1. Introduction

After a period of operating a conventional central bank, Lithuania adopted a currency board arrangement in April 1994. ^1/ The establishment of a currency board entails a change in the institutional framework for monetary policy, with the explicit intention of enhancing the credibility of the authorities’ anti-inflation policies. Under a currency board, the monetary authority’s activities are essentially limited to the buying and selling of foreign exchange at a fixed exchange rate without limitations as regards amounts, thus maintaining a given foreign exchange coverage of the domestic currency issued. This arrangement implies that the scope for monetary policy maneuver is reduced. In effect, the authorities attempt to enhance their credibility, beyond that stemming from a conventional fixed exchange rate policy, by giving up policy instruments that could be used for expansionary purposes (such as central bank credit extension and open market operations); thus, they forego the possibility of “monetary surprises.”

This chapter takes stock of the empirical evidence on the operation of Lithuania’s currency board from the two years since it was adopted, in order to assess the extent to which the currency board has helped enhance policy credibility and reduce inflation. This assessment is complicated by the shifting influence of factors other than the currency board per se during this period; some of these factors may be relatively easily identified (for instance, the energy sector’s financing difficulties in 1994/95 and the banking crisis in late 1995/early 1996), while others are less obvious. The chapter first looks at the evidence regarding “policy credibility” (section 2); the conclusion that emerges is that the currency board indeed appears to have improved credibility, but that this credibility remains fragile and might be easily undermined by any actions to alter elements of the currency board or by other economic policy actions that are perceived by markets to undermine stability. The discussion then turns to developments in inflation over the last two years (section 3). While inflation has been on a declining trend, it still runs at 2-3 percent per month. The empirical analysis suggests that the main factors contributing to the continued inflation have been relative price adjustments ^2/ in the face of downward price rigidity and a catch-up from the initial exchange rate undervaluation when the currency board was established; as could be expected, monetary policy has played little or no role in propagating inflation during this period. ^1/ Continuous inflation at 2-3 percent per month raises questions about the credibility--and indeed the sustainability--of the currency board arrangement over time; the final section of this chapter (section 4) reviews the evidence concerning Lithuania’s external competitiveness during the currency board period. While Lithuania’s competitiveness has been substantially eroded over the last two years, it appears to remain adequate, as evidenced by Lithuania’s low relative wages in U.S. dollar terms and low level of relative consumer prices, as well as its sound balance of payments position.

2. Economic policy credibility

Following a brief review of basic issues (definition of “credibility;” why credibility is desirable; how the design of the currency board might affect credibility), this section reviews empirical evidence on whether the currency board arrangement has helped improve the Lithuanian authorities’ economic policy credibility.

b. The Lithuanian experience

Some of the specific designs features of the Lithuanian currency board arrangement might not suggest that the arrangement would engender large credibility gains, for instance, the relatively limited administrative action needed to change the exchange rate peg. Pointing in the other direction are the relatively high foreign reserve backing of the domestic currency issue, as well as the continuing competitiveness of the Lithuanian economy, and the fact that the currency board has been kept in place for two years through at least two periods of major strains. Indeed, developments in economic variables, including in interest rates and real economic variables, suggest that credibility has improved.

If the Lithuanian authorities’ attempt to increase their policy credibility by establishing the currency board arrangement has been successful (and abstracting from the effects of other factors), one would expect credibility to increase over time. As a result, certain trends would be observed: ^1/

• ♦ declining domestic nominal interest rates towards international levels, and initially high ex post interest rates in U.S. dollar terms (as the exchange rate is kept stable, while credibility starts out from a relatively low level), followed by declining rates as credibility increases;

• ♦ increasing the demand for domestic monetary assets of the public which, given the currency board set-up, would be reflected in increases in foreign reserves;

• ♦ initially negative effects on economic activity, followed by a recovery of output, combined with a deceleration in inflation, diversification of trade toward markets with more stable exchange rate relationship vis-á-vis the litas (i.e., western markets), and increased foreign direct investment.

Clearly, in Lithuania in the two years since April 1994, factors other than the introduction of a currency board arrangement per se, and its effect on inflation, have affected the variables noted above. Over time, the broad-based reform and stabilization program is bound to have had implications, including on perceived credit and default risk, although these effects are hard to discern. In illustrating how other factors affect credibility, two episodes--one in late 1994/early 1995 and the other in late 1995/early 1996--stand out. In the first instance, the currency board came under pressure because of certain actions taken by the authorities to raise financing for the energy companies and enable them to import fuel inputs during the winter. ^2/ In the second instance, the pressures arose following the closure by the Government of some major commercial banks in December 1995 (see Chapter III), and thus may have reflected a heightened awareness of the weaknesses of the banking system, rather than doubts about the authorities’ commitment to the currency board as such. During the more recent episode, the problems were exacerbated by political uncertainty with the impending change of Government in early 1996. In both cases, the pressures occurred amidst calls for a depreciation of the litas, and led to temporary capital outflows and interest rate hikes.

Abstracting from these two episodes, developments since the currency board arrangement was introduced suggest that the arrangement has been successful in enhancing the credibility of the authorities’ disinflation effort. This is evident in the lower level of interest rates that has prevailed. ^1/ In the second half of 1994, after the currency board had been in operation for about six months, both nominal deposit and lending interest rates dropped (Chart 1). Deposit rates declined from about 55 percent in March 1994 to about 20 percent at the end of year, and have remained at that level, and lending rates followed a similar pattern, declining from 70 percent to 25-30 percent. The interest rates on treasury bills have, however, been more sensitive to pressures on the currency board; hence, while they also have been on a declining trend, this trend was temporarily interrupted during the episodes of late 1994 and late 1995. Similarly, following sharp variations during 1993, domestic ex-post interest rates measured in U.S. dollar terms declined in the second half of 1994, and stayed a little above 20 percent in the subsequent period (Chart 2). In domestic currency terms, real ex-post deposit rates have been close to zero since late 1994, while real lending rates have been substantially positive, although they have exhibited a significant decline following the establishment of the currency board.

LITHUANIA NOMINAL INTEREST RATES

(Monthly return)

Citation: IMF Staff Country Reports 1996, 072; 10.5089/9781451823929.002.A001

Source: Lithuanian authorities.

• Download Figure
• Download figure as PowerPoint slide

View Full Size

LITHUANIA NOMINAL INTEREST RATES

(Monthly return)

Citation: IMF Staff Country Reports 1996, 072; 10.5089/9781451823929.002.A001

Source: Lithuanian authorities.

• Download Figure
• Download figure as PowerPoint slide

LITHUANIA NOMINAL INTEREST RATES

(Monthly return)

Citation: IMF Staff Country Reports 1996, 072; 10.5089/9781451823929.002.A001

Source: Lithuanian authorities.

• Download Figure
• Download figure as PowerPoint slide

LITHUANIA REAL INTEREST RATES

(Monthly return)

Citation: IMF Staff Country Reports 1996, 072; 10.5089/9781451823929.002.A001

Source: Lithuanian authorities.

• Download Figure
• Download figure as PowerPoint slide

View Full Size

LITHUANIA REAL INTEREST RATES

(Monthly return)

Citation: IMF Staff Country Reports 1996, 072; 10.5089/9781451823929.002.A001

Source: Lithuanian authorities.

• Download Figure
• Download figure as PowerPoint slide

LITHUANIA REAL INTEREST RATES

(Monthly return)

Citation: IMF Staff Country Reports 1996, 072; 10.5089/9781451823929.002.A001

Source: Lithuanian authorities.

• Download Figure
• Download figure as PowerPoint slide

The lower interest rates have coincided with a strong expansion in monetary assets of the public that has been reflected in a similar increase in foreign reserves. However, this increase in monetary assets has not been associated with any clear trend toward increased monetization; monetization declined in early 1996 in the wake of the banking crisis (Chart 3).

LITHUANIA MONETIZATION AND FOREIGN EXCHANGE FLOWS

Citation: IMF Staff Country Reports 1996, 072; 10.5089/9781451823929.002.A001

Source: Lithuanian authorities.

• Download Figure
• Download figure as PowerPoint slide

View Full Size

LITHUANIA MONETIZATION AND FOREIGN EXCHANGE FLOWS

Citation: IMF Staff Country Reports 1996, 072; 10.5089/9781451823929.002.A001

Source: Lithuanian authorities.

• Download Figure
• Download figure as PowerPoint slide

LITHUANIA MONETIZATION AND FOREIGN EXCHANGE FLOWS

Citation: IMF Staff Country Reports 1996, 072; 10.5089/9781451823929.002.A001

Source: Lithuanian authorities.

• Download Figure
• Download figure as PowerPoint slide

As regards real-sector developments under the currency board, the output decline--which in Lithuania had been among the most severe in the region--came to an end in 1994 (Chart 4). Inflation in Lithuania had already been brought down to a moderate level, i.e., a level which is generally considered not to have major negative effects on output, before the currency board was established; ^2/ however, a further decline in inflation below 2-3 percent monthly rate has proven elusive. As could be expected, the reorientation of international trade towards western markets has continued since the establishment of the currency board (Chart 5). While the stable exchange rate relationship of the litas with those markets may have contributed to this continuing trend, undoubtedly, it also has been helped by the more open trade regime, trade agreements, and the continued after-effects of the dismantling of the previous directed trade system. In contrast to the experience in some neighboring countries, foreign direct investment into Lithuania has been relatively modest (about US$60 million in 1994 and 1996). However, the slow response of foreign investment might be more closely associated with delays in starting cash privatization and clear policy signals regarding foreign investment by the authorities ^1/ rather than exchange rate credibility as such.

LITHUANIA GROWTH AND INFLATION

Citation: IMF Staff Country Reports 1996, 072; 10.5089/9781451823929.002.A001

Source: EUII database.

• Download Figure
• Download figure as PowerPoint slide

View Full Size

LITHUANIA GROWTH AND INFLATION

Citation: IMF Staff Country Reports 1996, 072; 10.5089/9781451823929.002.A001

Source: EUII database.

• Download Figure
• Download figure as PowerPoint slide

LITHUANIA GROWTH AND INFLATION

Citation: IMF Staff Country Reports 1996, 072; 10.5089/9781451823929.002.A001

Source: EUII database.

• Download Figure
• Download figure as PowerPoint slide

LITHUANIA EXTERNAL TRADE INDICATORS

Citation: IMF Staff Country Reports 1996, 072; 10.5089/9781451823929.002.A001

• Download Figure
• Download figure as PowerPoint slide

View Full Size

LITHUANIA EXTERNAL TRADE INDICATORS

Citation: IMF Staff Country Reports 1996, 072; 10.5089/9781451823929.002.A001

• Download Figure
• Download figure as PowerPoint slide

LITHUANIA EXTERNAL TRADE INDICATORS

Citation: IMF Staff Country Reports 1996, 072; 10.5089/9781451823929.002.A001

• Download Figure
• Download figure as PowerPoint slide

3. Inflation

Inflation in Lithuania has declined sharply since the currency board was put in effect, but continues to run at a relatively high rate (Chart 6). The present section reviews overall developments in inflation, and discusses possible sources of inflation (undervaluation of the nominal exchange rate, relative price adjustments, monetary aspects, wage pressures, and differential productivity growth in the tradable and non-tradable goods sector).

LITHUANIA INFLATION IN CONSUMER PRICES

Citation: IMF Staff Country Reports 1996, 072; 10.5089/9781451823929.002.A001

Source: Lithuanian authorities.

• Download Figure
• Download figure as PowerPoint slide

View Full Size

LITHUANIA INFLATION IN CONSUMER PRICES

Citation: IMF Staff Country Reports 1996, 072; 10.5089/9781451823929.002.A001

Source: Lithuanian authorities.

• Download Figure
• Download figure as PowerPoint slide

LITHUANIA INFLATION IN CONSUMER PRICES

Citation: IMF Staff Country Reports 1996, 072; 10.5089/9781451823929.002.A001

Source: Lithuanian authorities.

• Download Figure
• Download figure as PowerPoint slide

a. Overall developments

In April 1996, the 12-monthly change in the consumer price index was 31 percent, compared with 45 percent in April 1995 and 79 percent in April 1994. Despite great month-to-month variability, in part, monthly inflation rates have continued to decline gradually since the establishment of the currency board (Chart 7).

LITHUANIA INFLATION AND TREND INFLATION

Citation: IMF Staff Country Reports 1996, 072; 10.5089/9781451823929.002.A001

Source: Lithuanian authorities; and Fund staff estimates.

• Download Figure
• Download figure as PowerPoint slide

View Full Size

LITHUANIA INFLATION AND TREND INFLATION

Citation: IMF Staff Country Reports 1996, 072; 10.5089/9781451823929.002.A001

Source: Lithuanian authorities; and Fund staff estimates.

• Download Figure
• Download figure as PowerPoint slide

LITHUANIA INFLATION AND TREND INFLATION

Citation: IMF Staff Country Reports 1996, 072; 10.5089/9781451823929.002.A001

Source: Lithuanian authorities; and Fund staff estimates.

• Download Figure
• Download figure as PowerPoint slide

Inflation measured by the producer prices index (PPI) has been consistently lower than consumer price inflation, but has exhibited the same downward trend. The 12-monthly change in the PPI was 14 percent in March 1996, down from 39 percent in March 1995 and 79 percent in March 1994.

b. Sources of inflation

Initial undervaluation of the exchange rate. There is empirical evidence that the nominal exchange rate under the currency board was fixed at a depreciated level compared with the equilibrium rate, and that this has contributed to inflation. ^2/ Findings on purchasing power parity (PPP) made by the Conference of European Statisticians ^3/ suggest that the 1993 price level prevailing in Lithuania was 18 percent of that prevailing in Austria. Taking into account nominal exchange rate movements and differential inflation rates between 1993 and April 1994, this implies that Lithuanian prices stood at about 30 percent of Austrian prices at the time when the currency board was established. These findings, coupled with the assumption that the PPP exchange rate was not too far removed from the equilibrium exchange rate, point to a substantial initial undervaluation of the Litas.

An exchange rate fixed below its equilibrium level puts upward pressure on prices in an open economy, as domestic prices tend to adjust to world market prices. In particular, those products which are most severely underpriced would be expected to be subject to the strongest inflationary pressures. The data on Lithuania exhibit such a pattern. Table 1 lists the March 1994 to March 1996 change in the price for 26 categories of products and their respective March 1994 price level relative to that prevailing in Austria. There is a strong negative correlation between inflation rates and initial price level; the coefficient of correlation is -0.46 (and the associated t-value indicates significance.)

Table 1.

Lithuania: Inflation and Undervaluation

Source: Fund staff estimates.

Table 1.

Lithuania: Inflation and Undervaluation

	Price change between March 1994 and March 1996	Lithuanian price relative to Austrian price in March 1994
	(In percent)
Bread, cereal products	97	18
Meat, poultry	35	35
Fish, fish products	24	34
Dairy products, cheese, eggs	118	17
Butter, oil, fats	72	50
Other food products	64	51
Soft beverages	63	59
Alcoholic beverages	80	52
Tobacco products	46	14
Clothes, fabrics	69	25
Footwear	70	76
Furniture	50	27
Household textiles	87	32
Domestic appliances	28	46
Dwelling expenses	129	5
Energy, fuel	161	13
Medical care, health services	48	15
Private transport	54	46
Public transport	119	14
Communication services	129	6
Education, recreation, entertainment	91	26
Goods for recreation	47	68
Cultural and leisure services	52	33
Printed media	227	18
Education	74	18
Other goods and services	83	7

Source: Fund staff estimates.

View Table

Table 1.

Lithuania: Inflation and Undervaluation

	Price change between March 1994 and March 1996	Lithuanian price relative to Austrian price in March 1994
	(In percent)
Bread, cereal products	97	18
Meat, poultry	35	35
Fish, fish products	24	34
Dairy products, cheese, eggs	118	17
Butter, oil, fats	72	50
Other food products	64	51
Soft beverages	63	59
Alcoholic beverages	80	52
Tobacco products	46	14
Clothes, fabrics	69	25
Footwear	70	76
Furniture	50	27
Household textiles	87	32
Domestic appliances	28	46
Dwelling expenses	129	5
Energy, fuel	161	13
Medical care, health services	48	15
Private transport	54	46
Public transport	119	14
Communication services	129	6
Education, recreation, entertainment	91	26
Goods for recreation	47	68
Cultural and leisure services	52	33
Printed media	227	18
Education	74	18
Other goods and services	83	7

Source: Fund staff estimates.

Relative price adjustments. Relative prices in Lithuania exhibit a high degree of variability, which is strongly positively correlated with the rate of inflation. There is tentative empirical evidence that causality runs from relative price variability to inflation rather than vice versa. Regressing inflation rates on relative price variability yields a significant positive correlation, independent of whether one-month, 3-month, or 12-month inflation is used. Chart 8 shows the development over time in inflation rates and relative price variability (which is measured as the weighted sum of the absolute deviations of inflation rates of CPI components from CPI inflation). There are at least two alternative explanations for this correlation, which imply a different direction of causality between relative price variability and inflation. The evidence from the data supports indirectly the view that relative price variability has contributed to inflation. According to this interpretation, relative prices in Lithuania were initially out of line with relative prices abroad; in the process of integration with the world economy, relative prices in Lithuania moved toward those prevailing on world markets and, if prices are rigid downwards, this adjustment process would have resulted in an increase in the general price level. It is conceivable, however, that relative price variability may have been a by-product of inflation, arising from the fact that the adjustment of individual prices is not perfectly synchronized in time. A testable implication of this interpretation is that the power of inflation to explain relative price variability would be relatively higher for short-run inflation than for long-run inflation. However, the data on Lithuania suggest the opposite: annual inflation is most closely correlated with relative price variability; three-month inflation is less closely correlated with relative price variability; and one-month inflation exhibits the weakest correlation (the associated coefficients of correlation are 0.97, 0.85, and 0.67, respectively).

LITHUANIA INFLATION AND RELATIVE PRICE VARIABILITY

Citation: IMF Staff Country Reports 1996, 072; 10.5089/9781451823929.002.A001

Sources: Lithuanian authorities; and Fund staff estimates.

• Download Figure
• Download figure as PowerPoint slide

View Full Size

LITHUANIA INFLATION AND RELATIVE PRICE VARIABILITY

Citation: IMF Staff Country Reports 1996, 072; 10.5089/9781451823929.002.A001

Sources: Lithuanian authorities; and Fund staff estimates.

• Download Figure
• Download figure as PowerPoint slide

LITHUANIA INFLATION AND RELATIVE PRICE VARIABILITY

Citation: IMF Staff Country Reports 1996, 072; 10.5089/9781451823929.002.A001

Sources: Lithuanian authorities; and Fund staff estimates.

• Download Figure
• Download figure as PowerPoint slide

Monetary policy. Since the establishment of the currency board, the institutional setup of the central bank has rendered it quite unlikely that monetary factors have made an independent contribution to inflation. The currency board leaves no room for expansionary monetary policy. Monetary policy is essentially passive, and limited to the BoL exchanging the anchor currency at the fixed rate against domestic currency upon demand. Thus, there is limited room for extending central bank credit. In actual fact, monetary aggregates have moved broadly in parallel with inflation.

Evidence from the recent banking crisis and a period of reduced confidence in the domestic currency suggests that money supply adjusts readily to money demand without any noticeable effects on inflation. Chart 9 depicts the development of reserve money, broad money, and the CPI since the establishment of the currency board arrangement. Two episodes of contraction in monetary aggregates can be observed, in late 1994 and late 1995. Between November 1994 and February 1995 reserve money declined by over 9 percent amidst devaluation rumors. When problems in the banking sector emerged towards end-1995, reserve money fell by over 20 percent between December 1995 and March 1996, following a freeze on deposits affecting about 20 percent of all commercial bank deposits were frozen. In both cases, the rate of inflation was unaffected.

LITHUANIA MONEY AND PRICES

Citation: IMF Staff Country Reports 1996, 072; 10.5089/9781451823929.002.A001

Source: Lithuanian authorities.

• Download Figure
• Download figure as PowerPoint slide

View Full Size

LITHUANIA MONEY AND PRICES

Citation: IMF Staff Country Reports 1996, 072; 10.5089/9781451823929.002.A001

Source: Lithuanian authorities.

• Download Figure
• Download figure as PowerPoint slide

LITHUANIA MONEY AND PRICES

Citation: IMF Staff Country Reports 1996, 072; 10.5089/9781451823929.002.A001

Source: Lithuanian authorities.

• Download Figure
• Download figure as PowerPoint slide

Wage pressures. There is little evidence that increases of nominal wages have contributed to inflation in Lithuania. Real wages experienced a sharp drop in 1992 and began to recover only in mid-1993. Still, at the time when the currency board was introduced, real wages stood at little over 50 percent of their level in January 1992. Since April 1994 nominal wages have grown broadly at the same rate as consumer prices (Chart 10). The nominal wage growth in excess of inflation over the course of 1995 was accompanied by decelerating inflation.

LITHUANIA INFLATION AND WAGES

Citation: IMF Staff Country Reports 1996, 072; 10.5089/9781451823929.002.A001

Sources: Data provided by the Lithuanian authorities.

• Download Figure
• Download figure as PowerPoint slide

View Full Size

LITHUANIA INFLATION AND WAGES

Citation: IMF Staff Country Reports 1996, 072; 10.5089/9781451823929.002.A001

Sources: Data provided by the Lithuanian authorities.

• Download Figure
• Download figure as PowerPoint slide

LITHUANIA INFLATION AND WAGES

Citation: IMF Staff Country Reports 1996, 072; 10.5089/9781451823929.002.A001

Sources: Data provided by the Lithuanian authorities.

• Download Figure
• Download figure as PowerPoint slide

Evidence on sectoral wage and price developments also fails to support the wage-push hypothesis of inflation. Table 2 shows the wage and price inflation that has occurred since the introduction of the currency board. They are negatively correlated with a coefficient of correlation of -0.325. Although the limited data availability requires caution in interpreting this result, it is possible that the more a sector is in trouble the more it increases prices and the less it increases wages relative to the average.

Table 2.

Lithuania: Price and Wage Inflation by Sector

Sources: Lithuanian authorities; and Fund staff estimates.

Table 2.

Lithuania: Price and Wage Inflation by Sector

	Price inflation March 1994 – March 1996	Wage inflation March 1994 – March 1996
	(In percent)
Agriculture and food processing	95.0	89.5
Manufacturing of textiles	69.0	68.6
Publishing and printing	80.2	227.4
Electricity	11.8	149.3
Steam and water	58.0	330.1
Hotels and restaurants	8.0	150.0
Transportation	88.8	76.8
Communications	140.7	128.5
Insurance	107.2	0.0

Sources: Lithuanian authorities; and Fund staff estimates.

View Table

Table 2.

Lithuania: Price and Wage Inflation by Sector

	Price inflation March 1994 – March 1996	Wage inflation March 1994 – March 1996
	(In percent)
Agriculture and food processing	95.0	89.5
Manufacturing of textiles	69.0	68.6
Publishing and printing	80.2	227.4
Electricity	11.8	149.3
Steam and water	58.0	330.1
Hotels and restaurants	8.0	150.0
Transportation	88.8	76.8
Communications	140.7	128.5
Insurance	107.2	0.0

Sources: Lithuanian authorities; and Fund staff estimates.

Differential productivity growth. The view that the relatively high inflation in Lithuania is partly due to higher productivity growth in the tradeable goods sector relative to the non-tradeable goods sector (the “Balassa-Samuelson effect” ^1/) is consistent with the evidence. If this view is correct, one would expect prices for services to grow more quickly than prices of traded goods. Concerning the development of major components of the consumer price index (CPI), prices for services have grown above average since the introduction of the currency board--at an annual rate of 37 percent while the increase in food prices has been relatively modest (27 percent), and prices of non-food products have grown at the slowest pace (24 percent) (Chart 11). However, energy prices have increased the most--at an annual rate of 78 percent.

LITHUANIA CPI BY COMPONENT

Citation: IMF Staff Country Reports 1996, 072; 10.5089/9781451823929.002.A001

Sources: Lithuanian authorities; and Fund staff estimates.

• Download Figure
• Download figure as PowerPoint slide

View Full Size

LITHUANIA CPI BY COMPONENT

Citation: IMF Staff Country Reports 1996, 072; 10.5089/9781451823929.002.A001

Sources: Lithuanian authorities; and Fund staff estimates.

• Download Figure
• Download figure as PowerPoint slide

LITHUANIA CPI BY COMPONENT

Citation: IMF Staff Country Reports 1996, 072; 10.5089/9781451823929.002.A001

Sources: Lithuanian authorities; and Fund staff estimates.

• Download Figure
• Download figure as PowerPoint slide

4. External competitiveness

While Lithuania’s exchange rate was initially undervalued in April 1994 (as discussed above), this margin has been at least partly dissipated by inflation. If the equilibrium exchange rate remained unchanged over the medium term, Lithuania would suffer a loss of competitiveness if the high relative inflation continued after the initial undervaluation had been eliminated. High relative inflation could be partly or wholly mitigated by the Balassa-Samuelson effect. The reverse is possible, however, if productivity growth were more rapid in the nontradable sector.

b. Real exchange rate indexes and indirect indicators

The first approach has been to look at a variety of indicators, including alternative measures of the real exchange rate and other measures of external performance. ^1/ Several alternative measures of the real exchange rate have been used to assess external competitiveness, including: (i) the real effective exchange rate index based on consumer price indexes (CPIs); (ii) relative unit labor costs in U.S. dollar terms; and (iii) U.S. dollar wage rates (Charts 12 and 13).

LITHUANIA EFFECTIVE EXCHANGE RATES (1/93–3/96)

[Trade Weights]

Citation: IMF Staff Country Reports 1996, 072; 10.5089/9781451823929.002.A001

Sources: IMF, International Financial Statistics, staff reports on Belarus, Lithuania, the Russian Federation, Ukraine, and staff estimates.1/ Increase implies an appreciation.2/ Baltics, Russia, and other FSU republics.

• Download Figure
• Download figure as PowerPoint slide

View Full Size

LITHUANIA EFFECTIVE EXCHANGE RATES (1/93–3/96)

[Trade Weights]

Citation: IMF Staff Country Reports 1996, 072; 10.5089/9781451823929.002.A001

Sources: IMF, International Financial Statistics, staff reports on Belarus, Lithuania, the Russian Federation, Ukraine, and staff estimates.1/ Increase implies an appreciation.2/ Baltics, Russia, and other FSU republics.

• Download Figure
• Download figure as PowerPoint slide

LITHUANIA EFFECTIVE EXCHANGE RATES (1/93–3/96)

[Trade Weights]

Citation: IMF Staff Country Reports 1996, 072; 10.5089/9781451823929.002.A001

Sources: IMF, International Financial Statistics, staff reports on Belarus, Lithuania, the Russian Federation, Ukraine, and staff estimates.1/ Increase implies an appreciation.2/ Baltics, Russia, and other FSU republics.

• Download Figure
• Download figure as PowerPoint slide

LITHUANIA AVERAGE MONTHLY WAGES

(In U.S. dollars)

Citation: IMF Staff Country Reports 1996, 072; 10.5089/9781451823929.002.A001

Sources: Country authorities.

• Download Figure
• Download figure as PowerPoint slide

View Full Size

LITHUANIA AVERAGE MONTHLY WAGES

(In U.S. dollars)

Citation: IMF Staff Country Reports 1996, 072; 10.5089/9781451823929.002.A001

Sources: Country authorities.

• Download Figure
• Download figure as PowerPoint slide

LITHUANIA AVERAGE MONTHLY WAGES

(In U.S. dollars)

Citation: IMF Staff Country Reports 1996, 072; 10.5089/9781451823929.002.A001

Sources: Country authorities.

• Download Figure
• Download figure as PowerPoint slide

While there is a trend real appreciation evident in each of the indexes, it is impossible to determine to what extent the initial undervaluation has been dissipated and how much the present real exchange rate may be below its equilibrium value. Often, real effective exchange rate measures based on price indexes that include prices of both tradables and nontradables, such as CPIs or GDP deflators, tend to show more rapid real appreciation than other measures if productivity growth in tradables exceeds productivity growth in nontradables.

It is tempting to conclude from a comparison of U.S. dollar wages in Lithuania, Estonia, and Latvia, as well as other Central and Eastern European countries, that Lithuania remains internationally competitive. Indeed, as shown by indirect indicators below, its external performance remains favorable (Chart 14). While the U.S. dollar wage comparisons are consistent with such a view, they should be judged with caution since Lithuanian wage measures capture only a portion of total labor remuneration, and because no adjustment has been made for productivity differences across countries.

LITHUANIA INDIRECT INDICATORS OF COMPETITIVENESS

Citation: IMF Staff Country Reports 1996, 072; 10.5089/9781451823929.002.A001

Source: Lithuanian authorities and Fund staff estimates.

• Download Figure
• Download figure as PowerPoint slide

View Full Size

LITHUANIA INDIRECT INDICATORS OF COMPETITIVENESS

Citation: IMF Staff Country Reports 1996, 072; 10.5089/9781451823929.002.A001

Source: Lithuanian authorities and Fund staff estimates.

• Download Figure
• Download figure as PowerPoint slide

LITHUANIA INDIRECT INDICATORS OF COMPETITIVENESS

Citation: IMF Staff Country Reports 1996, 072; 10.5089/9781451823929.002.A001

Source: Lithuanian authorities and Fund staff estimates.

• Download Figure
• Download figure as PowerPoint slide

As regards other indirect indicators of competitiveness, exports have grown rapidly, the trade deficit has narrowed in relation to GDP, and substantial international reserves have been accumulated. It is important to stress that many factors have contributed to these developments. Regarding the trade balance, this has been influenced to an important extent by reductions in energy supplies from Russia and the continuing restructuring of Lithuania’s agricultural sector. Foreign direct investment in Lithuania has been influenced by a variety of factors, including changes in the trade regime, credibility of macroeconomic policy, developments in the banking sector, and conditions for foreign investment including the prohibition of foreign land ownership; however, there is no indication that inflows have been dampened by an overvalued exchange rate. Foreign reserves have been heavily influenced by the manner in which the currency board arrangement has been operated and by conditions in the banking sector. Nevertheless, these indirect indicators clearly show that the real appreciation of the litas has not been associated with a deterioration in Lithuania’s external position.

1. Structure of the banking system

As of end-March 1996, 15 banks were licensed in Lithuania, down from 28 in early 1994. The three biggest banks are all majority owned and controlled by the Government. In addition to the state-controlled banks, there are 12 privately owned banks, although the Government also owns a small proportion of the shares in some of them, including one former privately owned bank which has been taken over by the Government. Currently, 11 banks are fully operational.

The Lithuanian banking system is highly concentrated. The biggest bank is the State Savings Bank, which accounted for some 20 percent of all deposits as of end-March 1996. Three other banks are of roughly the same size; the State Agricultural Bank, the State Commercial Bank, and the Innovation Bank, each accounting for roughly 15 percent of all deposits. In total, these four banks account for two thirds of all deposits. Of the remaining 11 banks, five have deposit market shares between 5-9 percent, three have market shares of 2-4 percent, and the remaining three have market shares of less than one percent.

2. Prudential regulations

The enactment of a new Commercial Bank Law in late 1994 created the necessary conditions for implementing prudential requirements adequate for reliable supervision in a market-based economy. The new Commercial Bank Law gave expanded powers to the Bank of Lithuania to implement prudential regulations as well as to impose sanctions on banks that do not meet prudential standards.

One of the main problems facing the banks is undercapitalization. When the banks were founded, the required amount of capital was very low and subsequently, as the balance-sheets grew, reflecting in part the high inflation, capital did not increase proportionally. Tax laws also contributed towards eroding the capital base, as credit losses were not permitted to be deducted from profit before tax, forcing banks to pay taxes (and dividends) on possibly non-existent profits. As a result, banks have had difficulties in meeting the prudential standards set by the Bank of Lithuania, largely due to the shrinking capital base to which most of the regulatory ratios apply.

Since July 1, 1995 the minimum capital requirement has been ECU 1.9 million (US$2.3 million). The amount will be raised to ECU 3.8 million (US$4.6 million) on January 1, 1997, and to ECU 5 million (US$6.1 million) on January 1, 1998, which is the amount required according to EU rules.

The banks are required to meet a capital adequacy ratio of 13 percent of risk-weighted assets, based on financial statements prepared under Lithuanian accounting standards. The Lithuanian rules differ from the Basle rules, which are the international standard, mainly in the treatment of losses which are not fully deductible from profits nor can be written off against the core capital of the bank. Thus, the capital adequacy ratio could differ substantially depending on the methodology, and it is not unlikely that a bank meeting the Lithuanian rules would have a negative capital if Basle rules were applied.

Connected lending (insider loans) may not exceed 10 percent of a bank’s capital. The definition is narrower than international standards, as related- and controlled-party lending are not considered to be part of connected lending.

Maximum lending to one borrower (large exposure) may not exceed 30 percent of a bank’s capital, which is somewhat higher than the 25 percent ratio commonly applied internationally. Moreover, the Lithuanian requirement is not calculated on a consolidated basis and does not include interbank credit.

Maximum positions in foreign currencies may not exceed 30 percent of a bank’s capital and the open position for individual currencies may not exceed 20 percent, except for U.S. dollars. The liquidity ratio requires that the ratio of liquid assets to liabilities may not be less than 30 percent. These ratios are generally in line with ratios used internationally.

3. Deposit insurance

At present, a number of laws designed to protect depositors are in effect. On December 20, 1995 a law was passed, protecting individual depositors in private banks up to Lit 4,000 (US$1,000); this law was to have become effective January 1, 1996, but has not yet been implemented. Initially only deposits in litai were to be protected but later (February 1, 1996) an amendment was passed including also domestic deposits in foreign currencies. Individuals’ deposits in the state-controlled banks, which are fully protected tinder the Civil Code, are by end-1996 to be included under the same deposit protection scheme as depositors in the private banks. Furthermore, two more laws were passed when the bank crisis surfaced, the first protecting all creditors (not only depositors) in the two banks placed in moratorium (see below), and the other protecting depositors up to Lit 2,000 (US$500) in banks that had already entered bankruptcy procedures by end-1995. These schemes have not been funded so far, effectively making the Government the insurer of the protected deposits.

4. The banking crisis

The Lithuanian banking system has been under increasing strain during the last two years. Since the beginning of 1994, 13 smaller banks, accounting for about 5 percent of all bank assets, have entered into bankruptcy proceedings. The first signals of deeper problems appeared during the summer of 1995, when a medium-sized bank (Aura Bank), facing liquidity problems, was put under administratorship and had to be supported financially by both the Government and the Bank of Lithuania. The banking problems became more serious during the fall of 1995: bank capital diminished; bank losses increased substantially; and, in order to keep another medium-sized bank from closing, the Government supported it with liquidity.

The fragility of the banking sector surfaced in late December 1995, when on-site inspections by the Bank of Lithuania revealed the insolvency of two privately owned banks (Innovation Bank and Litimpeks Bank). The operations of both banks were suspended and their activities were confined to collecting loans and other assets. Problems, however, spread also to another bank (Vakaru Bank), which had its operations partially suspended and was put under conservatorship. Altogether, these three banks account for 25 percent of all deposits. Moreover, published auditing reports for two of the state-controlled banks revealed that the banks made losses in 1995 and that they needed to be recapitalized in order to meet the capital adequacy ratio.

5. Bank restructuring plan

In response to a request from the authorities, a joint Fund/World Bank team visited Lithuania in January 1996 to work out a plan for restructuring the banking system as part of a proposed World Bank Structural Adjustment Loan. The authorities subsequently adopted a strategy to deal with the banking problems, which broadly was in line with this proposed plan. The plan is intended as a once-for-all restructuring, and the overall principle is that individual banks (i.e., their owners and managers) are responsible for their own restructuring. Apart from cases of systemic risk, the Government’s role would be to assure regulatory compliance, but not to keep banks operating. The use of government funds in the restructuring of banks would be contemplated only as a last resort option, and if such support is to be given, it would give the Government the same pro-rata portion of share capital and voting rights as new money provided by private contributors. Further, certain conditions were laid down in order to force banks to cut costs and operate in line with all prudential regulations. Specific changes in the Commercial Bank Law were also recommended, which would provide a new set of rules for the post-restructuring era. In summary, the restructuring plan as adopted--and which the authorities have begun to implement--includes the following key elements:

a. The three banks under moratorium (Innovation, Litimpeks, and Vakaru) would be restructured. This might initially involve government ownership, and the banks would later be privatized. ^1/ Bad loans would be transferred to a special asset management company. Existing private shareholders would lose all their rights, as well as the full value of their shares;

b. The balance-sheets of the State Commercial Bank and the State Savings Bank ^2/ would be cleaned up by a transfer of bad loans to the asset management company; the banks would receive an additional capital injection in cash from the Government; existing private shareholders would lose all their rights as well as the full value of their shares; later, these banks also would be privatized;

c. All other banks would be examined by external auditors who would have to submit a written statement, verifying that each bank is solvent and meets all prudential regulations. Banks found insolvent would immediately be closed and liquidated, while banks that did not meet all prudential standards would be given a respite of three months to achieve compliance;

d. The budgetary costs of implementing the plan would be financed by the issuance of special government bonds and cash transfers from the budget. No resources from the Bank of Lithuania would be used to finance the plan.

1. Institutional framework for fiscal policy implementation

Since independence was regained, the Ministry of Finance (MoF) has made considerable progress in transforming itself from a central planning institution, concerned with allocating funds and preparing and monitoring accounts, to a full-fledged MoF as in market economies. The MoF is now responsible for the Government’s mobilization of resources and their disbursement, and has acquired considerable influence in the formulation of policies in these areas. Efforts began early on in the reform process to upgrade the MoF’s system for budgetary management, and the Budget Department has been revamped to promote more active expenditure control. An essential part of these efforts is the introduction of a treasury system, which is now under way.

A Treasury Department was set up within the Ministry of Finance to take over the functions of expenditure control and cash management that were formerly performed by the monobank system. The project to establish a Treasury began in mid-1994 and has been supported by a coordinated program of technical assistance from, inter alia, the Fund and the Danish Government, each of which have provided long-term advisors. The implementation of a computerized treasury system, which is under preparation, is structured around an accrual based accounting system, drawing on the European model. Software for treasury transaction processing and accounting has been developed from a commercial accounting package, modified to meet the requirements of centralized revenue collection and payments. Development and testing of the software is nearing completion and hardware has been acquired and tested for the initial implementation of the system. Preparation for implementation by the Treasury Department and the spending ministries to be linked to the system is also in progress. The new system is expected to be operational for some ministries during 1996, and fully operational by mid-1997.

The treasury system, once it is established, will offer substantial benefits for expenditure control and fiscal management. Through its improved classification and direct payments to suppliers, the Treasury will exercise closer control over actual payments, will provide more accurate, timely, and analytical information on the Government’s fiscal position, and will allow the Government to reduce the level of cash balances held in the banks to finance government programs. Areas which still require some additional attention for development are: (a) strengthening of cash-flow forecasting; (b) reducing spending authorizations in light of reduced revenue of financing expectations; and (c) strengthening of internal audit. Information from the treasury system should, in turn, provide a better basis for budget planning and further strengthen expenditure management.

The Government is also developing methods to strengthen the budgeting process and to make the mechanism of collecting and consolidating fiscal data more frequent and comprehensive. Projections for tax receipts are unreliable, and the preparation and regular updating of medium-term macroeconomic and fiscal projections is essential in upgrading the existing budget and planning framework. Part of the ongoing effort to upgrade the capacity for budget preparation and implementation is the establishment of a fiscal policy unit, currently designated the Budget Policy Division (BPD) in the Ministry of Finance. Preparations are under way, with Fund technical assistance, to enhance analytical procedures for budget preparation within the BPD.

Budgetary control is being developed also through strengthening budget legislation and the recently introduced borrowing plan which is designed to help coordinate borrowing with other government operations. The Government is in the process of improving its capacity to shape and implement public investment programs while streamlining and rationalizing the use of externally provided funds.

2. Pension reform ^1/

In common with other transition economies of Central and Eastern Europe, Lithuania’s pension system is under strain owing to the following factors: (a) because of demographic trends since World War II, the system has high and rising dependency ratios (Chart 15); (b) coverage is more extensive than in most other middle income countries at a time when the role of the government in transition economies is shrinking; and (c) reform is made more complicated due to many concurrent structural changes in the economy, including changes in income distribution. Although not high at present, the share of pension costs to GDP is on a rising trend in Lithuania, while average pensions have lagged behind average wages (Chart 16). In addition, in its present form, the system lacks incentives for improving national saving. Based on these considerations, changes are required to ensure the sustainability of the system in the medium term.

LITHUANIA PENSION COST INDICATORS

Citation: IMF Staff Country Reports 1996, 072; 10.5089/9781451823929.002.A001

Sources: Lithuanian authorities; and Fund staff estimates.1/ Women over 55 are included in the non–working population group.

• Download Figure
• Download figure as PowerPoint slide

View Full Size

LITHUANIA PENSION COST INDICATORS

Citation: IMF Staff Country Reports 1996, 072; 10.5089/9781451823929.002.A001

Sources: Lithuanian authorities; and Fund staff estimates.1/ Women over 55 are included in the non–working population group.

• Download Figure
• Download figure as PowerPoint slide

LITHUANIA PENSION COST INDICATORS

Citation: IMF Staff Country Reports 1996, 072; 10.5089/9781451823929.002.A001

Sources: Lithuanian authorities; and Fund staff estimates.1/ Women over 55 are included in the non–working population group.

• Download Figure
• Download figure as PowerPoint slide

LITHUANIA AVERAGE PENSION, AND AVERAGE AND MINIMUM WAGE

(In litai per month)

Citation: IMF Staff Country Reports 1996, 072; 10.5089/9781451823929.002.A001

Source: Lithuanian authorities.

• Download Figure
• Download figure as PowerPoint slide

View Full Size

LITHUANIA AVERAGE PENSION, AND AVERAGE AND MINIMUM WAGE

(In litai per month)

Citation: IMF Staff Country Reports 1996, 072; 10.5089/9781451823929.002.A001

Source: Lithuanian authorities.

• Download Figure
• Download figure as PowerPoint slide

LITHUANIA AVERAGE PENSION, AND AVERAGE AND MINIMUM WAGE

(In litai per month)

Citation: IMF Staff Country Reports 1996, 072; 10.5089/9781451823929.002.A001

Source: Lithuanian authorities.

• Download Figure
• Download figure as PowerPoint slide

From 1990 to 1994, Lithuania made considerable progress toward the development of a coordinated and durable social security system, despite a difficult economic environment. A restructured social security system was enacted in 1994 and the collection of payroll taxes was improved. The pension age, which was below the OECD average as in other Eastern European countries in transition (Table 3), was increased at the beginning of 1995 by four months for women and by two months for men, and is scheduled to increase at the same rate annually until the pension age of 60 years for women and 62 1/2 for men is reached.

Table 3.

Lithuania: Average Retirement Age in Public Old-Age Schemes in OECD Countries, Poland, and the Baltics in 1990

Sources: For OECD countries OECD, New Orientations for Social policy (Paris, 1994), p. 90. Retirement age is a weighted average for the basic pension and early old-age pensions. Data for Belgium and Luxembourg are for 1983/84. Data for Poland are for the main social security Fund, FUS. Because of different classification, the OECD average in this table excludes France. Data for Estonia, Latvia and Lithuania provided by the authorities.

^1/Beginning on January 1, 1994 for Estonia and January 1, 1995 for Lithuania, the retirement age started to increase at semi-annual and annual intervals, respectively.

Table 3.

Lithuania: Average Retirement Age in Public Old-Age Schemes in OECD Countries, Poland, and the Baltics in 1990

Austria (employees and self-employed)
	Males	62.0
	Females	59.6
Belgium (employees)
	Males	63.3
	Females	60.7
Canada (Canada pension plan)
	Males	63.3
	Females	63.1
Finland
	Males	61.9
	Females	62.5
Germany (white-collar workers)
	Males	63.0
	Females	63.1
France (general scheme)
Workers		62.0
Japan (employees)
	Males	62.1
	Females	61.0
Japan (self-employed)
	Males	64.1
	Females	63.7
Luxembourg
	Males	60.6
	Females	63.0
Portugal
	Males	65.8
	Females	63.6
United Kingdom (category A)
	Males	65.5
	Females	61.0
United States (employees)
	Males	63.7
	Females	63.5
OECD countries (arithmetic average)
	Males	63.2
	Females	62.4
Poland (data for 1993)
	Males	59.0
	Females	55.0
Estonia (data for 1993) 1/
	Males	60.0
	Females	55.0
Latvia
	Males	60.0
	Females	55.0
Lithuania (data for 1994) 1/
	Males	60.0
	Females	55.0

Sources: For OECD countries OECD, New Orientations for Social policy (Paris, 1994), p. 90. Retirement age is a weighted average for the basic pension and early old-age pensions. Data for Belgium and Luxembourg are for 1983/84. Data for Poland are for the main social security Fund, FUS. Because of different classification, the OECD average in this table excludes France. Data for Estonia, Latvia and Lithuania provided by the authorities.

^1/Beginning on January 1, 1994 for Estonia and January 1, 1995 for Lithuania, the retirement age started to increase at semi-annual and annual intervals, respectively.

View Table

Table 3.

Lithuania: Average Retirement Age in Public Old-Age Schemes in OECD Countries, Poland, and the Baltics in 1990

Austria (employees and self-employed)
	Males	62.0
	Females	59.6
Belgium (employees)
	Males	63.3
	Females	60.7
Canada (Canada pension plan)
	Males	63.3
	Females	63.1
Finland
	Males	61.9
	Females	62.5
Germany (white-collar workers)
	Males	63.0
	Females	63.1
France (general scheme)
Workers		62.0
Japan (employees)
	Males	62.1
	Females	61.0
Japan (self-employed)
	Males	64.1
	Females	63.7
Luxembourg
	Males	60.6
	Females	63.0
Portugal
	Males	65.8
	Females	63.6
United Kingdom (category A)
	Males	65.5
	Females	61.0
United States (employees)
	Males	63.7
	Females	63.5
OECD countries (arithmetic average)
	Males	63.2
	Females	62.4
Poland (data for 1993)
	Males	59.0
	Females	55.0
Estonia (data for 1993) 1/
	Males	60.0
	Females	55.0
Latvia
	Males	60.0
	Females	55.0
Lithuania (data for 1994) 1/
	Males	60.0
	Females	55.0

Sources: For OECD countries OECD, New Orientations for Social policy (Paris, 1994), p. 90. Retirement age is a weighted average for the basic pension and early old-age pensions. Data for Belgium and Luxembourg are for 1983/84. Data for Poland are for the main social security Fund, FUS. Because of different classification, the OECD average in this table excludes France. Data for Estonia, Latvia and Lithuania provided by the authorities.

^1/Beginning on January 1, 1994 for Estonia and January 1, 1995 for Lithuania, the retirement age started to increase at semi-annual and annual intervals, respectively.

Additional legislation passed in 1994, however, and subsequent government decisions, including a generous benefits-setting formula, worsened the prospects for the medium-term financial sustainability of the Social Insurance Fund (SIF). ^1/ In the first quarters of 1995 and 1996, the SIF experienced short-term operating deficits which were covered by the depletion of the Fund’s financial reserves. The deficits resulted from a fall in tax collection and increased contribution arrears primarily from state-owned enterprises and government agencies. Additional arrears surfaced in the first quarter of 1996 following the closings of some banks in late 1995 and the subsequent freezing of bank accounts belonging to enterprises. Nonetheless, the SIF showed a surplus at the end of 1995 and is expected to be roughly in balance at the end of 1996.

Given Lithuania’s demographic structure, the pension system is not sustainable in the medium- and long-term due to the early retirement age, the incentives for early retirement, and an expected shift of the labor force to the private sector. ^2/ The main underlying problems of the existing system are the excessively generous formula for setting benefits and the complete reliance on a “pay-as-you-go” system. ^3/ This system, if not restructured, will become increasingly difficult to maintain given the rising share of the population that will qualify for pensions. The present pension system provides inadequate savings for retirement, and--as it effectively involves the transfer of income to groups with a high relative propensity to consume--does not contribute to the much needed increase in national saving.

Concrete problems facing the social insurance system include the following: (a) indexation provisions that are built into the 1994 pension formula increase the average rate at which pension spending will grow, and (b) the retired population grows faster than the work force whose contributions finance pension benefits. In order to reduce the cost of the pension system on the economy as a whole, the Government has undertaken to: (a) rationalize pension outlays; (b) accelerate increases in the pension age to six months per year until the retirement age reaches 65 years for both men and women, instead of the lower and differentiated age that is now scheduled; and (c) improve the collection of social insurance contributions. Other measures that could be taken immediately to help reduce costs include the following: (a) increase of the number of years for the calculation of benefits to 35; (b) reallocation of the contribution rate so that half is made by the employer and half by the employee; and (c) the set-up of internal and external control mechanisms to assure transparency and accountability in the books and activities of the SIF. These issues are being addressed in the context of the World Bank’s Social Safety Net Proj ect.

The Government has focused its long-term reform efforts on the three functions that public pension systems are intended to perform - saving, redistribution for alleviating old-age poverty, and insurance - and the most efficient ways that these can be achieved. One possibility is a multi-pillar system involving separate administrative and financing mechanisms for redistribution and saving: ^1/

(i) A tax-financed, mandatory, publicly managed tier, resembling the existing pension plan, would focus on redistribution of income in old age, thereby providing a social safety net for the old. To accomplish this, the benefit formula for this tier would be flat, means tested, or could provide a minimum pension guarantee;

(ii) A regulated and fully funded, mandatory tier would link benefits actuarialy to costs, and would be privately and competitively managed through personal savings plans or occupational pension plans. This tier would focus on saving and would be compulsory in order to force individuals who might be myopic with regard to their future needs to save for themselves. The mandatory nature of this tier would reduce the burden on the tax-financed public tier. Benefits would be linked to contributions to discourage evasion and labor market distortions. If this tier is fully funded, it can reduce intergenerational transfers, which would otherwise be expected given Lithuania’s demographics, it can help build national saving, and it can enable higher pensions by financing them partially through investment returns. Private competitive management of these pension funds would also enhance the development of Lithuania’s emerging capital market;

(iii) Lastly, there could be a third fully funded, voluntary tier, also managed through personal savings or occupational pension plans, designed to offer additional protection to those who want more income in their old age.

The Government is considering a form of the three-tier option, possibly with a privately funded third tier. There are currently two independent non-governmental teams which are preparing drafts for private pension options to be discussed for implementation.

3. Government borrowing strategy

Access to international capital markets is expected to increase as Lithuania becomes more integrated into the world economy. In this context, the Government is seeking seeks to achieve a more balanced government debt structure by diversifying its borrowing, which would include financing a larger share of the borrowing requirement abroad. On the other hand, the issuance and trade of government paper domestically will contribute to the deepening of the Lithuanian financial market which is in its early stage of development. In this situation, the Government has given consideration to the following factors when diversifying its portfolio:

(a) Fiscal discipline. The Government should retain an appropriate overall fiscal stance notwithstanding the expected increased availability of foreign financing;

(b) Cost of borrowing. The relative costs of borrowing in the domestic and international markets should be weighed. Possible exchange rate changes and roll-over availability in each case need to be considered when comparing costs. Complying with requirements of foreign lenders, and coordinating and matching maturities of loans would become part of the overall borrowing strategy and planning;

(c) Credibility of the exchange rate. As Lithuania establishes a record in borrowing abroad and does so for longer maturities, the credibility of the national currency will be enhanced;

(d) Manageability of foreign debt. The country’s foreign debt must not exceed acceptable limits; and

(e) Development of the domestic financial market. As Lithuania is coming out of its banking crisis, financing a larger share of the fiscal deficit externally will alleviate the demands on the domestic financial system and prevent crowding out. In the medium term, however, financing the fiscal deficit domestically and with government securities of varied maturities will encourage the development of domestic financial markets, including the establishment of a secondary market.

1. Trade policy developments

The average import tariff (unweighted) was 5 1/2 percent in mid-1995 and over 70 percent of items had zero tariff rates. ^2/ In May 1996, only three specific import tariffs remained (alcohol, sugar, and tobacco), and there are no quantitative restrictions on imports. However, import tariffs on some agricultural products range up to 45 percent and, although the weighted average tariff rate for eight main agricultural product groups was reduced to 27 1/2 percent on October 1, 1995, it remains high. ^3/ There are no quantitative export restrictions or tariffs, except that exportation of four items (feathers and down, raw leather, raw timber, and medical supplies) ^4/ is banned except to countries that have signed free trade agreements with Lithuania (such as the EU); such exports face a 50 percent export tariff.

Based on a weighted average calculation, ^1/ Lithuania’s agricultural tariffs remain low compared with its Central European neighbors, but high compared to industrial countries and to some FSU republics. Comparing with other Baltic countries (see Table 4), Estonia does not tax imports, while the average for Latvia is 46 percent. The average tariff rate was 29 percent for the Czech and Slovak Republics and 51 percent for Poland (Table 5). If the comparison is made using the maximum tariff rates within each product group (Table 6), a number of FSU republics (Armenia, Georgia, and Russia) maintain more liberal agricultural tariff regimes than Lithuania.

Table 4.

Agricultural Tariffs in Estonia, Latvia, and Lithuania

^1/Specific duties also apply.

Table 4.

Agricultural Tariffs in Estonia, Latvia, and Lithuania

	HS Codes	Weight	Estonia	Latvia	Lithuania
Sausages	1601	22	--	55	14
Meat	0201-0205, 0209-0210	20	--	55	30
Milk and dairy products	0401-0404	16	--	40	20
Butter	0405	16	--	55	45
Sugar	1701-1702	13	--	20 1/	35 1/
Eggs	0407-0408	7	--	40	30
Potatoes	0701	3	--	40	20
Poultry	0207	3	--	40	25
Weighted average		100	--	46.1	27.5

^1/Specific duties also apply.

View Table

Table 4.

Agricultural Tariffs in Estonia, Latvia, and Lithuania

	HS Codes	Weight	Estonia	Latvia	Lithuania
Sausages	1601	22	--	55	14
Meat	0201-0205, 0209-0210	20	--	55	30
Milk and dairy products	0401-0404	16	--	40	20
Butter	0405	16	--	55	45
Sugar	1701-1702	13	--	20 1/	35 1/
Eggs	0407-0408	7	--	40	30
Potatoes	0701	3	--	40	20
Poultry	0207	3	--	40	25
Weighted average		100	--	46.1	27.5

^1/Specific duties also apply.

Table 5.

Agricultural Tariffs in the Czech and Slovak Republics and Poland

Table 5.

Agricultural Tariffs in the Czech and Slovak Republics and Poland

	HS Codes	Weight	Czech and Slovak Rep.	Poland
Sausages	1601	22	20	35
Meat	0201-0205, 0209-0210	20	30	60
Milk and dairy products	0401-0404	16	30	80
Butter	0405	16	32	40
Sugar	1701-1702	13	50	40
Eggs	0407-0408	7	20	45
Potatoes	0701	3	10	50
Poultry	0207	3	18	60
Weighted average		100	29.1	50.6

View Table

Table 5.

Agricultural Tariffs in the Czech and Slovak Republics and Poland

	HS Codes	Weight	Czech and Slovak Rep.	Poland
Sausages	1601	22	20	35
Meat	0201-0205, 0209-0210	20	30	60
Milk and dairy products	0401-0404	16	30	80
Butter	0405	16	32	40
Sugar	1701-1702	13	50	40
Eggs	0407-0408	7	20	45
Potatoes	0701	3	10	50
Poultry	0207	3	18	60
Weighted average		100	29.1	50.6

Table 6.

Agricultural Tariffs in Armenia, Georgia, and Russia

^1/Implementation of a two-tier tariff structure with rates of 0 percent and 10 percent is in process in Armenia.

^2/Tariff rates for Russia are those in effect July 1, 1995.

Table 6.

Agricultural Tariffs in Armenia, Georgia, and Russia

	HS Codes	Weight	Armenia 1/	Georgia	Russia 2/
Sausages	1601	22	--	12	20
Meat	0201-0205, 0209-0210	20	--	12	15
Milk and dairy products	0401-0404	16	--	12	15
Butter	0405	16	--	12	20
Sugar	1701-1702	13	--	12	5
Eggs	0407-0408	7	--	12	10
Potatoes	0701	3	--	12	25
Poultry	0207	3	--	12	15
Weighted average		100	--	12	16

^1/Implementation of a two-tier tariff structure with rates of 0 percent and 10 percent is in process in Armenia.

^2/Tariff rates for Russia are those in effect July 1, 1995.

View Table

Table 6.

Agricultural Tariffs in Armenia, Georgia, and Russia

	HS Codes	Weight	Armenia 1/	Georgia	Russia 2/
Sausages	1601	22	--	12	20
Meat	0201-0205, 0209-0210	20	--	12	15
Milk and dairy products	0401-0404	16	--	12	15
Butter	0405	16	--	12	20
Sugar	1701-1702	13	--	12	5
Eggs	0407-0408	7	--	12	10
Potatoes	0701	3	--	12	25
Poultry	0207	3	--	12	15
Weighted average		100	--	12	16

^1/Implementation of a two-tier tariff structure with rates of 0 percent and 10 percent is in process in Armenia.

^2/Tariff rates for Russia are those in effect July 1, 1995.

Comparisons with the EU and the United States show that Lithuania’s main industrial country trading partners maintain more liberal agricultural import tariff structures than Lithuania, using Lithuanian consumption weights (Table 7). These averages do not, however, provide an accurate picture of the overall restrietiveness of the EU and U.S. agricultural trade regimes, since they, omit many forms of agricultural border protection. In the EU, for instance, the calculation does not take into account the ad valorem equivalent of specific tariff rates, variable import levies (a tax is levied that raises the cost of imports to internal levels), and entry prices (minimum import prices are set above the level of world market prices).

Table 7.

Agricultural Tariffs in the European Union and the United States

^1/Ad valorem tariff rates during 1986.

Table 7.

Agricultural Tariffs in the European Union and the United States

	HS Codes	Weight	EU	U.S. 1/
Sausages	1601	22	24	8
Meat	0201-0205 0209-0210	20	24	31
Milk and dairy products	0401-0404	16	13	20
Butter	0405	16	13	10
Sugar	1701-1702	13	20	15
Eggs	0407-0408	7	12	0
Potatoes	0701	3	21	0
Poultry	0207	3	10	0
Weighted average		100	19	15

^1/Ad valorem tariff rates during 1986.

View Table

Table 7.

Agricultural Tariffs in the European Union and the United States

	HS Codes	Weight	EU	U.S. 1/
Sausages	1601	22	24	8
Meat	0201-0205 0209-0210	20	24	31
Milk and dairy products	0401-0404	16	13	20
Butter	0405	16	13	10
Sugar	1701-1702	13	20	15
Eggs	0407-0408	7	12	0
Potatoes	0701	3	21	0
Poultry	0207	3	10	0
Weighted average		100	19	15

^1/Ad valorem tariff rates during 1986.

Lithuania has signed or is in the process of negotiating trade agreements with several countries and regional groupings. The Association Agreement between Lithuania and the EU was signed on June 12, 1995. ^1/ Lithuania’s import tariff rates on imports from the EU were lowered in line with the October 1, 1995 tariff reductions. In December 1995, a new free trade agreement (FTA) was signed with the European Free Trade Association (Iceland, Norway, and Switzerland, and Liechtenstein) that replaced the bilateral free trade treaties between Lithuania and EFTA members, with protocols on basic agricultural products expected to be completed in 1996. Bilateral FTA negotiations are underway with Central European Free Trade Agreement (CEFTA) members (Czech Republic, Hungary, Poland, Slovak Republic, and Slovenia) ^1/ with a view to Lithuania’s eventual membership in CEFTA. Negotiations with the Czech and Slovak Republics and with Poland have been delayed due to opposition from Lithuania’s agricultural interests; the draft FTAs specify that agricultural import tariffs would be eliminated on a bilateral basis within two years (although not all agricultural import tariffs on intra-CEFTA trade would be eliminated under CEFTA provisions). A Baltic Free Trade Agreement has been in effect since April 1, 1994 but this does not cover agricultural products; the Prime Ministers of the Baltic countries have announced the intention to sign a trilateral treaty on free trade in agricultural products in 1996.

Regarding Lithuania’s application for membership in the World Trade Organization (WTO), meetings of the working party on Lithuania’s accession to the WTO were held in November 1995 and March 1996. Lithuania has responded to questions regarding its trade regime; services were discussed at the March 1996 meeting. The next step is for Lithuania to begin negotiations on tariff bindings, subsidy levels, and services. ^2/

2. Economic effects of lower tariffs

Reductions in agricultural import tariffs, from the present 27 1/2 percent average to the 20 percent average planned for March 1997, would be expected to lead to lower import prices, a contraction in domestic agricultural production and employment, an expansion in consumption, and a net increase in national income. This section develops a methodology for quantifying these effects and provides some calculations using this methodology.

Chart 17 illustrates the economic effects of a decrease in the import tariff applied to an agricultural product such as sugar. Domestic demand is given by the curve dd; domestic supply is given by ss. Imports and domestic production are assumed to be perfect substitutes. The supply of imports is perfectly elastic at world price P_w multiplied by one plus the ad valorem tariff rate, t1; this reflects Lithuania’s role as a price-taker in world markets. Consumption is equal to OC and domestic production is equal to OP; imports are equal to PC.

Effects of Agricultural Tariff Reduction

Citation: IMF Staff Country Reports 1996, 072; 10.5089/9781451823929.002.A001

• Download Figure
• Download figure as PowerPoint slide

View Full Size

Effects of Agricultural Tariff Reduction

Citation: IMF Staff Country Reports 1996, 072; 10.5089/9781451823929.002.A001

• Download Figure
• Download figure as PowerPoint slide

Effects of Agricultural Tariff Reduction

Citation: IMF Staff Country Reports 1996, 072; 10.5089/9781451823929.002.A001

• Download Figure
• Download figure as PowerPoint slide

A decrease in the agricultural import tariff from t₁ to t₂ would lead to an increase in consumption from C to C^*, a decrease in domestic production from P to P′, and an increase in imports from PC to P′ C^*. Consumers would benefit by an amount measured by area P_w(1+t₂) J G P_w(1+t₁), which is the change in consumer surplus. Producers would lose an amount measured by P_w(1+t₂) D E P_w(1+t₁), which is the change in producer surplus. The net gains to the Lithuanian economy from this tariff reduction are measured by area DFE plus area HJG, which are the deadweight losses in production and consumption, respectively.

Algebraic expressions for these various economic effects are given in Table 8. To apply this methodology empirically, it is necessary to specify the value of imports, elasticities of domestic demand and supply, and imports as a share of domestic consumption and production. It should be stressed that there would be additional, dynamic, benefits from agricultural trade liberalization, due to increased foreign investment and more rapid economic growth, although these effects are not easily quantified.

Table 8.

Model Equations

Table 8.

Model Equations

Domestic Demand:
	$\ln \text{C}\text{=}\text{-}{\mathit{\eta }}_{\mathrm{d}}{\text{ln P}}_{\mathrm{m}}$
Domestic Supply:
	$\ln \text{P}\text{=}{\mathit{\eta }}_{\text{s}}{\text{ln P}}_{\mathrm{m}}$
Change in Import Price:
	$\mathrm{d}\mathrm{}\ln {\mathrm{\text{P}}}_{\mathrm{m}}\mathrm{\text{/}}\mathrm{d}\mathrm{}\ln \mathrm{}\mathrm{\text{t}}=\mathrm{(}{\mathrm{t}}_{\mathrm{2}}-{\mathrm{t}}_{\mathrm{1}}\mathrm{)}\mathrm{/}\mathrm{(}\mathrm{1}\mathrm{+}{\mathrm{t}}_{\mathrm{1}}\mathrm{)}$
Change in Import Quantity:
	$\mathrm{d}\mathrm{}\ln \mathrm{\text{M/dl}}\mathrm{n}{\mathrm{P}}_{\mathrm{m}}\mathrm{\text{=}}\mathrm{\text{-}}{\mathit{\eta }}_{\mathrm{d}}\mathrm{(}\mathrm{C}\mathrm{/}\mathrm{M}\mathrm{)}\mathrm{\text{-}}{\mathit{\eta }}_{\mathrm{s}}\mathrm{(}\mathrm{P}\mathrm{/}\mathrm{M}\mathrm{)}$
Change in Producer Surplus:
	$\mathrm{-}\mathrm{A}\mathrm{r}\mathrm{e}\mathrm{a}\mathrm{\left[}{\mathrm{P}}_{\mathrm{w}}\mathrm{(}\mathrm{1}\mathrm{+}{\mathrm{t}}_{\mathrm{2}}\mathrm{)}\mathrm{D}\mathrm{E}{\mathrm{P}}_{\mathrm{w}}\mathrm{(}\mathrm{1}\mathrm{+}{\mathrm{t}}_{\mathrm{1}}\mathrm{)}\mathrm{\right]}$
	$\mathrm{=}\mathrm{-}\mathrm{A}\mathrm{r}\mathrm{e}\mathrm{a}\mathrm{}\mathrm{\left[}{\mathrm{P}}_{\mathrm{w}}\mathrm{(}\mathrm{1}\mathrm{+}{\mathrm{t}}_{\mathrm{2}}\mathrm{)}\mathrm{\text{FE}}{\mathrm{P}}_{\mathrm{w}}\mathrm{(}\mathrm{1}\mathrm{+}{\mathrm{t}}_{\mathrm{1}}\mathrm{)}\mathrm{\right]}+\mathrm{A}\mathrm{r}\mathrm{e}\mathrm{a}\left(\mathrm{D}\mathrm{F}\mathrm{E}\right)$
	$\mathrm{=}\mathrm{\text{-}}{\mathrm{P}}_{\mathrm{w}}\mathrm{M}\mathrm{(}\mathrm{P}\mathrm{/}\mathrm{M}\mathrm{)}\mathrm{(}{\mathrm{t}}_{\mathrm{1}}\mathrm{-}{\mathrm{t}}_{\mathrm{2}}\mathrm{)}\mathrm{\text{+}}\mathrm{(}\mathrm{1}\mathrm{/}\mathrm{2}\mathrm{)}\left\{\mathrm{[}{\mathrm{P}}_{\mathrm{w}}{\mathrm{(}\mathrm{1}\mathrm{+}{\mathrm{t}}_{\mathrm{1}}\mathrm{)}\mathrm{]}}^{\mathit{\eta }}\mathrm{s}\mathrm{\text{-}}\mathrm{[}{{\mathrm{P}}_{\mathrm{w}}\mathrm{(}\mathrm{1}\mathrm{+}{\mathrm{t}}_{\mathrm{2}}\mathrm{)}\mathrm{]}}^{\mathit{\eta }}\mathrm{s}\mathrm{\right\}}{\mathrm{P}}_{\mathrm{w}}\mathrm{(}{\mathrm{t}}_{\mathrm{1}}\mathrm{-}{\mathrm{t}}_{\mathrm{1}}\mathrm{)}$
Change in Consumer Surplus:
	$\mathrm{A}\mathrm{r}\mathrm{e}\mathrm{a}\mathrm{\left[}{\mathrm{P}}_{\mathrm{w}}\mathrm{(}\mathrm{1}\mathrm{+}{\mathrm{t}}_{\mathrm{2}}\mathrm{)}\mathrm{J}\mathrm{G}{\mathrm{P}}_{\mathrm{w}}\mathrm{(}\mathrm{1}\mathrm{+}{\mathrm{t}}_{\mathrm{1}}\mathrm{)}\mathrm{\right]}\mathrm{\text{+}}\mathrm{A}\mathrm{r}\mathrm{e}\mathrm{a}\mathrm{\left(}\mathrm{H}\mathrm{J}\mathrm{G}\mathrm{\right)}$
	$\mathrm{=}\mathrm{A}\mathrm{r}\mathrm{e}\mathrm{a}\mathrm{\left[}{\mathrm{P}}_{\mathrm{w}}\mathrm{(}\mathrm{1}\mathrm{+}{\mathrm{t}}_{\mathrm{2}}\mathrm{)}\mathrm{H}\mathrm{G}{\mathrm{P}}_{\mathrm{w}}\mathrm{(}\mathrm{1}\mathrm{+}{\mathrm{t}}_{\mathrm{1}}\mathrm{)}\mathrm{\right]}\mathrm{\text{+}}\mathrm{A}\mathrm{r}\mathrm{e}\mathrm{a}\mathrm{\left(}\mathrm{H}\mathrm{J}\mathrm{G}\mathrm{\right)}$
	$\mathrm{=}{\mathrm{P}}_{\mathrm{w}}\mathrm{M}\mathrm{(}\mathrm{C}\mathrm{/}\mathrm{M}\mathrm{)}\mathrm{(}{\mathrm{t}}_{\mathrm{1}}\mathrm{-}{\mathrm{t}}_{\mathrm{2}}\mathrm{)}+\mathrm{(}\mathrm{1}\mathrm{/}\mathrm{2}\mathrm{)}\mathrm{\left\{}\mathrm{[}{{\mathrm{P}}_{\mathrm{w}}\mathrm{(}\mathrm{1}\mathrm{+}{\mathrm{t}}_{\mathrm{2}}\mathrm{)}\mathrm{]}}^{\mathrm{-}\mathit{\eta }}\mathrm{d}\mathrm{\text{-}}\mathrm{[}{{\mathrm{P}}_{\mathrm{w}}\mathrm{(}\mathrm{1}\mathrm{+}{\mathrm{t}}_{\mathrm{1}}\mathrm{)}\mathrm{]}}^{\mathrm{-}\mathit{\eta }}\mathrm{d}\mathrm{\right\}}{\mathrm{P}}_{\mathrm{w}}\mathrm{(}{\mathrm{t}}_{\mathrm{1}}\mathrm{-}{\mathrm{t}}_{\mathrm{2}}\mathrm{)}$
Change in Net Economic Welfare:
	$\mathrm{A}\mathrm{r}\mathrm{e}\mathrm{a}\mathrm{\left(}\mathrm{D}\mathrm{E}\mathrm{F}\mathrm{\right)}\mathrm{\text{+}}\mathrm{A}\mathrm{r}\mathrm{e}\mathrm{a}\mathrm{\left(}\mathrm{H}\mathrm{J}\mathrm{G}\mathrm{\right)}$
Change in Employment:
	$\mathrm{d}\mathrm{}\ln {\mathrm{\text{E/dln}}\mathrm{\text{P}}}_{\mathrm{m}}\mathrm{\text{=}}\mathrm{d}\mathrm{}\ln \mathrm{\text{P/dln}}{\mathrm{P}}_{\mathrm{m}}\mathrm{\text{=}}{\mathit{\eta }}_{\mathrm{s}}\mathrm{(}{\mathrm{t}}_{\mathrm{2}}\mathrm{-}{\mathrm{t}}_{\mathrm{1}}\mathrm{)}\mathrm{/}\mathrm{(}\mathrm{1}\mathrm{+}{\mathrm{t}}_{\mathrm{1}}\mathrm{)}$

View Table

Table 8.

Model Equations

Domestic Demand:
	$\ln \text{C}\text{=}\text{-}{\mathit{\eta }}_{\mathrm{d}}{\text{ln P}}_{\mathrm{m}}$
Domestic Supply:
	$\ln \text{P}\text{=}{\mathit{\eta }}_{\text{s}}{\text{ln P}}_{\mathrm{m}}$
Change in Import Price:
	$\mathrm{d}\mathrm{}\ln {\mathrm{\text{P}}}_{\mathrm{m}}\mathrm{\text{/}}\mathrm{d}\mathrm{}\ln \mathrm{}\mathrm{\text{t}}=\mathrm{(}{\mathrm{t}}_{\mathrm{2}}-{\mathrm{t}}_{\mathrm{1}}\mathrm{)}\mathrm{/}\mathrm{(}\mathrm{1}\mathrm{+}{\mathrm{t}}_{\mathrm{1}}\mathrm{)}$
Change in Import Quantity:
	$\mathrm{d}\mathrm{}\ln \mathrm{\text{M/dl}}\mathrm{n}{\mathrm{P}}_{\mathrm{m}}\mathrm{\text{=}}\mathrm{\text{-}}{\mathit{\eta }}_{\mathrm{d}}\mathrm{(}\mathrm{C}\mathrm{/}\mathrm{M}\mathrm{)}\mathrm{\text{-}}{\mathit{\eta }}_{\mathrm{s}}\mathrm{(}\mathrm{P}\mathrm{/}\mathrm{M}\mathrm{)}$
Change in Producer Surplus:
	$\mathrm{-}\mathrm{A}\mathrm{r}\mathrm{e}\mathrm{a}\mathrm{\left[}{\mathrm{P}}_{\mathrm{w}}\mathrm{(}\mathrm{1}\mathrm{+}{\mathrm{t}}_{\mathrm{2}}\mathrm{)}\mathrm{D}\mathrm{E}{\mathrm{P}}_{\mathrm{w}}\mathrm{(}\mathrm{1}\mathrm{+}{\mathrm{t}}_{\mathrm{1}}\mathrm{)}\mathrm{\right]}$
	$\mathrm{=}\mathrm{-}\mathrm{A}\mathrm{r}\mathrm{e}\mathrm{a}\mathrm{}\mathrm{\left[}{\mathrm{P}}_{\mathrm{w}}\mathrm{(}\mathrm{1}\mathrm{+}{\mathrm{t}}_{\mathrm{2}}\mathrm{)}\mathrm{\text{FE}}{\mathrm{P}}_{\mathrm{w}}\mathrm{(}\mathrm{1}\mathrm{+}{\mathrm{t}}_{\mathrm{1}}\mathrm{)}\mathrm{\right]}+\mathrm{A}\mathrm{r}\mathrm{e}\mathrm{a}\left(\mathrm{D}\mathrm{F}\mathrm{E}\right)$
	$\mathrm{=}\mathrm{\text{-}}{\mathrm{P}}_{\mathrm{w}}\mathrm{M}\mathrm{(}\mathrm{P}\mathrm{/}\mathrm{M}\mathrm{)}\mathrm{(}{\mathrm{t}}_{\mathrm{1}}\mathrm{-}{\mathrm{t}}_{\mathrm{2}}\mathrm{)}\mathrm{\text{+}}\mathrm{(}\mathrm{1}\mathrm{/}\mathrm{2}\mathrm{)}\left\{\mathrm{[}{\mathrm{P}}_{\mathrm{w}}{\mathrm{(}\mathrm{1}\mathrm{+}{\mathrm{t}}_{\mathrm{1}}\mathrm{)}\mathrm{]}}^{\mathit{\eta }}\mathrm{s}\mathrm{\text{-}}\mathrm{[}{{\mathrm{P}}_{\mathrm{w}}\mathrm{(}\mathrm{1}\mathrm{+}{\mathrm{t}}_{\mathrm{2}}\mathrm{)}\mathrm{]}}^{\mathit{\eta }}\mathrm{s}\mathrm{\right\}}{\mathrm{P}}_{\mathrm{w}}\mathrm{(}{\mathrm{t}}_{\mathrm{1}}\mathrm{-}{\mathrm{t}}_{\mathrm{1}}\mathrm{)}$
Change in Consumer Surplus:
	$\mathrm{A}\mathrm{r}\mathrm{e}\mathrm{a}\mathrm{\left[}{\mathrm{P}}_{\mathrm{w}}\mathrm{(}\mathrm{1}\mathrm{+}{\mathrm{t}}_{\mathrm{2}}\mathrm{)}\mathrm{J}\mathrm{G}{\mathrm{P}}_{\mathrm{w}}\mathrm{(}\mathrm{1}\mathrm{+}{\mathrm{t}}_{\mathrm{1}}\mathrm{)}\mathrm{\right]}\mathrm{\text{+}}\mathrm{A}\mathrm{r}\mathrm{e}\mathrm{a}\mathrm{\left(}\mathrm{H}\mathrm{J}\mathrm{G}\mathrm{\right)}$
	$\mathrm{=}\mathrm{A}\mathrm{r}\mathrm{e}\mathrm{a}\mathrm{\left[}{\mathrm{P}}_{\mathrm{w}}\mathrm{(}\mathrm{1}\mathrm{+}{\mathrm{t}}_{\mathrm{2}}\mathrm{)}\mathrm{H}\mathrm{G}{\mathrm{P}}_{\mathrm{w}}\mathrm{(}\mathrm{1}\mathrm{+}{\mathrm{t}}_{\mathrm{1}}\mathrm{)}\mathrm{\right]}\mathrm{\text{+}}\mathrm{A}\mathrm{r}\mathrm{e}\mathrm{a}\mathrm{\left(}\mathrm{H}\mathrm{J}\mathrm{G}\mathrm{\right)}$
	$\mathrm{=}{\mathrm{P}}_{\mathrm{w}}\mathrm{M}\mathrm{(}\mathrm{C}\mathrm{/}\mathrm{M}\mathrm{)}\mathrm{(}{\mathrm{t}}_{\mathrm{1}}\mathrm{-}{\mathrm{t}}_{\mathrm{2}}\mathrm{)}+\mathrm{(}\mathrm{1}\mathrm{/}\mathrm{2}\mathrm{)}\mathrm{\left\{}\mathrm{[}{{\mathrm{P}}_{\mathrm{w}}\mathrm{(}\mathrm{1}\mathrm{+}{\mathrm{t}}_{\mathrm{2}}\mathrm{)}\mathrm{]}}^{\mathrm{-}\mathit{\eta }}\mathrm{d}\mathrm{\text{-}}\mathrm{[}{{\mathrm{P}}_{\mathrm{w}}\mathrm{(}\mathrm{1}\mathrm{+}{\mathrm{t}}_{\mathrm{1}}\mathrm{)}\mathrm{]}}^{\mathrm{-}\mathit{\eta }}\mathrm{d}\mathrm{\right\}}{\mathrm{P}}_{\mathrm{w}}\mathrm{(}{\mathrm{t}}_{\mathrm{1}}\mathrm{-}{\mathrm{t}}_{\mathrm{2}}\mathrm{)}$
Change in Net Economic Welfare:
	$\mathrm{A}\mathrm{r}\mathrm{e}\mathrm{a}\mathrm{\left(}\mathrm{D}\mathrm{E}\mathrm{F}\mathrm{\right)}\mathrm{\text{+}}\mathrm{A}\mathrm{r}\mathrm{e}\mathrm{a}\mathrm{\left(}\mathrm{H}\mathrm{J}\mathrm{G}\mathrm{\right)}$
Change in Employment:
	$\mathrm{d}\mathrm{}\ln {\mathrm{\text{E/dln}}\mathrm{\text{P}}}_{\mathrm{m}}\mathrm{\text{=}}\mathrm{d}\mathrm{}\ln \mathrm{\text{P/dln}}{\mathrm{P}}_{\mathrm{m}}\mathrm{\text{=}}{\mathit{\eta }}_{\mathrm{s}}\mathrm{(}{\mathrm{t}}_{\mathrm{2}}\mathrm{-}{\mathrm{t}}_{\mathrm{1}}\mathrm{)}\mathrm{/}\mathrm{(}\mathrm{1}\mathrm{+}{\mathrm{t}}_{\mathrm{1}}\mathrm{)}$