calculating exact welfare impacts as opposed to first-order impacts for the distributional and efficiency implications of tax reforms.
See also Sadoulet and de Janvry (1992) for an analysis of the likely short- and long-run effects on the poor in different African and Asian economies. They also examine the potential for social protection programs to offset the short-run adverse welfare effects on the poor.
See also various chapters in Newbery and Stern (1987) for further discussion of the theory and application of the shadow-pricing approach.
For a similar result in the context of factor market distortions, see Devarajan, Thierfelder, and Suthiwart-Narueput (2001). Using CGE analysis for Bangladesh, Cameroon, and Indonesia they find that some tax increases have a “negative deadweight loss” reflecting reallocation of factors across sectors with differential factor productivities. Their analysis shows that the results can be very sensitive to the underlying assumptions about factor market functioning and that the potential for efficiency improving tax reforms is great.
Using a CGE model for Mexico, Sobarzo (2000) found that increasing VAT rates did not lead to substantial changes in producer prices. This is not surprising given the openness of the economy because, for traded sectors, producer prices are determined by world prices. The incidence of VAT increases was found to be progressive whereas the pattern of incidence of higher energy prices was found to have an inverted-J shape, with welfare decreases being higher for the middle-income group, followed by the “poor” and the “rich,” ordered by magnitude. Reducing the VAT combined with higher energy prices had a progressive incidence. The poor gained least from the removal of tariffs.
Similar results are found by the Devarajan and Hossain (1995) analysis of taxes in the Philippines, which finds that indirect taxes as a whole are near neutral. Energy taxes are found to be progressive, reflecting the relatively high energy-intensity of goods consumed by higher-income households, whereas import and value-added taxes were found to be neutral in their incidence. When combined with the substantial progressive incidence of expenditures, the overall tax-cum-expenditure incidence is strongly progressive. The effect of taxes is virtually identical across income deciles, leading to a 20 percent decrease in real incomes. But there are substantial differences between the incidence of expenditures, with the bottom decile experiencing a 47 percent increase in income, which falls to around 11 percent for the middle two deciles and to less than 7 percent for the top three deciles. The net effect of the tax expenditure system led to a 26 percent increase in income for the lowest decile, about an 8 percent decrease in income for the middle two deciles, and nearly a 20 percent decrease in income for the top decile.
See Shah and Whalley (1991, Pakistan), Clarete (1991, the Philippines), and Harrison, Rutherford, and Tarr (1993, Turkey) for the analysis of the impacts of trade liberalization in specific countries.
Note also that, subject to regularity conditions, the constrained demand functions x~ (.) also have the standard properties with respect to q and mh. For instance, Roy’s identity and the Slutsky equations continue to apply. Similarly, the Slutsky matrix S is symmetric and negative semi-definite and q.S = 0. The main difference is that the matrix S has columns of zero entries for commodities such that the quantity constraint is binding (because a small change in the price of such a commodity works like a change in lump-sum income).
Strictly speaking, we need only convexity in the space of commodities for which the quantity constraints are not binding.
Note also that the quantity constraints enable one to treat the net supply vectors of firms operating under constant returns to scale as functions rather than as correspondences.
This does not require the assumption that producer prices are actually constant. If producer prices are among the “control variables,” then the derivation remains valid by the envelope theorem. Further, it should be remembered that the control variables formally include the market-clearing variables, that is, the variables that implicitly adjust to clear the scarcity constraints. Seen in this light, the device of holding producer prices constant is much more general than it appears at first sight. More precisely, the derivation is valid if any of the following hold: (1) producer prices are actually fixed (as in Diamond and Mirrlees, 1975), (2) producer prices adjust endogenously to clear the scarcity constraints, or (3) producer prices are directly controlled by the planner.
Note the slight difference regarding the definition of partial equilibrium compared with standard introductory textbooks, which often include responses in the market under analysis.
If one ignores income distribution issues and assumes that government revenue is optimal (i.e =λ=β = 1), if the gain in revenue is less than the aggregate direct income effect (so that η< 1), then the difference captures the welfare loss from the price increase. This loss is analogous to the partial equilibrium Harberger welfare-loss triangle from taxes. See Coady and Drezé (2002) for more detailed discussion.
For a discussion of price shifting within a broader class of models (e.g., incorporating different degrees of competition), see Stern (1987).
Throughout this Appendix, in equations lower case refers to row vectors and uppercase to matrices.
Vatable sectors do not pay the component of VAT in taxes on traded inputs.
The solution vector of prices is a (1 xn) vector with the elements being interpreted, in general, as the “weighted average prices” for aggregate sectors. Alternatively, one could treat each component of p as a separate (1 X n) vector and solve out for each vector simultaneously.
Note also that if taxes are imposed at the wholesale stage then these rates will need to be adjusted to reflect the (lower) tax proportion of retail prices.
In this case, for t > 0 then dq < 0.
See Coady and Drezé (2002) for a recent survey of the literature in the context of these three roles.
Note that a proportional reduction in tariffs “financed” by a proportional increase in any existing consumption taxes will not be unambiguously welfare improving; see Anderson (1999).
Note that the radial and concertina reforms are now only unambiguously welfare-improving in the space of shadow taxes.
For an in-depth discussion of import substitution experiences in Latin America see Edwards (1994). For a critique of the traditional view on import substitution strategies, see Rodriguez and Rodrik (2001).
Although poverty is a multidimensional concept encompassing not only insufficient income but also other important dimensions, such as lack of access to adequate health, education, and sanitation services, the definition of poverty for the purposes of this chapter is limited to monetary measures of poverty. The rationale underlying this choice is that this definition is typically adopted by most papers in the surveyed literature.
Another strand of studies analyzes the impact of trade liberalization on poverty by assessing its impact on several variables related to the labor market that are highly correlated with poverty. These studies have as a premise that, given that it is difficult to establish a relationship between trade policies and aggregate poverty measures, it is more manageable to relate changes in trade policy to particular phenomena or variables that are highly correlated with poverty. Consistent with this view, for example, are studies that assess the impact of trade liberalization on transitional unemployment, economy-wide unskilled labor wages, industry sector wages, and child labor. For a survey of these studies see Goldberg and Pavcnik (2004).
For a more detailed and general discussion of this typology of studies for general price reforms (trade liberalization and devaluation in most respects could be considered as special cases of price reforms), see Coady (2006).
Although the work of Winters, McCulloch, and McKay (2004) refers specifically to trade liberalization, the flow channels of impact of a devaluation on poverty are similar and therefore the same framework is also applicable. However, unlike trade liberalization, a devaluation can affect poverty indirectly through stock channels or balance sheet effects. Specifically, if a country’s private sector and/or the government (composed of banks and nonfinancial firms) have significant unhedged foreign currency liabilities, a significant devaluation can generate a financial crisis by making a large number of banks and/or firms bankrupt with a potentially very strong negative impact on economic growth and an indirect impact on poverty. This issue is discussed further in Section D.
See Sections C and D for discussion.
See Sections C and D for further discussion.
See Sections C and D.
See Dollar (1992), Sachs and Warner (1995), and Edwards (1998) for examples. These studies also discuss many of the methodological difficulties inherent in empirical analyses of the welfare impacts of trade liberalization.
A recent paper by Lee, Ricci, and Rigobon (2004) shows that even after correcting for the endogeneity problems, openness would have a positive though small effect on growth. For a more general discussion of the methodological problems, see Rodriguez and Rodrik (2001).
See Winters, McCulloch, and McKay (2004, p. 78), for a brief discussion.
See Section C for more details.
If trade liberalization is accompanied by capital account liberalization, the reduced risk spreading in production could be at least partially diversified away from using the international capital markets.
Insurance actions taken by poor households include diversifying income (Ellis, 1998), engaging in precautionary savings (Townsend and Mueller, 1998), maintaining buffer stocks of key assets (Rosenzweig and Wolpin, 1993) and building social capital (Grimard, 1997). Actions to address negative shocks include asset depletion (Rosenzweig and Wolpin, 1993), borrowing (Udry, 1995), changes in labor supply (Kochar, 1995), temporary migration (Lambert, 1994), and reductions in human capital investment (Jacoby and Skoufias, 1997).
This tendency is typically true for importable goods subject to tariffs. In the case of exportables, if there are no marketing boards and there are export taxes, changes in the world price would be smaller than changes in the price of the exportable good.
See also footnote 12.
Given that different types of households own the factors of production in different degrees, movements in factor prices are expected to be a key determinant of the impact of trade liberalization on the distribution of income.
This interpretation is subject to the caveat that when the basic Heckscher-Ohlin model is generalized by introducing additional factors, sectors, and nontradable goods, the mapping between goods prices and changes in factor prices becomes much more complex.
These hypotheses include the following: (1) trade liberalization increased the returns to particular occupations that are associated with a higher educational level; (2) trade liberalization eliminated the protection in the unskilled-labor-intensive sectors that were the most protected previous to the reform; (3) trade liberalization encouraged outsourcing: Foreign direct investment flows from developed-country firms associated with more capital-intensive technologies increased skilled labor demand in developing countries because of the complementarity of capital and skilled labor; (4) trade liberalization has brought about technological change that encourages the use of skilled labor; and (5) the product mix in developing countries is shifting toward more skilled-labor-intensive products.
Ebrill and others (2001) arrive at the broad conclusion that trade tax revenues tend to fall with tariff levels when the latter, measured as the ratio of trade tax revenue to import value, is beyond 20 percent. However, Khattry and Rao (2002) estimate it to be about 40 percent.
Macroeconomic volatility and creation and destruction of markets are not discussed in this section because the author is not aware of papers or evidence establishing them as potential channels of impact in the case of devaluation.
This section assumes that the nominal devaluation will have real effects, namely, increase the real exchange rate defined as the relative price of tradables versus nontradables. The implicitly assumed situation underlying the discussion of the impact of a devaluation is that the equilibrium real exchange rate is overvalued. If the exchange rate is overvalued, the devaluation is presumed to return the real exchange rate to its equilibrium level typically by achieving a reduction in real wages. The reduction in real wages helps clear the labor market by reducing unemployment, and therefore boosts growth and reduces poverty in the medium to long term. The assumed capacity of a devaluation to restore the real exchange rate to its equilibrium level is not a trivial assumption. An increase in inflation could potentially eliminate completely the real impact of the devaluation under certain circumstances. Section D discusses important considerations related to the inflationary impact of a devaluation.
Large devaluations are likely to fall mostly on the contractionary side, as suggested by Burstein, Eichenbaum, and Rebelo (2003).
The indirect impact on poverty through growth is the only one highlighted in the text because it is typically assumed in the literature that the poor have few assets and not much attention is given to what may happen to nonpoor groups. However, in countries that have sufficiently important banking systems, a large devaluation could have a direct impact on poverty by causing nonpoor groups to fall into poverty. A large devaluation could not only significantly reduce their real income but also significantly reduce the real value of deposits that could be an important asset.
For additional papers documenting the generally nonlinear negative relationship between inflation and poverty, see the short survey in Cashin and others (2001).
See discussion in Section D.
See Burstein, Eichenbaum, and Rebelo (2003). The key factor underlying this behavior on nontradable goods prices is the sluggish adjustment of nominal wages. See the factor price section for more details.
Engel’s law is reflected in McKenzie (2001) as an Engel curve linking household expenditures on individual goods to total expenditure and to the demographic characteristics of the household. The Engel curve effect of a fall in income on expenditure is to reduce the share of spending in luxury goods and increase the share ofspending in necessities. The observed fall in the consumption of luxuries and the increase in the consumption of necessities for the Mexican case was bigger than the one captured by an estimated Engel curve.
Azam (2004), however, argues that poverty increased massively in the wake of the 1994 devaluation despite a significant recovery in economic growth. The paper presents a model in which formal sector workers are at the same time investors in the informal sector, providing employment to vulnerable groups. The main model storyline is as follows: If formal sector workers anticipate that a devaluation will lower their salaries, they start saving before the devaluation by investing in their informal sector businesses, their main savings vehicle. After the devaluation actually happens, they start dissaving by reducing the activities of their informal businesses, which affects the vulnerable groups employed by them. This retrenchment produces the increase in poverty. The paper’s empirical evidence seems limited because only the case of Cote d’lvoire is considered.
If rural farmers are landless workers depending on salaries, a devaluation can make them worse off, as pointed out in Fallon and Lucas (2002).
For an earlier example of this type of literature, see Schiff and Valdes (1992).
This refers to a nominal devaluation that managed to increase the relative price of tradables with respect to nontradables.
In particular, see Chapters 10 and 12.
One example of substitution is the switch from refined meal to hammer-milled meal in Zambia, as described below. Similarly, a 53 percent rise in the price of refined meal raised expenditures of low-income households by only 1 percent, because of the substitution of cheaper hammer-milled meal (Jayne, Tschirley, and Rubey, 1995).