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* Work on this paper was started while Guillermo Calvo was a Senior Advisor and Enrique Mendoza was an Economist in the IMF Research Department, Guillermo Calvo is now professor of economics at the University of Maryland, and Enrique Mendoza is an economist with the Board of Governors of the Federal Reserve. The authors thank Lawrence Christiano and Hugo Hopenhayn for useful comments and suggestions.
As in Levhari and Srinivasan (1969), feasible plans require that rt satisfies the condition E[(rt)1-γ]< β−1.
There is also a feasibility constraint 0 < λ/η < 1, or λ < η.
The difference is larger the lower the degree of risk aversion, but it is always positive.
A cross-country empirical analysis of the link between terms of trade and growth implied by this model is undertaken in Mendoza (1994).
Recall that r−1 = R−1p−1/p0, r0 = ==R0p0/p1 and p is the inverse of the terms of trade.
This experiment is interesting because trade reforms introduced in recent years coincided with a secular decline in real commodity prices.
Evidence from Ostry and Reinhart (1992) suggests that β may actually be slightly higher. Increasing β does not affect our results significantly, except for estimates of welfare costs that increase sharply as β rises.
Welfare costs are measured as percentage changes in stationary consumption paths that compensate households for the loss in lifetime utility resulting from existing distortions. For example, in the case of costs resulting from σ = 0.025, we compute equation (21) under σ = 0.025 and σ = 0. assuming π = 0, and use equation (1) to compute two time-invariant levels of C that represent the same expected utility.
Mathematical proofs are available from the authors.
This result is consistent with the findings of Calvo and Drazen (1993) for the sustained boom of the reform of uncertain duration under incomplete markets and no rebates.
In the case with rebates, both the free-trade economy and the economy with permanent tariffs produce the same welfare, and hence the difference between credibility and temporariness is immaterial.