Determining the Appropriate Levels of Exchange Rates for Developing Economies: Some Methods and Issues

The purpose of this paper is to review a number of approaches that are available for determining an appropriate exchange rate level for a developing economy.1 Developing countries in recent years have been experiencing increasing balance of payments difficulties that, in many instances, are attributable to their foreign exchange regimes. In a typical situation, the government maintains an exchange rate fixed at an unrealistic level, while the level and composition of imports are determined by quantitative restrictions that give rise to the misallocation of resources. In an effort to overcome these problems and to re-establish conditions for reasonable economic growth and a sustainable balance of payments position, many countries resort to adjustment programs, including exchange rate actions. However, before any exchange rate action can take place, the appropriate new level for the exchange rate must be determined. This paper outlines a series of approaches that, in combination, can be used to address the issue.

Abstract

The purpose of this paper is to review a number of approaches that are available for determining an appropriate exchange rate level for a developing economy.1 Developing countries in recent years have been experiencing increasing balance of payments difficulties that, in many instances, are attributable to their foreign exchange regimes. In a typical situation, the government maintains an exchange rate fixed at an unrealistic level, while the level and composition of imports are determined by quantitative restrictions that give rise to the misallocation of resources. In an effort to overcome these problems and to re-establish conditions for reasonable economic growth and a sustainable balance of payments position, many countries resort to adjustment programs, including exchange rate actions. However, before any exchange rate action can take place, the appropriate new level for the exchange rate must be determined. This paper outlines a series of approaches that, in combination, can be used to address the issue.

The purpose of this paper is to review a number of approaches that are available for determining an appropriate exchange rate level for a developing economy.1 Developing countries in recent years have been experiencing increasing balance of payments difficulties that, in many instances, are attributable to their foreign exchange regimes. In a typical situation, the government maintains an exchange rate fixed at an unrealistic level, while the level and composition of imports are determined by quantitative restrictions that give rise to the misallocation of resources. In an effort to overcome these problems and to re-establish conditions for reasonable economic growth and a sustainable balance of payments position, many countries resort to adjustment programs, including exchange rate actions. However, before any exchange rate action can take place, the appropriate new level for the exchange rate must be determined. This paper outlines a series of approaches that, in combination, can be used to address the issue.

The appropriateness of a particular exchange rate level should take into account a country’s production, consumption, and trade and payments structure, including tariffs, subsidies, various forms of exchange controls, and developments in foreign exchange reserves. An ideal approach requires the integration of the real production economy with financial transactions in an intertemporal multisector general-equilibrium framework to produce an optimal path for the exchange rate and intermediate variables (balance of payments, budgetary positions) as functions of various parameters and targets. However, such an approach is difficult to implement empirically, given the absence of key data in many developing countries, the absence of adequate forward markets, the difficulties of assessing the rate of time preference, etc. In view of these realities, let us embark on a multidirectional partial equilibrium solution to the problem, which tends to incorporate many features of the ideal model, without using a single all encompassing optimization model.

In this paper, the focus is on two aspects of the exchange rate issue:2 (1) assessing the appropriateness of the prevailing level of the exchange rate; and (2) choosing the appropriate level, if the present level is found to be inappropriate by some criteria. Any meaningful analysis of the appropriate exchange rate level should contain both backward-looking and forward-looking elements. The backward approach is designed to explain how past exchange rate policies, pari passu with other economic policies and with the changing exogenous circumstances, brought the economy to its present position. A number of alternative backward-looking investigations have been conducted into price competitiveness, the economic viability of production (measured in terms of profitability) and its trends, the implicit market value of foreign exchange, and the distortionary nature of the exchange regime. These backward approaches measure the recent movements in the various indicators with possible implications for the appropriateness of the exchange regime and the exchange rate, but any conclusion regarding the sustainability of an exchange rate at the existing nominal level would be premature without a forward-looking analysis. What is important is whether the prevailing rate is compatible with reasonable economic growth and a viable balance of payments position in the medium term. The two types of approach (backward and forward analysis) are methodologically independent of one another, but conceptually, one is the extension of the other and they can be mutually reinforcing.

In the forward approach, the search procedure for the appropriate exchange rate level involves specification of the underlying adjustment mechanisms that follow a hypothetical exchange rate action. Different aspects of wage/price transmission mechanisms, allocation of resources, and terms of trade effects are considered. Consequent effects on the balance of payments3 and the government budget are estimated to determine the overall sustainability of the exchange rate, given appropriately designed accompanying demand management policies. The integrated approach, as described in the following sections, is outlined in Figure 1. This schematic diagram should not, however, give the impression that evaluations of the appropriateness of an exchange rate can be conducted in a mechanical way, devoid of substantial elements of judgment; the diagram is intended only to show the diversity of the issues to be considered in the backward and forward approaches and how they are linked to each other.

Figure 1.
Figure 1.

Schematic Diagram of Various Tests That Have Been Suggested to Determine Adequacy of an Exchange Rate1, 2

Citation: IMF Staff Papers 1983, 004; 10.5089/9781451930610.024.A005

1All the issues considered in various backward-looking and forward-looking tests have implications for foreign exchange reserves. Developments in the level of foreign exchange reserves may serve as an indicator to determine the adequacy of the prevailing exchange rate, but in this paper, these developments are viewed as the effect of other factors noted in the schematic diagram.2Backward approaches, some of which may also be extended as forward looking, and the first round of forward analysis to evaluate government budget and balance of payments, are used to determine the appropriateness of the current exchange rate; subsequent rounds of forward looks are processed to determine the sustainable exchange rate range.3Taxes, tariffs, revisions of budgetary expenditure, or policy combinations to affect relative prices are some of the policy parameters.

The plan of the paper is as follows. Section I presents a conceptual framework for analyzing competitiveness and the role that the exchange rate can play to that effect. Sections II and III explore the methodological issues that have been encountered in practical applications of this theoretical framework. Methodological issues are somewhat different for backward-looking and forward-looking analyses; they are treated separately. Section II summarizes various backward-looking approaches at both aggregated and disaggregated levels. Section III describes the features of the adjustment mechanism that underlie any evaluation of the sustainability of an exchange rate level in the forward analysis, along with some discussion of the associated demand management and other economic policies. Section IV presents the concluding observations.

I. Framework for Analyzing Competitiveness and Appropriate Exchange Rate

The purpose of this section is to discuss briefly the conceptual framework that underlies the methodological approaches described in the following sections. Analytically, the appropriateness of an exchange rate has to be determined on the basis of the simultaneous external and internal competitiveness of tradables and the degree of imbalance in the external sector. Domestic producers of exportables (or tradables) are in competition with producers of similar tradables in other countries, as well as with producers of nontradable goods in their home country. Internal competitiveness would ensure an adequate supply of traded goods through favorable internal relative price effects and the corresponding internal allocation of resources. An analysis of competitiveness can be linked to the evaluation of export receipts and import payments; the forward analysis would then determine the sustainability of the prevailing exchange rate.

External competitiveness can be modeled in terms of a single-good economy, while domestic competitiveness is analyzed in a two-goods framework (containing tradables and nontradables). The real effective exchange rate (REER) provides a broader measure of external competitiveness, as it can be expressed as an index of relative prices deflated by an index of the nominal effective exchange rate (NEER).4 Similar measures of internal competitiveness can be obtained by the indices of export or import prices (in domestic currency), relative to prices of domestic goods. The measures of internal competitiveness provide a check on the measure of external competitiveness, and the two-goods framework is also central to the expenditure-switching arguments offered in connection with exchange rate action. However, partial-equilibrium measures, in terms of profitability indices of major industries or commodities, can also be useful as implicit indicators of both internal and external competitiveness.

Starting from an initial equilibrium situation, in a two-goods model (with traded and nontraded goods), it can be shown that the exchange rate policy has at least a transitory effect on switching the expenditure and employable resources between tradables and nontradables, by altering the domestic relative prices. However, if the prices of nontradable goods are not inflexible and the system is price neutral (i.e., wages and prices rise by the same proportion as the devaluation of the currency), devaluation has no real effect in the static equilibrium sense. This neutrality of devaluation is based on the absence of money illusion in the excess demand functions for commodities and factors. Transitory improvements in the trade balance can be achieved through devaluation alone, but lasting real effects are attainable only with appropriate accompanying monetary and fiscal policies. If the monetary policy is accommodating, domestic price increases through devaluation will erode the purchasing power of money and reduce absorption to improve the trade balance. Fiscal intervention may also attain the same objective. The underlying neutrality of demand functions determines the long-run equilibrium, given the demand management policies; but the impact effect and the medium-term movements resulting from devaluation are determined by the wage/price interactions and other forms of rigidity or rationing mechanism frequently encountered in developing economies.

Moreover, in a situation of disequilibrium with rationing, which characterizes the predevaluation scenario in many developing countries, the exchange rate action is attractive. In a disequilibrium situation with nonmarket allocation rules (i.e., various forms of rationing), the nominal exchange rate matters; the relative prices of import-competing goods exceed their world relative prices, and the degree of variation depends on the exchange rate. If the quantitative restrictions remained unchanged, domestic prices of the import-competing goods would change little, with consequent effects on the relative prices of various classes of tradable commodities.5

In the formulation of an adjustment path to a sustainable balance of payments position, it is necessary to determine to what extent the adjustment is to be concerned with aggregate demand and to what extent with expenditure switching. In the literature, a sharp distinction is sometimes made between deficits that are due to “excessive expenditure or aggregate demand” and deficits that are due to the noncompetitiveness of domestic products. However, except for limiting cases, such sharp distinction is not meaningful; every deficit implies that aggregate expenditure exceeds the money value of aggregate output. In a two-goods model, domestic relative prices can be altered, enabling exchange rate policy to assume an expenditure-switching and resource-switching role by restoring internal and external competitiveness. If the excess demand causes inflation to be higher than in partner countries, deflation is essential but in itself cannot eliminate the deficits, as costs are adjusted to higher prices and tend to be downwardly rigid. When expenditure switching is the goal of the exchange rate policy, monetary and fiscal policies have a supporting role; on the other hand, if, on the basis of various indicators, the exchange rate is found to be appropriate, then the focus of the adjustment should be on appropriate demand management policies.

All these conceptual issues related to the exchange rate policy are potentially important in the formulation of any adjustment program. Since the appropriate level of the exchange rate cannot be determined in isolation, the methodological approaches described in the following sections take these issues into account.

II. Determining Adequacy of Prevailing Exchange Rate Level

In this section, a set of alternative steps is employed to arrive at a judgment regarding the adequacy of the existing exchange rate level. To this effect, three different types of investigation (both backward-looking and forward-looking) are suggested.

(1) Movements in the various weighted effective exchange rates, relative profitability, and in the relative price/cost developments adjusted for exchange rate changes from which inferences about the competitiveness of tradables can be drawn. At a micro-level, the structure of production and distribution of major export and import commodities are to be examined; these can indicate the extent of exchange rate action that may be needed to restore the price competitiveness of the products and the profitability of production.

(2) Exchange and trade regime and any associated distortions. Examination of the operations of the parallel exchange market, if any, and the exchange rate movements in the official and parallel exchange markets.

(3) Evaluation of past fiscal and monetary policies and their possible role in creating excessive absorption over aggregate supply and consequent balance of payments imbalances.

(4) Medium-term forecasts of the country’s economic growth and balance of payments performance in the absence of exchange rate action.

The first two classes of indicator in their various forms are essentially backward looking, and the third is also retrospective, but, like the fourth, can also be forward looking. Backward-looking measures indicate shifts in the competitive position, the supply situation in exports and import substitutes, intensity of any distortionary effects of the exchange regime, and the underlying balance in demand for and supply of foreign exchange. While these are indicative of the potential need for exchange rate action, more definite conclusions can be derived from forward approaches based on balance of payments and budgetary projections, as described in the next section.

determining the competitiveness

Movements in the real effective exchange rate (REER) indices

The REER indices refer to an average change in the reporting country’s exchange rate against that of all other countries, adjusted for price or cost developments. The appeal of these indices derives from the interpretation generally attached to them, that is, when the real effective exchange rate of a country appreciates, it suffers a loss of international price competitiveness. This loss in turn contributes to a deterioration of the trade balance (by reducing exports and increasing imports) and causes balance of payments difficulties. Various aggregate weighted (trade, export, and import weights), nominal effective exchange rate (NEER), and REER indices have been suggested in the literature and are being widely used in various Fund studies.6 In general terms, the NEER index can be denoted as

NEERt=ΣWjiRtEji

where

  • Wjt = relevant weights (import, export, or trade shares of partner countries)

  • Ejt = value of unit of currency of trading-partner country in terms of numeraire currency (say, U.S. dollar or SDR)

  • Rt = value of one unit of numeraire currency in terms of domestic currency

The REER index is obtained by deflating the NEER index with the weighted relative price or cost index:

REERt=NEERtRPt

where

RPt=ΣjWjt(Pt/Pjt)
  • Pt = relevant price index for home country at period t

  • Pj = appropriate price index of country j at period t

  • (j = 1,…, N, N being total number of relevant trading partners)

The interpretation of the index depends on the choice of weights, while the weights employed depend on the policy objectives selected as the “focal point of the index” (Rhomberg, (1976, p. 89)). If external price competitiveness is the main point of interest, one should look at the performance of domestic currency relative to the currencies of the major competitors in exports. For each major commodity, the choice of competitor countries used in the calculations should be based on the share of their exports of the commodity in question in total world trade. This phenomenon points to the importance of the commodity approach, which is discussed later in this section. Various forms of REER indices have been used in the applied literature; Maciejewski (1983) provides a fairly exhaustive taxonomy of indices and their differences.

The use of REER indices has both theoretical and practical limitations, which have been discussed in detail in the relevant literature. Abstracting from the conceptual difficulties and the desirability of the implicit product composition associated with the policy of re-establishing original (base-period) price competitiveness, it is not possible to derive from these any precise conclusion regarding the value of the exchange rate that would minimize balance of payments difficulties over the medium term. Experience with practical applications suggests that calculated values of effective exchange rates or exchange rate indicators may result in wide quantitative differences and may give rise to imprecise and sometimes contradictory conclusions. A major problem is the identification of the base period. For example, in one case, it was difficult to gauge whether 1975–76 was a better base period than 1977–78. If the earlier period is a better base, the appreciation of REER indices may be regarded as a short-term phenomenon, and the argument for currency depreciation is tenuous. With 1977–78 as a better base, the potential case for depreciation would be stronger.

Variations in the weights and deflators used in the construction of indices may often yield significantly different quantitative results. In one application, export competitiveness was determined using as weights exports from the period 1973–75 by ten other exporters. The results indicated an erosion of 48.3 percent in the competitive position (from January 1973 to 1980). On the other hand, the relative consumer price index (CPI) deflated by a relative trade-weighted exchange rate index of 14 major countries indicated an appreciation of the currency of 27.8 percent, compared with the base period. The quantitative difference in the extent of apparent appreciation is noteworthy. In conclusion, it is appropriate to note only the approximate range for the effective past appreciation or depreciation of the exchange rate, instead of any point estimate.

Biases in exchange rate action and REER determination

The methodologies implicit in the construction of REER indices, based on the principle of restoring the underlying price competitiveness, are designed to maintain the status quo of the base period. The policy of maintaining the REER unchanged attempts to restore the base-year commodity composition by restoring the competitiveness of the base-year products. This policy implicitly biases the outcome to an unchanged product composition. In a changing world with deteriorating terms of trade for many primary products over the medium-term period (as noted in various studies on coffee, tea, rice, cocoa, etc.), the relevance of this status quo policy may be questionable. The exchange rate policy needed to develop new export industries may be different from past policies; it may serve to ease the short-run and medium-term balance of payments problem, but its long-term effects may not be desirable.

The bilateral export-weighted index of the nominal EER is essentially a Laspeyres index (Maciejewski (1983)). This index shows (holding price and quantity of exports constant at the base-period level) how much the value of export earnings would change in period t, owing to changes in the exchange rates of the home country and its export partners. This equivalence between the bilateral weighted index of the nominal EER and Laspeyres index helps one to understand the underlying properties and shortcomings of the indices applied in the studies under consideration. It is well known that the Laspeyres price index is biased downward, compared with the Paasche index or Fisher’s ideal index, if price and quantity tend to move in the same direction over time, and that Laspeyres index is biased upward if price and quantities tend to go in opposite directions. (See Allen (1975) for proof and discussion.) In the construction of REER, the real relative exchange rate (nominal exchange rate adjusted for inflation differential) plays the role of prices, and the base-year value of exports is analytically similar to the role of quantities. Thus, for the countries in which the exchange rate adjusted for price levels (using relative foreign-to-domestic price ratio) appreciates while the value of exports increases over time, the index would be biased upward. Thus, this index might suggest a greater exchange rate action than is actually needed because of the underlying bias. No quantitative information regarding the extent of this bias is available in the context of EER indices; but studies on price indices indicate that this bias (or deviation) could be significant over time.

Microlevel analysis and determination of profitability

Microlevel studies on the structure of the costs of production and competitiveness, as well as the profitability of certain economic activities, can provide necessary information on the relative production incentives that underlie an exchange regime. In their various forms, the microanalyses may serve as indicators of external, as well as internal, competitiveness in both relative and absolute terms.

In some applications, the microlevel analysis is based on sample surveys, while in most other cases profitability indices are constructed for major export categories and also relative to importables and nontraded goods. In the absence of unit costs of production for exports, index analysis can be performed in terms of different proxies; experience with other applications suggests that the evaluation of export profitability depends crucially on the choice of proxy for the unit cost index.

In some economies, domestic procurement prices for export products are fixed by the monopolistic trading institutions, effectively severing the relationship between the exchange rate and producer prices for exportables. The exchange rate in this case ceases to perform its traditional role of inducing resource allocation through changes in relative prices, and plays only the accounting role in determining the profits and losses of the trading agencies. To generate an adequate supply response of exportables under this kind of institutional arrangement, it may be necessary to raise the relative domestic producer prices of exportables; the consequent loss to the trading organizations can be compensated for through devaluation.

Movements in the constructed indices of NEER or REER are not necessarily similar to the movements in the profitability index, although they often happen to be so. Changes in profitability are not uniform across the board for every exportable in sample survey studies. The effect depends on variations in real prices that are faced by the products in the world market, changes in the domestic costs of production, implicit taxes on exportables by public trading or export agencies, etc. For one country, for example, the average effective tax on the value of output for cocoa, coffee, and palm kernels was estimated to be 52 percent. Thus, a distinction should be made to determine the extent of reductions in profitability that are due to variations in REER, implicit taxes on exportables, and the general decline in the real world prices for the products. A longer-term deterioration in the terms of trade of certain primary products (i.e., the so-called weak commodities) may necessitate a speedy diversification of the export base; in that case, simple restoration of profitability and the status quo in domestic production (through exchange rate and other actions) may not be desirable.

Single-commodity approach to evaluating export performance

Any significant trend in the aggregate or disaggregated competitiveness indices generally indicates changes in the average competitive position, but large deviations do not necessarily imply that a corrective measure in the form of an exchange rate action is essential. To a great extent, the spur for exchange rate action comes from the potential effects of exchange rate changes on exports and imports and consequent balance of payments repercussions. While the evaluations can be made in many ways, for many developing countries in which a limited number of products accounts for a large proportion of export receipts, one can adopt a commodity-by-commodity approach. One such procedure has been suggested by Ridler and Yandle (1972) and Bélanger (1976). Using a partial-equilibrium analysis, this approach evaluates the effects of exchange rate changes on exports, based on the shifts in the supply of and demand for the commodity concerned; then, aggregating the results for several commodities, this analysis allows inferences to be drawn about the net gains or losses for a country’s exports as a whole. Given each supplier’s responsiveness to price changes, the export receipts of individual producers are identified. Using simple world demand and supply specifications with equilibrium conditions for products and prices, the percentage change in the value of exports for country j(ΔVXj), measured in numeraire currency, is as follows:

ΔVXj=ΔP(1+Nsj)ΔejΔNsi(1)

where ΔP represents the percentage change in the world price in numeraire currency and

ΔP=Ns.ΔexNd.ΔemNsNd
  • Δem = weighted average percentage change in importers’ exchange rate

  • Δex = weighted average percentage change in exporters’ exchange rate

  • Nd = price elasticity of world demand for imports

  • Ns = price elasticity of world supply of exports

  • Δej = percentage change in j the exporter’s exchange rate

  • Nsj = export supply elasticity of jth exporter

While this formulation captures the simultaneous variation of more than one exchange rate change by importers and exporters, an individual producing or exporting country comes out as a special case. When em = 0 and ex = 0, so that the exchange rates of importers and major exporters are approximately unchanged, ΔP would tend to zero. Under such circumstances, if a small country (j) increases its exchange rate (in terms of numeraire currency), this increase would cause the percentage change in the value of exports to be negative (owing to underlying volume effect); the magnitude would be proportional to the elasticity of supply.7

This measure, while partial equilibrium in nature, can provide information as to what extent the changes in the value of exports are attributable to exchange rate changes; the significance of exchange rate changes, compared with other variations, would indicate the relative usefulness of exchange rate action in reversing the situation.

trade and exchange regimes with associated distortions

Phases of trade and exchange regimes

The evolution of restrictive regimes can be traced through different phases, based on the restrictive content and associated blend of control and price instruments. Historically, it has been found that when countries face some unsustainable payments deficit, they begin to impose quantitative restrictions. Gradually, as a result of many small ad hoc decisions rather than an overall policy design, the detailed workings of the regulations become increasingly complex. Many developing countries maintain overvalued currencies with rigid exchange controls that are supported by quantitative restrictions. The value and composition of imports are determined by import licensing, and the actual value of imports does not reflect the outcome of market forces. The widespread interference with market forces causes misallocation of resources; if it persists long enough, both the static and the dynamic effects could reinforce each other, causing significant damage to the economy. Payments arrears may develop that strongly indicate the medium-term to long-term unsustainability of the prevailing form of the exchange regime.

In some instances, the overall tax structure is biased against exports, creating an apparent case for export subsidies. Imposition of import taxes and quotas for revenue and balance of payments purposes may reduce the relative profitability of exports in various ways: (i) a reduced volume of imports tends to yield a domestic-currency premium for importers; (ii) import-substituting activities are generally more profitable than before; and (iii) higher costs of imported or import-substituting inputs lower the profitability of the export activities in both absolute and relative terms. For specific reasons concerning resource allocation, a case could be made for specific subsidies for exports, but these piecemeal solutions, taken together, could be detrimental to the overall efficiency of the allocation process.

One simple method of establishing a link between economic efficiency and the foreign trade regime is to examine indicators of “productivity” for a possible association between levels and turning points vis-á-vis the trade regime.8 In another approach, economists calculate the domestic resource cost (DRC) of earning a unit of foreign exchange in alternative activities and treat these costs as an approximate index of the differential returns obtained from different activities, as observed at any time. Despite some well-known difficulties in computation and interpretation, DRC and its parallel concept—the effective rate of protection (ERP)—do provide a reasonable explanation for the wide variations in the social returns to different activities in the system.9 Both are indicative of the differences in the returns to the use of domestic resources, applying the often-used approximation that the observed unit values of exports measure the true opportunity costs to society.

While the standard error of the differential rates of effective protection and DRC indicates potentially significant losses to the economy, some idea of the magnitude of the costs can be obtained by using the simple measure suggested by Johnson (1960). The welfare loss that is due to a distortionary tax, subsidy, or various forms of quantitative restrictions can be evaluated more comprehensively by solving multisector general-equilibrium models (Shoven and Whalley (1972) and Whalley (1982)). Also, see the Appendix, Measuring welfare costs by Johnson’s (1960) method and Measuring welfare costs by a small-dimensional multisector general-equilibrium model.

The measures just suggested indicate the degree of potential losses to the economy owing to the distortionary components of the exchange and trade regime. To restore allocational efficiency, various reforms may be needed in the form of a currency devaluation-cum-liberalization package. Before establishing any schedule to correct various distortions, it is necessary to estimate the ERPs offered to individual industries under consideration. ERPs and/or DRCs should be estimated before measures to reform the protection regime are introduced.

So far, various indicators of competitiveness have been discussed; the quantitative relationships between these indicators and the volume of exports and imports can also be established. One simple approach may be to estimate econometrically the import demand and export supply functions, and to simulate the effects of changes in relative prices and competitiveness under alternative scenarios. Application of the single-commodity approach detailed in the subsection, biases in exchange rate action and reer determination, may also be useful if a limited number of tradables accounts for a large proportion of total trade. A number of conceptual and methodological problems are associated with the determination of the effects of income and prices (including the exchange rate) on exports and imports. For more on the issues related to specification (imperfect-substitute and perfect-substitute modeling), choice of variables, lag structure, simultaneity, and stability of trade relationships, see Learner and Stern (1970), Magee (1975), Stern and others (1976), and Goldstein and Khan (1982).

Parallel exchange market

A parallel exchange market is one of the by-products of re-strictionist exchange policies. The development of a parallel foreign exchange market is contingent upon unofficial supplies of foreign exchange fed by various illegal or legal sources, and corresponding demand arising out of various government regulations. The demand for illegal foreign exchange is normally fed by the supply created by such phenomena as “leaked” inward remittances and capital flows, and primarily by underinvoicing exports and overinvoicing imports.10

The focus on the parallel exchange market should be determined on the basis of its size, that is, how much economic activity is performed through this channel. If its size is significant, some other relevant issues that should be addressed are as follows:

(1) Any detrimental effect that the parallel market has on official foreign exchange reserves, the balance of payments, and the economic objectives of the government.

(2) How to interpret the parallel market rate, which reflects mostly the tightness and the effectiveness of exchange control.

(3) What the appropriate exchange rate policy should be to draw resources away from the parallel market.

(4) The role of nonexchange rate policies (e.g., interest rate policy, reforms in import policy) to achieve the same objectives independently or in combination with any exchange rate action.

Although for many developing countries the parallel market could be quite sizable and potentially influential in the consideration of exchange rate policy, its overall size relative to official activities is hard to determine, owing to lack of reliable data. Sufficient incentives for underinvoicing exports and overinvoicing imports could potentially attract significant amounts of foreign exchange to the parallel market over time. (See the Appendix, Determining size of parallel market.) Moreover, if the suspected, and sometimes observed, premium on foreign currency is significantly higher than the corresponding official rate, a significant proportion of remittances would eventually pass through the parallel market. Much of the evidence and conclusions on the level of smuggling, another potential source for generating a higher recording effect, is impressionistic. An obvious approach would be to look at the data on confiscation and, based on some expected risk of confiscation, to infer the volume of smuggling.

All the verifications may suggest the significance of potential sources for fueling the activities of the parallel market, and one can draw some tentative inferences about its overall size. The detrimental effects of the parallel market on official foreign exchange reserves, the balance of payments position, and various economic objectives of the government are well known and need not be mentioned in detail. 11

The exchange rate in the parallel market generally does not represent the market-clearing equilibrium rate; it reflects mostly the tightness and the effectiveness of exchange control. The equilibrium rate lies somewhere between the parallel and official exchange rates, and a devaluation of the official rate would generally lead to an appreciation of the parallel rate. The two exchange rates are inversely related to each other; this relationship holds under both partial-equilibrium and general-equilibrium frameworks (Nowak (1983)).12 The parallel rate is generally more depreciated than is the restriction-free rate, and, thus, proper caution should be exercised in using the parallel rate as an indication of the exchange rate adjustment that is necessary to attain balance of payments equilibrium.

The appeal of a devaluation, if a sizable parallel market exists, is that it allows the authorities to reduce overinvoicing or under-invoicing and to attract foreign exchange back to the official economy. Activities attracted out of the parallel market would be recorded as official transactions and might be significant without any change in the overall real level of economic activity. The impression is that for many countries these unrecorded economic activities are substantial and that the tapping of them could be a strong case for exchange rate action with immediate positive effects on the recorded balance of payments and the tax base.

developments in fiscal and monetary policies

For many economies, external payments imbalances are the result of excessive domestic demand generated through expansionary fiscal and monetary policies. Ambitious development efforts, generally in the form of extensive capital expenditure without commensurate mobilization of domestic resources, create a situation of fiscal disequilibrium with adverse implications for the balance of payments. Various indicators may be employed to determine the role that past fiscal and monetary policies could have played in creating macroeconomic imbalances. Some of these indicators are recent developments in the overall budget deficit, patterns of expenditure and revenue, expansion of net bank credit to the public sector, increases in total liquidity, and other similar measures. The emergence of fiscal disequilibrium (Tanzi (1982)) through expansionary policies of the past may be examined by looking at the pattern of government expenditure (e.g., permanent components of public sector expenditure and revenue).13

A more sophisticated quantitative analysis can be made using appropriately specified macroeconomic models. The model should be specified in such a way that a change in the budget deficit affects both the private sector absorption and the current account balance, depending on the empirically observable spending behavior of the private sector, the financing of the budget deficit, and the stance of monetary policy. The monetary sector can be linked to the macromodel and linked in a manner that is usable in the context of a complete adjustment program. In a simple illustration, the effects of budgetary adjustments on the current account balance may be specified to be felt through their contribution to aggregate demand, and via its effects on the supply of and demand for money. The model should contain behavioral equations determining real private sector absorption, price level, exports, imports, budget deficit, and demand for money. A number of identities defining nominal income, current account balance and money supply, and the equilibrium condition for the money market would complete the model.

This model may also be used to perform dynamic simulations and to form the basis of various counterfactual experiments with alternative sets of policy packages.

III. Forward-Looking Analysis and Determination of Associated Policy Mix

So far the discussion has been based mostly on developments in the recent past. But it is well known that the adequacy of the exchange rate level cannot be determined only on the basis of past events; what is more important is the medium-term to long-term prospect of maintaining a given exchange rate. In this context, it is useful to prepare two types of scenario with various degrees of analytical comprehensiveness—first, the effects of maintaining the same exchange rate, and, second, if the exchange rate is found to be inappropriate, determine the effects of a change of x percent in the exchange rate. For both scenarios, the necessary analytical steps are similar and should emphasize the effects on the balance of payments, the government budgetary position, income distribution, and welfare implications. This paper is confined to the effects on the current account deficit, ignoring portfolio adjustments and monetary and capital movements.

The analysis can be performed with various degrees of sophistication; a simple approach may be to rely on the traditional elasticities approach, using reduced form export supply and import demand functions.14 In this specification for a small open economy, the outcome depends mostly on two parameters—the export supply and import demand elasticities—and the system can be specified using some simple external sector closure rules. In the simplest form, foreign and domestic prices are exogenous or predetermined and, thus, the exchange rate depreciation changes domestic relative prices with real effects on demand and supply; export supply increases and import demand falls, depending on their respective elasticities, and the trade balance improves.

When projecting the balance of payments, budgetary position, and other performance indicators, several methodological issues need to be addressed. These include formulation of the wage/price adjustment mechanism; analysis of the supply response with the underlying reallocation of resources; and the consequent internal terms of trade effects—all of which follow an exchange rate action accompanied by appropriate demand management policies. In a general-equilibrium framework, all of them should be determined simultaneously, while in a partial-equilibrium analysis, they are addressed sequentially. If the sequence is worked out and repeated a few more times, a significant proportion of the feedback effects can be captured and the approximation would be close to a general-equilibrium formulation. These considerations should provide the background information needed to determine the three types of change (i.e., valuation effects, recording effects,15 and real effects) in the balance of payments and budget analysis. Exchange rate action emphasizes the role of expenditure and resource switching between traded and nontraded goods through changes in relative prices. This expenditure switching adds a dimension to exchange rate policy that is not present in the demand management policies, but the lasting effects of the exchange rate action are contingent upon the commensurate fiscal and monetary restraints and, thus, require closer quantitative examination.

demand management policies

In the aggregate form, the current account balance may be defined in terms of domestic investment and savings of the private and public sectors, that is,

CAB=(SpIp)+(SgIg)=(SpIp)(GT)

where CAB is the current account balance, equaling the balance in goods, services, and transfers; S and I are savings and investment, with superscript p and g referring to the private and public sectors, respectively; G is government expenditure; and T is government revenue. This is an ex post identity, and if one assumes that private sector surplus (Sp IP) is “stable,” any increase in the budget deficit would cause an equal deterioration in the current account balance. This relationship shows the qualitative relationship between budget deficit and trade balance; but, in any quantitative evaluation, the private sector surplus should not be treated as independent of the overall budget deficit and its financing.16 The composition of government expenditure is also important; an increase in government spending on traded commodities (exported or imported) causes an equivalent increase in the trade balance deficit. For the nontraded sector, the process is different—government expenditure on nontraded goods expands production in that sector, contracts the traded goods industry (under a full employment situation), and, consequently, increases the deficit in the trade balance. All these factors indicate that for many countries, when an adjustment program is being framed, the financial operations of the government and public sector enterprises deserve close attention.17

Along with the requisite fiscal discipline, adjustment programs should be accompanied by domestic credit restraint. Under a fixed exchange rate regime, any attempt by the authorities to reduce a deficit or to increase a surplus is facilitated by domestic credit control, which releases resources to expand exports and to reduce imports. A relationship can be established between domestic credit expansion and the balance of payments to show that excessive domestic credit expansion relative to the rate of growth of the demand for money will induce an overall balance of payments deficit. The transmission mechanism operates through a complex link with major variables, such as expenditure, income, domestic prices, and the demand for money (Guitián (1973)).

wage/price adjustment mechanism

Devaluation has some induced effects on the country’s costs and prices that tend to offset the competitive advantage achieved by the devaluation. The larger the rise in money costs and domestic prices, ceteris paribus, the smaller would be the real effect on relative prices and the consequent improvement in the trade balance. The attractiveness of exchange rate action arises in the situation of disequilibrium with rationing, which characterizes the predevaluation scenario in most developing countries. The effects of devaluation on the price of importables would be different under restrictive quota and tariff barriers: with quotas, the price is determined by domestic excess demand, the quantity imported being exogenous; with tariffs, the price is determined by world supply (with allowance for the tariff rate), and the quantity imported is endogenous.

One simple approach may be to use data on the structure of production and final demand to estimate primary and secondary effects on the CPI and wages, assuming a fixed proportional change. An alternative formulation is to focus on the wage/price interaction in terms of a simple two-equation wage and price model to determine both rounds of effects. This type of model has been used in many empirical studies of wage and price behavior, and simpler versions (with one price) have been suggested in the context of exchange rate actions by Goldstein (1974) and Bruno (1978). A variant of this model can be expressed as

Wt.=a10+a11Ut1+a12P˙t1;a11<0,a12>0
Pxt.=b10+b11W˙t1+a12Q˙t1+b13P.mt1;b12<0;b11,b13>0
Pnt.=b20+b21W˙t1+b22Q.t1+b23P.mt1;b22<0;b21,b23>0
Pt.=θ1Pxt.+θ2Pnt.+θ3P˙mt;0θ1,θ2,θ31;Σiθi=1

where W, P, U, Q, and Pm are, respectively, the indices of money wage rate, retail price, unemployment rate, labor productivity, and the price of importables; Px and Pn are the price indices of traded and nontraded goods, respectively. The variables with dots represent proportional changes from their previous value. This formulation allows for differential price effects for the exportable and nontraded goods sectors, owing to devaluation and the consequent wage/price effects. The effect of the exchange rate change on the price of importables (Pm) should be based on the nature of the import restrictions (quota or tariff) and should be determined simultaneously or independently.18 The exact formulation should vary from country to country to capture individual characteristics, and, to that effect, the preceding specification should be viewed merely as an illustrative example.

Price determination is one of the most unsettled issues in macroeconomic analysis; general-equilibrium formulations, while satisfactory for equilibrium relative prices in terms of chosen numeraires, are not so uncontroversial about the general price level. Given these conceptual difficulties, it is practical to use some less satisfactory method that takes care of the wage/price interaction and has the potential to analyze the effects on resource reallocations in terms of a two-sector model of traded and nontraded goods.

In evaluating the effects of exchange rate changes on import prices, one should take into account the nature of the devaluation “package.” Devaluation generally involves a simultaneous trade liberalization and a stabilization program of contractionary monetary and fiscal policy to reduce the level of aggregate demand, along with some degree of exchange rate unification. It is non-inflationary to the extent that import quotas are effectively replaced by the depreciated exchange rate. As the distributor of foreign exchange, the monetary authorities would receive the scarcity rents that previously accrued to the privileged importers. Since price rationing is replacing quantitative rationing, the effects on the final market price for the users would be partially offset.

While specifying the wage/price dynamics, one should also be aware of several other potential factors that may cause a devaluation to affect domestic expenditure directly, apart from the indirect effects that are due to devaluation-induced changes in monetary conditions. Some of these factors that have received theoretical and empirical significance are described as follows:

(1) In discussing price effects, Hirshman (1949) demonstrates that the critical sum for trade balance improvement is lowered if a developing country initially has a trade deficit.19 Jones (1960) points out that an initial trade deficit may even reverse the expected impact of changes in the external terms of trade on the trade balance, reinforcing rather than weakening the effects of devaluation. The conditions that combine to make this happen, expressed in terms of elasticities and marginal propensities to save and to import, can be found in Jones (1960).

(2) Exchange rate action generally redistributes income, which, on occasion, may play an important role in the postdevaluation period. Diaz-Alejandro (1965) notes that the devaluation of the Argentine peso in 1958 redistributed income from workers to landowners, causing a sharp recession in the following year. Finland also had a similar experience after its devaluation in 1957. However, under different circumstances, the redistributional effects could induce a spending boom as well.

(3) Expectations effects may influence the short-run outcome. If devaluation is widely anticipated, expenditure would generally be higher, followed by a period of lower than normal expenditure in the postdevaluation period. However, expectations effects would last only during the period in which excessive inventories were being worked off.

(4) If there are excessive distortions in the economy, the liberalization program associated with devaluation will increase real output through more efficient allocation of resources. If domestic and foreign demand do not increase to absorb the excess supply, deflationary pressures will emerge. The time dimensions required for the realization of this resource-allocation effect would depend on the nature of the factors and the structure of production in the economy.

Thus, in a range of circumstances common to many developing countries, devaluation may be deflationary or could, to some extent, offset the preliminary inflationary impact. Devaluation will, of course, increase the domestic prices of imports and import-competing goods; this is deflationary, since higher money payments for imports absorb purchasing power and reduce expenditure on domestic goods. These issues, wherever relevant, should be taken into account in the formulation of the wage/price adjustment mechanism; the model just described should be appropriately adjusted to this effect.

supply response and underlying resource allocation

Once the price changes are determined, the next step is to derive the expected supply response and the underlying resource-allocation effects. The first step is to determine the responsiveness of factors of production to changes in the foreign exchange regime, and, if sensitivity is significant, to check for any potential bottleneck in achieving the supply response that is due to resource immobility or nonavailability. It is generally recognized that a major objective of any exchange rate action is to reinstate price competitiveness, which would ensure desired supply responses, that is, a real effect, apart from the valuation and recording effects on the balance of payments and the budget. Given the economy’s endowments, any policy aimed at stimulating supplies of exportables (for example) could be effective only if relative prices for products and corresponding factor rewards are adequate, and if barriers against efficient resource flow are minimized. The impact on the supply of other products (e.g., nontradables) owing to this shift of resources should also be taken into account.

Cross-sectional data can be used to determine any significant association between the variance in protection across subsectors and factor-to-factor or factor-to-output ratios. If, for example, protection is correlated positively with the capital/labor ratio, this would suggest that the structure of production might have caused capital intensification despite the abundance of labor. This finding was evident in Ghana (Leith (1974)) and in Israel (Michaely (1975)). This method might help to determine the responsiveness of factor movements to changes in the foreign exchange regime.

Using the estimates of sectoral elasticities of substitution between the various factors of production, one can determine the allocational impact of specific foreign trade regime or commercial policies. Potential bottlenecks in the availability of factors, which may jeopardize the attainment of production and export targets, can be identified and appropriate actions can be taken (either by revising the targets or by implementing allocational priorities).

However, the simple analysis of supply response based on elasticities of supplies may not be able to capture the outcome adequately. The transmission mechanism and the associated supply response based on the accepted elasticity values may yield different results under partial-equilibrium and general-equilibrium simulations. It has been noted by Behrman (1976) in the context of Chile that, while the partial-equilibrium supply responses are found to be significant, in the general-equilibrium simulations, when allowance has been made for indirect effects, the final outcome may not be as significant. Thus, in the absence of general-equilibrium computation, the partial-equilibrium outcomes should be interpreted with due caution.

external terms of trade effects and exchange rate policy

The external terms of trade effects of the supply response often do not receive much attention in the evaluation of the effects of exchange rate action. An assumption of a typical small economy with no impact on world prices is implicit when the external terms of trade effects are ignored. However, for many developing countries, it has been observed that a sustained short-term to medium-term downturn in export prices is one principal cause of balance of payments difficulties. Seen from a global point of view, the policy of stimulating “weak” commodities (experiencing deterioration in real prices) could turn out to be unrewarding and to some extent “immiserizing.”20 For some commodities, such as cocoa in Ghana, jute in Bangladesh, and copper in Zaire, one country does furnish a significant proportion of the world market supply;21 any significant increase in the supply by those countries would cause a deterioration in their terms of trade. In some instances, countries are operating under an international commodity price agreement (e.g., coffee, sugar, tin) with binding quota restrictions on sales. These agreements, if implemented properly, make the prices firmer but eliminate the short-term potential to increase export receipts through price incentives in the form of a devaluation.

Devaluation would, however, be effective in other respects,22and should, in the preceding circumstances, be accompanied by an export tax or its equivalent to prevent accumulation of unsold stock or deterioration in the terms of trade. It may be recalled that, in the context of immiserizing growth, the imposition of an optimum tariff is suggested (Bhagwati (1958), Johnson (1967), and others) to eliminate the paradoxical effects. However, both the Bhagwati (1958) and Johnson (1967) examples of immiserizing growth belong to the class of cases in which immiserization is caused by welfare-reducing distortions in the economy, and the use of optimum tariffs or export taxes should be viewed as a second-best solution.

balance of payments projections, budgetary analysis, and other related issues

Balance of payments projections

Given the derivations of price and supply responses, balance of payments and budgetary projections can be performed taking into account the resulting valuation, recording, and real effects. For many countries with exchange restrictions and an overvalued currency, the recording effect may be significant, with important implications for the treatment of parallel market activities (discussed in the subsection, parallel exchange market). To the extent that parallel market activity is significant but not taken into account in the balance of payments forecasts, the results could be biased significantly toward a deficit in the official accounting balance.

Separate projections are needed for important categories under the balance of payments accounts with major emphasis on the performance of exports and imports. For many developing countries, where a few major primary products play a key role in export earnings, a commodity-by-commodity approach (described in the subsection, single-commodity approach to evaluating export performance) or its variants would be appropriate. For imports, an aggregate approach may be used, while for some important import categories a more detailed approach may be desirable. On the basis of the payments and receipts of foreign exchange, along with expected foreign grants and loans, one can determine the sustainability of the balance of payments position. In this evaluation of sustainability, let us look at the ratio of current account deficits to GDP, the ratio of debt service payments to the receipts of foreign exchange earnings on the basis of projected developments in foreign debt, and other suitable indicators.

Budgetary analysis

The objective of this analysis is to see if the government budget would be in a sustainable position after the exchange rate action, or what fiscal adjustments are necessary to make it so. Since the emergence of a relatively large budget deficit normally leads to excessive money creation in developing countries, it is expected that adjustment programs should contain elements to stabilize the budget deficit. If the budget deficit is not found to be compatible with the fiscal targets specified earlier, appropriate fiscal measures should accompany the exchange rate action.

The revenue effects of devaluation depend on the change in the aggregate nominal value of imports, exports, and their composition—all of which are determined essentially by the price transmission and supply response as discussed in the context of balance of payments analysis. Institutional arrangements, such as procurement, marketing, and price control operations of the government agencies, influence the budget deficit significantly after devaluation. Effective subsidies to the exporters are reduced as the procurement prices of exportables can be improved; the opposite happens if the government subsidizes the importables. The revenue effect also depends on the prevailing or suggested tax structure, or, more specifically, on the proportion of import duties in specific terms as opposed to ad valorem terms. An extensive analytical framework for estimating the impact of devaluation on the central government budget can be found in Klein (1972) and Byrne (1981). Klein analyzes the budgetary outcome in terms of price effects (owing to changes in prices) and income effects caused by changes in various tax bases induced by changes in income. Price effect covers the effects of changes in imports and exports and the duties received and subsidies paid, government receipts from abroad, and expenditures to be made given the new set of prices. If the government plans to maintain a certain level of real expenditure, some additional outlays are called for, owing to higher domestic prices as determined from the specified wage/price adjustment mechanism. Debt-servicing obligations of the government should also be evaluated at the new exchange rate. Byrne (1981) considers the money market adjustment in evaluating the impact of devaluation on the budget and the corresponding implications for credit ceilings to attain a desired balance of payments target. In reality, balance of payments and budgetary analysis are interdependent systems and, to the extent possible, should be treated as such.

The effect of devaluation on the overall budgetary deficit and the consequent bank financing required by the public sector is not unambiguous. Depending on the direction and the magnitude of the change in the budget deficit, one can determine the fiscal implications of the hypothetical exchange rate. An appropriate exchange rate level should not only be consistent with the balance of payments sustainability but also be in line with the budgetary position. However, devaluation should not be treated as a means of attaining budget balance, and changes in the expenditure or tax structure may be needed to supplement the exchange rate policies.

Other related issues

Income distribution and welfare implications of exchange rate action are two other aspects that may merit attention from policymakers. Income distribution effects help the authorities to determine the potential gainers and losers of any exchange rate or combined policy action. Although not directly relevant for sustainability of the balance of payments and government budgetary position, it reflects to what extent the social and political fabric would be strained owing to the adopted policies. There have been situations in which the effects on income distribution among various segments of the population have influenced the size of feasible exchange rate adjustments. In many instances, adverse redistributional effects against the low-income groups have been cited as a case against devaluation. While an overvalued currency through lower price levels may imply a higher real wage for labor, restrictive systems tend to discriminate against workers because they do not capture any of the large private gains from the distortionary nature of the system. Another possibility may be that labor productivity (and, thus, real wages) may have been lower because of protection from competitive forces. There are other relevant issues in the context of income distribution effects of exchange rate action, and no qualitative generalization is possible, a priori.

IV. Conclusions

In this paper a number of simple methods have been assembled, some of which are widely used, to determine the appropriate level of the exchange rate for a developing country. The objective has been to assemble enough evidence to generate a consensus and thereby obtain a sustainable level rather than an optimum level of the exchange rate derived from some optimization process. Thus, although from a theoretical point of view this sustainability approach is not as elegant as a fully specified optimization solution, it is intuitively more appealing, being more amenable to quantitative evaluation, given the scarcity of data.

Various aspects of the exchange rate issue that should be addressed in any comprehensive evaluation of the appropriateness of an exchange rate have been considered in this paper. These substantive issues are described as follows:

(1) The adequacy of an exchange rate level cannot be determined only on the basis of past events; both backward-looking and forward-looking elements should be considered simultaneously.

(2) Apart from various effective exchange rate indices that are widely employed in various studies, other microlevel studies on the production and cost structure, analysis of distortions stemming from restrictive policies, and their costs should be given proper attention.

(3) The effects of exchange rate action should be seen in conjunction with other supporting policies. As a matter of fact, analytically, any exchange rate policy can be validated by appropriate adjustments in the level of economic activity or the rate of monetary expansion. While devaluation can be effective to initiate corrective forces, it may not be able to bear the full burden of adjustment, especially if the imbalances arise from the demand side.

(4) Consideration of underlying adjustment mechanisms that follow an exchange rate action is crucial to the outcome of any forward approach. Implicit price dynamics should be adequately specified, taking various institutional and other rigidities into account.

It should be emphasized, finally, that the adoption of the approaches reviewed in this paper will not lead to an unambiguous specific conclusion regarding the “right” exchange rate level. These approaches should, however, improve the basis for judgments that will always be required of the policymakers. Economic analysis can establish convincingly that an exchange rate will have to be changed to a new level within a certain range if certain economic objectives are to be achieved. However, the choice of the precise new level will be influenced by judgments of policymakers regarding the mix of associated policies; these judgments are likely to be influenced strongly by the perceived sustainability of the adjustment strategy envisaged.

APPENDIX: Measuring the Parallel Market and Welfare Costs Owing to Distortions in the Exchange Regime

Determining size of parallel market

Underinvoicing of imports may be in response to high tariffs, as recorded by Bhagwati (1964) for Turkey, using the classic technique of the comparison of partner-country trade data. Comparing the trade flow data from origin and destination sources and allowing for possible statistical reasons for some discrepancies, Bhagwati concluded that significant differences remained that could be explained only by underinvoicing of imports. Application of Bhagwati (1964) and Naya and Morgan (1969) showed that the comparison of partner-country data worked reasonably well for Turkey and Southeast Asian countries, if the “noise” from the statistical factors discussed by Morgenstern (1963) was not excessive.

More rigorous analysis of faked invoicing can be performed following Sheikh (1974) in the context of Pakistan. Using the partner-country comparison technique, Sheikh worked with 36 commodities and with partner countries that supplied more than 80 percent of Pakistan’s imports. Commodities were then divided into two groups, “restricted” and “liberal,” based on a careful examination of the incidence of import licensing thereon. If significant underinvoicing was occurring, for the restricted categories, the home-country import values should fall significantly below the partner-country export values. Sheikh also established a relationship between underinvoicing and the classification of a commodity in a high-tariff or low-tariff category. If more goods were in the high-tariff category, the system was more prone to underinvoicing.

Measuring welfare costs by Johnson’s (1960) method

Johnson distinguished between two sources of costs owing to protection. Total costs, the sum of production, and consumption costs, as a proportion of national output, were given as follows:

C=ΣikiTivi+12Σiei(θimi)(Ti2ΣjsijTiTj)

where

  • Ki= proportion of excess of domestic over foreign prices that is not rent

  • T i = “effective” tariff rate in domestic prices at the margin

  • vi = proportion of expenditure on domestically produced ith good

  • ei = proportion of expenditure on ith good

  • θi = uncompensated own-price elasticity of demand for ith good

  • mb = marginal propensity to spend on ith good

  • Ni = are elasticity of supply at production point with tariff

  • Sij = proportion of substitution between ith good and jth good

When imports do not completely replace domestic production,

Ki=12TiNi

where Ni is as just defined.

Measuring welfare costs by a small-dimensional multisector general-equilibrium model

General-equilibrium formulation of an economy is characterized by (i) a set of market demand functions that are the sum of individual demand derived from utility maximization subject to budget constraint; (ii) a description of the technological production possibilities of the economy; (iii) endowments of the consumers; and (iv) the conditions of equilibrium. On the production side, the technology is described by an activity matrix, or production functions exhibiting nonincreasing returns to scale. Various policy models can be specified to analyze the welfare costs of trade restrictions and other policy evaluations for various countries (Feltenstein (1980) and Whalley (1982)). The appropriately specified models can be solved iteratively using trial and error methods or, more accurately, by using the Scarf (1973) algorithm or its variants (Merrill (1971) and Laan and Talman (1979)). Counterfactual equilibrium computed for the new policy regime is compared with the benchmark equilibria for policy appraisal.

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Mr. Mansur, economist in the Special Fiscal Studies Division of the Fiscal Affairs Department, was in the Exchange and Trade Relations Department and the Asian Department when this paper was prepared. He is a graduate of the University of Dhaka, Bangladesh and received his doctorate from the University of Western Ontario.

1

An appropriate exchange rate level is defined as that which yields a sustainable balance on the external current account, given appropriate monetary, fiscal, and incomes policies.

2

Other relevant issues in the context of an appropriate exchange rate regime include the nature of the peg to a particular currency or a basket of currencies and the optimality of fixed versus flexible exchange regimes; these important issues are not covered in this paper.

3

Portfolio adjustments and monetary and capital movements have been ignored; the discussion has been confined to the effects on the current account balance. The countries considered here have limited commercial borrowing power in the world capital markets and, thus, exclude the open, “Latin American” type of economy in which capital flows, expectations, etc., play a large role.

4

In the standard formulation, REER indices are constructed by deflating the NEER indices by the corresponding indices of relative prices; Maciejewski (1983) points out that a deflated nominal index is not a meaningful exchange rate concept, as the exchange rate is inherently a nominal measure. However, he also shows that the standard formulation is, in fact, equivalent to an index of relative prices deflated by an index of NEER movements.

5

Aizeman (1981) modeled exchange rate behavior in a three-goods economy (exportable, importable, and nontradable goods) and showed that with restrictive import quotas, devaluation lowers the relative prices of both importable (subject to quota) and nontraded goods.

6

For the origin and development of the effective exchange rate (EER) concept, see Hirsch and Higgins (1970), Thakur (1975), Rhomberg (1976), and Feltenstein, Goldstein, and Schadler (1979).

7

Ridler and Yandle (1972) show the value effect as the sum of price (ΔP) and volume (ΔQj,) effects, that is,

ΔVX=ΔP+ΔQj=ΔP+Nsj(ΔPΔej)

from which follows the relationship in equation (1).

8

Leith (1974) for Ghana, and Behrman (1976) for Chile, found that the degree of restrictionism has been associated with the marginal output/capital ratio; investments shifted to capital-intensive sectors during the restrictionist regime. In a separate study of Israel, Michaely (1975) uses Kendrick-type estimates of overall factor productivity; he notes that the period of rapid transition to price mechanism (to regulate imports and other economic activities) was marked by rapid increases in the rate of productivity.

9

The rationale for using ERP has been given by Corden (1966) and for DRC, by Bruno (1972) and Krueger (1966; 1972).

10

Sometimes parallel commodity markets exist in key exportables and in selected importables. In some economies, precious minerals are exported through bordering countries; this kind of parallel market for commodities has a potential for development if the official procurement prices are substantially lower than the corresponding world prices.

11

Revenue collected, given a tariff, would always be smaller when there is smuggling; a given revenue could be collected at a lower tariff rate in the absence of smuggling, when revenue collected by tariff is assumed to increase with increases in the rate. From a government’s budgetary point of view, smuggling reduces the (import) tax revenue below what it would otherwise be and so reduces the amount of public good that is provided by the government.

12

Nowak (1983) points out that a devaluation of the official rate contracts the parallel market but increases exports; since this parallel rate equilibrates the demand for and supply of foreign exchange, it would appreciate.

13

For many countries that export primary products, temporary commodity booms might cause a permanent increase in expenditure, resulting in future fiscal disequilibrium. Tanzi (1982) attempts to classify the countries according to factors that caused fiscal disequilibrium by examining the current expenditure, ordinary sources of revenues, and capital expenditure of selected countries.

14

Various approaches have been developed over the last few decades to measure the effect of exchange rate changes on the current account. Most of these can be classified under four broad categories: (i) elasticities approach; (ii) absorption approach; (iii) monetary approach to the balance of payments; and (iv) small-dimensional multisector general-equilibrium approach. Each of these contains some elements that are relevant for real world specifications.

15

Activities attracted out of the parallel or black market would be recorded in official market transactions even without any change in the level of real economic activity and, thus, would influence both the balance of payments and budget outcome.

16

An analytical framework for evaluating the effects of fiscal policy changes on the current account balance is discussed briefly in the subsection, developments in fiscal and monetary policies.

17

As part of an “expenditure reducing” policy, often a reduction in the ratio of the overall public sector deficit to gross domestic product (GDP) is called for, which is thought to be an important operational policy step in reducing the ratio of current account to GDP. It is frequently necessary to bring the overall government deficit under control and to improve the profitability of public sector enterprises.

18

The specification considered here is ad hoc; a more choice theoretic specification may be attempted by employing an appropriately specified set of excess demand functions.

19

The critical sum refers to the familiar Marshall-Lerner condition, which states that, for devaluation to be effective in improving the trade balance condition, the sum of import and export demand elasticities should be greater than unity.

20

Bhagwati (1958) notes the case of “immiserizing growth,” in which a country faces acute growth-induced deterioration in its terms of trade, implying a sufficiently large loss of welfare that outweighs the gain from growth. While this applies to countries with some degree of monopolistic power in trade, Johnson (1967) shows that this phenomenon may arise in a small country without monopolistic power, if there is technical progress in a tariff-protected, import-competing industry, or if the factor in whose use this industry is intensive is augmented.

21

For many countries, exports are unofficially passed through neighboring countries (cocoa for Ghana, diamonds for Sierra Leone, jute for Bangladesh), and thus a substantial recording effect may be experienced by the individual countries without any external terms of trade effect.

22

From a long-term point of view, diversification of the export base can minimize the potential for terms of trade deterioration. By increasing the profitability of exportables in general, devaluation can augment the process.

IMF Staff papers: Volume 30 No. 4
Author: International Monetary Fund. Research Dept.
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    Schematic Diagram of Various Tests That Have Been Suggested to Determine Adequacy of an Exchange Rate1, 2