Stabilisation strategies in primary commodity exporting countries

formation. Trade liberalis uct aad factor prices, an private sector have bee Douglas !l9Sl)]. Coincident with the intro the pursuit, by the economic ~~t~~r~t~ monetary ~~~t~~~~t.Until the structure of the econa

earnings, the extent of exp employment to world copper pr in the world copper market and in the this fact. By November 1981 the average level of 1980. Since over this Chile maintained a fixed parity betw the f.o.b. export price in Chilean amount. A price decline of the ma

trade. The particular sev stimulated much debate abo macroeconomic stabili this paper we consider a r

need not, however, imply that the shares of the absoqtion accounted for by households, private investors,c and government remain constant. For example, if the authorities use the increase in domestic money to finance the public sector deficit, goveramrent expenditure would increase at the expense of pri,vate consumption and investmctrt expenditure. While this utould lead to solmewhat different sectorat eff&~ts through differences in the StsraI composikm of each of the final deman.d categories, t&e broader irn~l~c~tion~ would be equivalent to the case where the three components of absorption were held fixed. Of course, option (i) would only be sensible if the decline in the fure~gn terms of trade could be considered temporary. If internatio*lal reservr3s together with access xo foreign capital (for exan~ple, cornpemsatory finr-e.ncing) were sufficient, the economy could simply ride out the short terr ‘Lbal trade deterioration. olicy option (ii) involves, in an environment of constant real dxnestic rption, a real wage cut just suficient to meet the employment constraint. ‘ahether the required fall in real -wages to compensate for the aggregate employment contraction associated with the copper price decline is politically feasible is a separate issue. By quantify:ng this fall together bvitla its implications for the sectora. distribution of output and the functional distribution of income our analysis provides some guidance in this area. A wage cut suficient to reslore employment in an environment of consta-tt real domestic absorption is u.nlikeiy :o eliminate the balance of trade deficit caused by the copper price dl;3cline.The bal;:nce of trade constraint could b‘ met simply by adopting a purely deflationard domestic monetary policy iq tn environment of constant money wages. This forms our option (iii), in which real domestic absorption is sc(ueezed just sufficiently to eliminate the balance of trade de&it occasioned by the slump in world copper prices. As is well known, an adverse foreign terms of trade shock will neither endanger the internal equilibrium of a country when factor prices adjust to the diminished relative valuation of its exports nor endanger its external equilibrium when real absorption decreases in line with the reduced real ctor income. The orthodox neoclassical solution then requires bo ~atjonary monetary policies to reduce domestic expenditure and WB ~ex~b~~~tydownwards to restore the previous employment level, This forms tjon (iv), namely, a real wage cut to meet the domcsti int and a cut in real domesti: absor#ion to meet the b constraint. At least in the short run, however, markets may not be sufficiently exibie to ensure adjustment. ith Commcdity and factor prices being rigid uld still be reached by a devaluation of e sate together with a restrictive monetary policy. e of the f~~~~~r~ of real wages to

Under this heading we consider three altcrnati~~es, a devaluation of the ChiI;an SO against the i?S dollar [option (v)], an across the boar42 increase in protection afforded domestic industries [option (vi);, and subsidies to export iRdust~~s E[( option (\-ii)]. A devaluation is ~1.traditional tool for restoring the balance of trade. To be about an increase in the price of traded relative to “rut of non~traded ds. If the devaluation is not accompanied by fiscal and ~~o~~tary restraint, en the initial change in relative prices it causes will be eroded by domestic inflation. In short, a devaluation, to have real effects, must be capable of briirgin about a reduction in the real returns to one of the economy’s factors of oduction. We illustrate this by comparing the results from a devaluation (at constant money wages) with tilosi from option Pch money wages are adjusted at a constant nominal exchange rate. parison indicates that the real effects of the two options are equivalent once the devaluation and the nominal wage reduction have been scaied to represent the same real wage effect. Protection is always a tempting strategy to help restore the balance of trade and sustain employment fotfowing a terms of trade induced economic depress on? The fact that protection imposes significant long run social COSLS by ind icing a misallocation of resources is well known. Our conce.rn here Is with trre question: how effective is an across the board increase in tarrffs i;l g the balance of trade an employment in the short run? ‘Tariff raise the price of imports n 1+e domestic market, alioJr ing solme expansion in employment in import competing industries. Howe! x this is only the beginning c;f &AGstory. Higher domestic prices feed into I;roduction costs and the consumer pnce index. They may also generate money wage increases as workers strive to mair tain their real wage. The inflationary boost to the economy weakens the internationally competitive position of es whose ability to pass on omestic cost increases is limited. tibzness of increased protec n in improving the balance of trade and in stimulating emf>loyment is questionable. Export subsidies are a frequently used tool in debeloping cou It:-ies. The> are sometimes seen as being necessary to offset the cost disadvantages experienced by export indgstrios due to tariffs on ~rn~~~rt~d inputs and an overvalued exchlrngc rate. hej, provide an tidditional means of improv;lng the price--cost situatitifl of xport industries to that OC exchange rate apad es. Our option (vii) intio t’t‘s i~~~if~~~1~ I

the

power of 0-w

subsidy7 on export ccmmodities to bring about an im~ro~rem~nt in foreign

52

H. Dick et al., Stabilisation strategies in Chile

exchi?nge earnings sufficient to offset the effects of the world cop decline. 3. Analytical framework ‘we have constructed a disaggregated, economy-wide model of the Chilean economy. This model is general equilibrium in character, provkin integ:rated deskpt;on of production possibilities and demand c endogenising bctn commodity and factor prices and quantitiesS comparative-static type, it is not designed to simulate a partir~ for the Chilean economy. Rather, its purpose is to give ins implications of disturbances which carry the economy away established trends, and the adjustment consequences of va.rious stabilization alternatives undertaken to offset the initial disturbances. The model structure plays close attention ts microeconomic theory. its key bchavioural equations are derived from the constrained o~tim~sation of neoclassical production and utility functions=* These equations emphasise the importance of relative prices and substitution prospects in explai flows and the composition of domestic econorGc activity. This fla.vour is ps!rticnltarly appropriate for Chile, given the essentially open free market character of the real side of its economy. The model is centred around an input-output system of accounts, allowing for the inclusion of many types of commodity and factor flus. e. commodity flows from domestic and imported sources to current production, capital creation, households, government and exports, and factLIt= flows (labour by occupation, fixed capital, land) to industries fQr use in current production. It thus allows us to trace, in some detail, .:he effects of the change in world copper prices on the pattern of domestic economic activity and the d&rib utional consequences of alterna tivt: policy responses. The model equations, expressed in linear percentage change form (the form in which the model is sclved) are listed in table A. l? Model variables are ‘Major beha VI ‘oural postulates are: (i) Producers choose their commodity and factor inputs IO minimise production costs of a given output subject to th level constant industr;; production functions. At the first level is the Leo f ~ssunl~)tjol~of ‘ktween input categories x between ;hem and an aggregate af the pri~~~~ryfactors, At the second level are CES functions des, .k~ng substitution between d of each input category and between the three primary factors (a land). At the thirti level are CES functions describing substitution within the aggregate labc ur category. (ii) Households chuos additive nested utility function cubject to an aggregate budget con commodity categories con&n CES functions describing substitution pro and imported sources of each category. ents a son~ewhat simpiifi ~n~r~~ for k4

53

s

ln

table

A.3.

T e equatibtls

may

be

for

dQRlestic and imported cumfretters, other domestic (mainIy gov(1) indi~at~$ that households can subd sources of their consumption goods ees of these goods from tl,,: two a given reIative price change, is

bstitution elasticity (al”‘). Eq. (2) tute betwen di!Terent commodity les, the extent of substitution being of the commodity categories and Eq. (3) indic xtes that producers Qqcan svcritch their demands between domestic and imported

rice changes between the two commodities for other (mainly are related to real consumption expenditure [eq. (4)_1. tes that provision is made for Chilean exports to world ~~rn~~ity prices.

These are Sescri substitute kt

d by eqs. (6)-(9). They. indicate that Chilean industries n domestic and imported sources of their intermediate n I: primary factors labour, fixed capital, Sand, and between nputs, cupations in ~r~du~in~ their outputs. The extent of different la~~~lr e in &ela;ive t.>:icesis governed by the relevant ~u~st~tuti~n for a ~u~stituti~~~ ~~~sti~t~es.

can

54

H. DScket al., StaMisatlon strategies in Child

importing (which is the domestic currency equivalerlt of the foreign currency price including the tariff). Eq, (13) equates the revenue from exporting (righthand side) to the cost of doing so. 3.4. M arka cCearing These refstionships are depicted by (14)--(17), which equate supply with demand for domestically produced commodities, uccupational labour, fixed capital, and Ian& Note that imports are not added to domestic production in determining total supplies. Thi s is because commodities from foreign and domestic sources are treated as being distinct commodities. Note also that (15)-j 17) simply amount to saying that factor employment levels are satisfied. Tky do not necessarily dispose full employment assumptions.

We include a rather simple monetary sector in the model. The money supply (A42) is assumed to be determined by applying a constant multiplier to the monetary base. The latter is decomposed into a domestic component, i.e., credit to the private and public sectors, and an international co i.e., international reserves. Demand for money is assumed to be a funct aon of the domestic price level, gross domestic product, and expected inflation.” Eq. (18) equates the supply of money to its demand. Eq. (18a) define:\ the Lreign component of money.’ l In *hc F-KM closures of the experiments in section 4, both components of the mor;t’y supply are determined endogenously. In such closures, the role of eqs. f 18) alrd (Xa) is merely to illustrate some likely implications for the domestic and foreign components of the money supply of changes in other model variables. 3.6. Miscellancotfs equation3

The model includes a large group of equations which are mainly d~~nit~ona~ in character. Their structure is for the most part self ~xpl~n~t~ry~ Of thzse however, eqs. (23)_425), which determine the a t across industries, rec,uire further cc nment. l9 They follow from F”TFhts variable is designed to reflect the op;Jortunity CL.? of holding mone exogenous to the model. In the experiments rqorted later. a value c variable. Hence the results abstract from any changes in in~~ti~~n~ry tassociated with the poiicy shocks under consideration.

the assumption that t;,) ir,vestment takes one period to instaIl,‘” (b) investors have an expected r#ite o return schedule from new inves ment which is downwards sloping. and (c) aggregate investment is aHocated across industries to equate expe:ted rates of return.

From tables A.1 3nd A.2 we see that there are 4gh + 11g -+ 9h + r/j + 2r + 15 equations in 4gh -t+- t 1h + rh -I- 3r -I- 2 f variables. The model is first closed o a selection of 4g + 2h + r -+6 variables. iT!- - exogenous for each of the experiments reported in section k is set out in table AL) Solution values for the remaining variabIes are + .sined c”y simple matrix methods

In table 1 we summa&z the short run’” macroeconomic and sectoral implications of the 25 percent decline in world copper prices and the v~lrious stabilisation licies considered to ‘neutralise’ the shock. These results should be consider in conjunction IGth the information on model closures corresponding to eal:h simulation (table A.4). It is the particular selection of nous variables which frames the macroeconomic environment in which cts of the policy options are studied. Main differences ir this selection ktween simulations relate to the exogeneity ‘endogeneity of real absorption and its dual (the balance of trade). and aggregate iabour demand ant! its dual (wages). With, respect to the latter pail of variables it should be noted that our neoclassical assumptions of constrained cost minimisation on the part of producers imply that decreases in real wages will increase aggreate labour demand. t ’ e restrict our presentation of resu ts to some macro aggregates and to industry outputs, iabour demands, an ; exports and imports of the m:jjor traded ~~~te~~ries It is important to emphasise that the model is not being used here to provide forecasts about the likely level of cndogenous v:iri;&l~~

. _--

- 4.34 - 6.43 -- 6.43

2.95 - 16.56

- 31.69

0.71 0.98 --(X21

- 0.52 0.73

- 5.55

0.35

- 4.57 - 4.57

money wages, and real domestic absorption

WWb

change rate, and real domestic absorption

chmge itite, devah&~z,

WNb

- 21.51

- 3223

-0-13

-- 524 119.3I

0. - 11.24

0.92

0.14

0.23

- 0.37

-- 2.08

8.86

-0.48

0.07

- 0.03

9.89

7.07

3.45

wwb

domestic abir ~~~tion, and money i/ages I- _1_

fixed real

chain$6=r&e, real 6#Xn&e a&or&ion, Bdddmoney wzqps

5.28

: 7.25

5.02

O(EXp 3.45

- 224 14.26

.. ..-_

sorgtian, and muney wages

dcmesk ah-

fix& exChange rate. reaI

cxpmt subtidy pmm,

change ratt?

pmt32ct@ fix&dexd

per-t

in-in

increase in

12.317percent ex-

m.64

option (vii)

18 g3fmxmt

opt;m (ti)

measures.*

(v)

option

I_

stabilisation

- 3.03

-4.94 - 1.91

wm”

-4.90

-4.90

WWb

-271 -2.71

trxti ex&ange rate, aggregate empioyment, arid Iw+IJMIC~of trade

prictzdecline,

25 percent world copper

1.21 percent decline in Option (iii) 25 percent world copper price dechrri;, fixed ex&ange rate, money wages, and balance of trade

Option (iv)

_Option (ii) money wages, f&d czx-

_-.____n_--~-.W-_-

cd’ the efforts of the copper price shmk and alternative

Table 1

57

d

Tt I

,‘

2

vi

h3 vi

I

s; F d C

m d I

M

$

R

I

I

cl!

8 c5

d I

CT5

rc

3

3 d

sci a 0 pll

facturing

(export

( Import

^--

^___I__-

____-__

11.44

- 6.64

.28

0.51

0.09

-0. 0.

0.41

!c)ti

0.36

2.43

1.36

1.15

0.87 2.84

- 6 00

- 1.18

- 3.70

5.22

-- I .48

- 1.40

- 1.30 4.48

4.15 - 1.94

- 1.00

13.01

4.82

3.85

2.71 14.24

10.49 4.14

3.48

24.15

f354

11.43

0.95 0.06

0.00

- 0.40

0.13

-0.12

Ok8

-4.44

8.74

28.23

-0.80 1.82

275

1221

3

dC’alculatedby defl:arlr1grnrll err-n’s

constant.

n money wages by movements in the model’s consumer price index.

‘s at the 1977 ections are in percentage changes, with the exception of the balance of trade. which has the u&s millions of rate with the l”S dollar. nously set to zero. ‘The proportional composition of this absorption (between aggregate consumption, investment and government spending) is assumed

___

( 10) Services

(9)

(8)

(7)

(6)

(9

(4)

(3) Crude oil

60

H. Dick r’t al., StdrilLwtian strategies in Chile

at a future date. It merely projects the changes in th< Jevels of these variables due to the changes in exogenous variables. Thus, for example, the figure in line 2 of column (i) in table 1 indicates that, after a short run adjustment period (considered to be about two years) real GDP is projected to be 3.45 percent lower than it would have been at the same point in time had world copper prices remained unchanged. Optim (i). The maintenance of reul domestic absorption, cfixed money wages, atzd a fixed exchmge rate. The world copper price decline leads to a 3.5

percznt decline in GDP, which, with sustained real absorption, is entirely made up of the deficit on the trade balance. To hold real absorption constant the domestic component of the money supply must increase considerably. The foreign component declines by 76 percent. The reductic,n in aggregate employment of 0.7 percent together with a 0.2 percent incrc: se in real wages coming from a corresponding decrease in the domestic prict level implies an increase in real labour income of 0.5 percent despite a 3.5 percent decline in rea! national income. The sectoral results clearly indicate zhat a policy of maintaining the real value of domestic absorption in the face of ;he terms of trade decline is particularly successful in containing th:: adjustment pressures to the copper sector itself.’ 6 The export led contraction in copper output results iii employment in the copper sector declining by 12 percent. This sector, however, ean@oys only 6 percent of the economy’s workforce, which is the reason for th: small aggregate employment decline. Perhaps the only other notable Gzature of the sectoral results is a modest (0.9 percent) expansion in the output of sector 9 (Heavy manufacturing). This sector is heavily import competing. 1’ It enjoys a slight improvement in its domestic costs relative to the price of competing imports, leading to some substitution by domestic us\=rs away from the imported to the domestic product. Option (ii). The maintanance of real domestic absorption, exogenous empioyment, wage flexih’lity. The figures in column (ii) represent the effects

of an economy-wide W+Y cut sufficient to increase aggregate employment by 0.71 percent, i.e., the a ilount of the aggregate employment loss from the copper price declint: [$i e column (i)]. l8 The required wae;e adjustment is ‘61his sector has lev+ LA,n t brd and forward linkages with other domestic >.ectors. ’ -The A,eg-ce to which it sector competes against imports is, according to the model, an ly$icasing function of the tbase period import penetration of commodities classified to that sector and the elasticity of substitution between domestic and imported P;ourccs. ~i~~por~sdcL’.Junl f~ So percent of the base period usage cf commodities classified to the sector while the importtiomestic substitution elasticity is 2.0 (see table A.3). that the sectoral distribLtrlnta of employment di,rfers markedly between r price decline with fixed real a

;1.

L.--b\&

C.

al., Stuh~lisaticzn strategies in Chile

61

quite small, amountink to a ! 21 percent decline in money wages, which. after taking into account the deflationary effect on the domestic price level, is cquiv;iient to a 0.88 rcent decline in real wages. The slight improvement in the economy’s in tet ionaf r=ompetitiveness stimulates an immproeement in the balance of trade. However, with real absorption held constant this improvement (t07’ million pesos) is a long way short of t required to eliminate the deficit of IO,7t f million pesos arising from copper price decline. Real GDP remains 3.1 percent below the level it would have reached had the copper price decline not occurred. Real returns to labour decline by 0.17 percent implying a 0.52 percent decline in the share of the economy’s income a=ruing to labour. At the sector Eevel traded industries receive a boost to their international ness Expsrts of major export commodities expand, particularly those produce I ir industries whose production technology is labour intenz?ve,19 ar,J m.ijor competing imports contract as domestic importcompzting industries are better placed to meet import competition. The distribution of sector;11 labour demands follows closely the sectoral outyui changes.l’ Opt ion (iii).

Cutting real domestic absorption. fixed money wages. The

figures in column (iii) represent the effects of the 25 percent copper price decline in an economic environment of fixed money wages with the balance of trade constraint being met by the zndogenous contraction of real domestic absorption. The results highlight the seveE I;onseq‘*?nces of money wage inflexibility in the presence of a balance of trade (onstraint. This constraint can only be met by a sharp deflation of the domes% conomy resulting in a contra&on in real GDP of 4.6 percent and in agge ,ate labour demand of 4.3 percent. The domestic priye deflationary efft;cts of the economic contraction imply d 2.7 percent Increase 111rt=ai wages with the share of the reduced national i come accruing to labour increasing by &out 3 percent. With the foreign component of the money supply constant, the domestic component has to fall by 32 percerlt tc deflate the domestic economy and rrleet reduced money demand.

62

W. Dick et al., Stabilisation strategies in Chile

At the sectoral level traded industries (with the exception of copper whose world price is falling sharply) receive a boost to their international competitiveness from the reduction in the economy’s price level, leadin an expansion of exports and a contraction of imports. The sectoral distributiun of the economy’s industrial production and employment shifts heavily towards the non-copper traded sectors. IAX!-,traded sectors, such as for example Services, suffer particularly severe output and employment declines. Option (iu). Reduct2ons ivr tprpt wages nnd real domestic u~s~r~~~~~. These policy instruments taken together represent the orthodox neoclassi approach to acl”lieving internal and external balance. We allow the mode! to determine the size of the wage and real absorption reductions to Chilean economy to the position, with respect to aggregate employment and the balance of trade, existing before the chainge in world copper- prices occurred. The results indicate that a cut in real domestic absorption of 2.? percent together with a cut in money wages of 4.9 percent is requireA to hit these ta*:gets. The reduction of the domestic component of money indicates ahat the appropriate means of achieving the cut in real domestic abskjrption is by a purely deflationary monetary policy, i.e., a cut in the money supply. Thts result? in a reductiora in the consumer price index of 3.03 percent, implying (.ince the money exchange rate is held constant) a devaluation of the real exchange rate of the same amount. Thus the comp&itive position of the traded goods sector is improved sufficiently to restore external balance. The decline in real wages of 1.9 perce2lt simply reflects the reduced marginal product of Chilean labour at the lower foreign terms of trade. Labour share of the reduced national income improves slightly. The industrial structure of the economy that emerges is biased towards traded industries (with the exception of course of the copper sector). Option (v). An exchange race devaluation with fixed rcsclldont&c

~~~~~~p~i#~~

ului mofley wcrges. As noted earlier, for a devaluation to have the real economy it must impose a s~u~~z~~on the factors of production. Here we assume that factor to . oney ov,rgesconstant the real price of lnbour f;llls by the ~~~cr~~~~ in tic price level caused by the devaluation and concurriB p rn~~n~t~~r?~ ansion. The model indicates that an .I- p cent dcvaluatio 1, assw-qin stant absorption and rul~l ~agtx, simply inc o~~~c~~~~ ~~r~~~~ ;I0 supply by x percent while leaving all end+ Genous real v~~r~~~ble~

Since the

maintarget of the

ge r;ite instrument is the balance of mn (v) rtff~r to the effects on cndogenous variables of te the Man:,-e. of trade deficit which r price decline in the mact-oeconomic ut to be 12.17 d de~a~uat~o~ turns a~~urned constant, t is leads to an r~e~t~ the size of the GDP contraction in exe

mar -:tary cxpat sion reent. T’ha_ is, the rezJ exe reiativz to no+tradeJ goods) is and ht:ncc improvement in the es, occurs because of the 8.80 ut ‘-1~the devaluation. In fact, tween optjons {ii) ;Ind ( v\, i s s entirely due to this real wage levct, the pattern of adjustment is the same as In toral e international competitiveness of ‘There is, however, a difference in the

y policies necessary

to a~~rnrn~date the real efkxts in options f ii) and ( t’). This is associated with owed and in instruments used by the two i~er~n~e bath in tar As the policy target in option (v) is to restore the balance urn, the foreign cesmponent of money has to increase, omestie component decreases (both by considerable alnountsj. This adjustment ttern reflects the fact that the potential intrease ill ue to the rise in employment must be neutr.llised irn ~~Rt~~t~~ demand monetat

M, Dick et al., Stabilisrrhn strategies in Chile

64

f&four

of an increase of exports. Total money rises by about 19 p4XCent(10

real terms) in order to accommodate the increased domestic economic activity (3.4 percent of GDP). Returning to option (ii), we see that while the pattern of money variable changes is the same (decrease im domestic component, increase in‘ forei component, overall increase in real and nominal terms) the ma not comparable. Consider for example a devaluation sufficient the same employment effects (0.71 percent increase) as the 0.88 wage reduction of option (ii). The required devaluation is 1 Although real variables would change by the same amounts ur,der the 1.2 percent devaluation and 0.88 percent real wage cut options, the monetary changes to achieve this differ. Under the 1.2 percent devaluation the domestic component of money falls by 3.2 percent [5.6 percent in option (ii)]$ the n component increases by 7.6 percent [as in option (ii)] while total money increases by 1.9 percent CO.7percent in option (ii)]. These di@erences reflect the din”erent sources of the increased international compet conferred in options (v) and (ii), a, devaluation accompanied by increased inflation in option (v) compared witli a cost deflation in option (ii). Note that, because of the heavy’squeeze on real wages imposed by the devaluation, aggregate labour demand increases by 7.07 percent, cons above the contraction of 0.71 percent observed from the 25 percen price decline in column (i). Hence the required devaluation to hit the bala of trade target while maintaining real domestic absorption ceufd oaly bc achieved if there was a pool of unemployed equal to 6.36 percent of the the Iabour force in the base period before the fall in world coppi prices took place. If, foF example, Chile was at full employment in the base period, that is, with labour supply effectively constraining growth, then our results indicate that the maximum devaluation that could be undertaken is only 1.22 rcent. Note t.hat this would improve the balance of trade by only 1074 10,711 million pesos required to elimina% the r words, with supply constraints in the lubout arket, a real wage cut achieved either through a devaluation with fixed ges cannot suficien tl r by a direct reduction in real percent

in

s must be accompanied

e of the devaluation required to achieve the balance of trade t imprt x*ement of 1OJ f 0.60 rnillron SOS) while at the same ti in~r~~si~~ the domestic price level (consumer price index).24 The results needs to be accompanied by a 3.5 tion to achieve this. However, with price level fixed there can e no level. The result is a further increase added to that caused by the copper price decline. G~f~~~ (0i). ~~~~~~~~ ~r~~~c~~~~quinst imports. In an environment current account restriction, inflexi ality of nominal currency deqaluation, one possible reaction to the terms of trade decline is to increase protection. Column (vi) refers only to a 10 percent across the board increase in the ad valorern rate of prot ion i;l33ach sectoP with constant real domestic &sorption and money ages. It does not inclut.ie the copper price shock.2” The results c’early indicate the futility of Chile reverting to increased protection as a means of impro ng its balance of trade. The tariff increases, by allowing industries to increase their domestic sellielg prices, improve ir competitive position against imports, leading to output and ployment increases in these sectors. In doing so, however, they increase onomy’s domestic cost structure, thus worsening the comvtitiveness of export oriented sectors which for the most part are unable to recoup these ses in the form of higher se1 ing prices for their products. In fact, ports overall turn out to be more responsive to deteriorations in their domestic cost-world price situ ticn than are Chilean imports to d&&orations in their domestic selling price relative to the (now increased) of the domestic couuterpar Wence the foreign exchange lost selling pri from exports exceeds the forei e saved from import substitution to a small decline in the balance of trade a ploymcnt is simply redist tmg sectors. The increaie in t licit mone

crucial in mitigating against the output losses of she cvport oriented set;tors and in permitting a small increase in aggregate employment. As the balance; of trade moves into deficit, the fore component of money must decrease. The domestic component of money ust increase such that money supply (in nominal terms) rises. This is n ssary to

accommodate the increase in consumer prices. Note that real money supply contracts, reflecting the lower ecctnomic activity as indicated by the fall in GDP. We have rerun option (vi) with money wages fully inderr.ed to consumer price movements, i.e., constant real wages. Under this assumption the domestic inflationary effects of the protection increase are higher (consumer price index increase of 8.32 percent). This leads to a larger detetkration in the balance of trade ( - 382.1 million pesos) and real GDP ( - 0.12 percent). It is interesting to note that aggregate empkyment now d~~lirtas by 0.11 percent. That is, in the absence of real wage flexibility downwards, increased protection destroys more jobs than it creates, while worsening the balance of trade to a greater extent than in the fixed money wage option. (vii). Export

subsidies.

The results in column (vii) refer to a unifomi (10.64 percent) increase in the power of the export subsidy for each export commodity (in an environment of constant real domestic absorption and constant money wages). The boost to exports from this increase is just su~fkient to eliminate the balance of trade delicit arising from the copper price decline in the same macroeconomic environment [option (i)]. However, the subsidies, by raising domestic prices of export commodities which are also ti:;ed in the domestic economy, increase domestk inflation. This has adverse effects for import competing industries, which lose domestic market share to imports. Apart from its bias towards export industries at the expense of implsrt competing industries within the traded goods sector, the export subsidy result has a number of similarities to the devaluation result. In particular, the increase in the domestic price level brings about a corresponding contraction in rleal wages, allowing a big increase in aggregate labour demand cunsiderabiy in excess of that required to compensate for the ern~~o~rnent IXSCSassociated with the copper price decline. Nevertheless, because of the ~~~.~l~~~~~~~ of import competing indL~tric?s; the domestic inflationary aqd yAoyment creating erects of the export subsidy approach to meeti the alance of trade constt-Ant are so!mewhat less t an is the Cast’ wi thi: devaluation approach. Optic

r

i

e

y composition

of outpus and ~~~~~0~~~~~ of seve alternative ,301icy responses in world copper prices. Option (i), the main;enance of a 25 percmi decl orpt~on and money wages, is effective n confining the cd real domestic adjustment pressures to the copper sector itself. Wowelfer. the shal p ba~~~~e of trade (together with an increase in dete~~rat~~~ in t nse tcceptable only in~~af adjustment r trade de&e could be re ornry. The economy to for~~~~~currency to sustain it until the foreign indurates that d money wage cut of only ient to restore employment, but with fixed real domestic pact on the balance of trade deficit exibility, attempts to meet ;he balance of track csrrstraint by domestic deflation [option (iii)] require an extrcm+ scwre contraption in domestic activity and employment. Puttijg options (ir) ther indicates that the neoclassical policy package of a combi, .cd ut in real wages and 2.7 percent reduction in real domestic abs.~ption is sufficient to restore both aggregate emp oyment and tkle balance of trade. Under this package, the share of th-z (albeit reduced) national income accruing to labour actually increases. To achieve this adjustment, employment must be transferred from the copper sector t;) other traded (particularly xl~ort oriented) industries. Of the trade pa cles concidered the real wage deprt:ssing effects of a devaluation suficir:ni to meet the balance of trade constr; int with fixed real domestic absorption result in a demand for labour far in excess of thal required to compensate for the copper price decimc. The domestic inflationary effect of the devaluation is rather large. This rafses the possibility of a rekindling of inflationary expectations, dampened in Chile in recent years b> deflationar; tiomzstic mokletary policies to support a relatively high fixed exchange rate. Our comparative-static analysis makes no proviAon for the incorporation of the effects of such expectations. To avoid stimulating inflation, a dcvafu#tion in an t nvironmerrt of fixed money wagf=s must be accompanied by a cut in real cfomestic :h;>sorption. Tht* problem with this t~but~~n

y, however,

is

meet the empl The export subsidy rcr;ll

donlestic

at because apprc9au

a~)sorpti~)~ &x

it rules

out

;i rcfuctkw

in red

wqe3,

it

H. Dick et-d.,

68

~t~~~is~ti~~ stra&gies iti Chile

envtiunment of fixti re&I.domestic absorption, our axnalysisabstracts from the macroecoaoznic l~~lemen~~~on of finandng these subsidies. It is interesting to note that t-lx protection option fails completely to improvrz the balanm at’ trade, Its ~~~~~~~v~ employment effects come only by tiG -pric42sixli. aa. environment of co its ab3& by-,inGreasing dy ntom$y-Iv~&S,:to bting .&out wages. is the 5-n The inexorab1e impression from our fIexib&y downwards “to comp~n~k for the reduced k&our implid by; the temns of trade decline. Xn the presen supply cowtrain&, wage flexibility on its own is insuffieiea coupled with expenditure restraint to release resources from the dornes~~ to the foreign account.

Table A.1 The CUean mobd equations: A linear system in pwentage changes.” --Subscript IdenGfier Aqua tion range Number Description

-Y

Household demmds for commodities by sourrx Household demands fi)t

(

2

(2) pisX~f~)j=JJj--Qij IP

rndristry

inputs

(

(11 Xfis)j = zj -tY$) pjs-

s= 1

tiated by source (2) (is)j P)is

f_-: 1. . . ..g s= 1,2

2gh

Demands for inputs tl, capital creation

j=l,...,h

2

(1, Es (is)j ,s= I

P) is

i=l ,...,g s=lJ

2g

i==l v...,g

g

si=l 1”‘” = ,

WI

demands Export demands

.

--

.~Subscript Number

--

Description --

-in

---

production

J= l,...,h

h

--in capital creation

i-1 ,a..,&!

I?

-in

importing

i=l ,...,$?

$?

-in

exporting

tApply equals demand for

j=l ,..--g

8

-dom(estxaliy procluced commodities

q= l,...,r

r

-iabour of each occupation

j= l,...,h

h

-capital

j== l,...,h

h

-land

Supply eqt;als demand for money Defines foreign reserves

Competitive 1

import volume

currency rmports

ate of return to L”a

Table A.1 (continued) Subscript rfinge

Identifier Equation

Number Description

--

General price of goods to households

(271 (28)

1

(29)

1

Consumer price index

Aggregate real consumption

(30) (31)

. = j-p 1R

(32)

11p-cR=

Aggregate real investment Relationship &; ween real consumption and investment

fR

(33)

1

Aggregate e nployment

(341

1

Aggregate capiti! stock

r

Allows for exogenous setting of wages

(35)

q=l ,*..,r

( 36)

+ See - S,m

1

Gross domestic product

“Told equatic ns = 4g/r+ 1lg + 9h + rh + 2r + 15. The model distinguishes ten domestic industri _,.\each pr{Jducing its respective commodity i.e., g and h = 10, Hence pjl =~b)~ t, j = 1,. . . , h, i= 1,. . .,g. (Labels for these are given in table 1.) The labour market is divkkd into twc occupational categories, i.e., r = 2. The nomenclature of variable subscripts and superscripts is a i follows. Subscript s denotes the source of the commodity; s = 1 (domestically produced), s = 2 (import@. Suba;cript u denotes the type od’primary factor; o= 1 (aggregate labour), u- 2 (fix capital), t’= 3 (land). Subscript q denotes laboul- occupation; q =: 1 (qualilied labour), q== (unqualif!ed labour). Superscript ‘P’ denotes a prinary factor quantity or price, superscript ‘M’a p, ice for imports (c.i.f.) and sluperscript ‘6’a foreign price for exports (fob.). Superscript o!es the use of that variable in current production, (2) in capital creation, (3) by ~~u~l~~~~s,(4) exports, and (5) by other (mainly government) demands. Note that thertr is no superscript on the local prices of domestic and imported commodities (the /Jo,).That is, the price of a commodity is assumed to be the: same in all domestic end uses. All variables i3re in percentage changes except the balance of trade, dB, which, t~~~use it can move through zero, is expressed in thirstdilferences.

H. Dick et al., St~~i~isatiQ~~ strategies in Chile

71

Table A.2 _--~ Variable

-~-.Number

- -.__-_-_--

Chilean model variabh s. -.-----.I______..--- ---.---

_---- .---__

ription -Ho~~hoki demands for domestic and imported goods Houshold dads for goods und~K~rentiated by source: Price of good i from source s te money ~~nsurnpt~on consumer goods by type but not by SOUIXX Demands for inputs fdomestic and imported) for capital creation Capital creation by using industry vernment) demands for domestic and i?\ported goods

ported) for curren s production Industry outputs Industry demands for labour in general, fixed capital. and land Rental prices of capital (u= 2) and fatid (t?= 3) in each industry Economy wide price of labour in general Demands for labour by occupation and industry Price oi labour by occupation Costs of units of capital C.i.f. foreign currency prices for competing Imports One plus the ad valorem rates of protection on imports Exchange rate [Chilean peso/foreign currercy (S US)] One plus ad valorem export subsidies Employment by occupation Industry capital stocks Industry land Domestic component of money Foreign component of money Consumer price index Gross domestic product Ex inflation f trade Ba Commodity import volumes Foreign currency value of imports Foreign currency value of exports Industry rates of return to capital ~~~n~~rny~wid~expected rate of return egate norn~na~ investment ement goods prw index Aggregate real mvestmcnt Shift ierm to set relationship between aggreg,lte co!PsUfTtt)titln ~ifd ~~~~st~~~~

Aggregate employment Economy”s aggregate capital stock wa

72

Coefficknts of the Chilean model.’ CES import-domestic subs:itution elasticities for (a.i3)),intermediate usage in industry j for current capital creation #)+ A common value of 2.0 was value, wh& judgemental, is consistent with ~tima

this area CES substitution elasticities labour (4 I) in industry j. Sin in all exptkiments, the v resuhs. The following (0.20), (3) Crude oil extrac (6) Light manufacturing oriented) (Ml), (8) Petroleum (0.43). The vaiues for estimates in Behrman supply elasticity for (1981). Values for the and Meiier (1979). Expenditure &:I)and C~SI @x jqrki +A) dastidia in howhoid consumption fo i. Estimates for ei were obtained from the Chileon household demand studi in Lluch et aL (1977) and Taborga (1978). Tht! r&mates used for tar;rh of t comm-xiity groups are: (1) (0.60), (Z)--(S)(0.X), (Gj &lo), (7)-(S) (1.41h (9) (1.62), (10) ( 1.18). Since the underlying household utility functions are ass& to be additive the price (qJ and cress :~lricc(qJ consumtr demand matrix of unto elasticities were c: Frisch formula from t1.t sl, houschold for the Frisch parameter al -2525 [obt for gaod i (IO), an - Frisch parameter relationship in Reciprocals of the foreign demand elasticities for Chilean e commodity categories except copper, the ‘small country’ by assigning a very smaIi value (0.05) to the respective $s. F was used. This value is based principally on the world price copper and the Chilean share in world copper exports. Industry investment parameters. Q1 is the ratio of tht gross ( net (after depreciation) rate of return in industry j. f$ is the of the expected rate of return schedule for industry j ti investment to its following year capital stock, T, is the sh accouateri for by industry j (X0). Values assigned to Q, (1.41 largely judgemental. Respectively the share of aggregate employment account share of the economy’s aggregate capital st skilled (52.2) and unskilM (47.8) worke “Encuzsta nacionaf de1 empieo’. Values for 3/2j are 10 Allov/e for indexation of ol:cupational wa zero in options (i)-(v), (1ii). For the s reddctions in real wages, the hl,, were set to 1.0. Respectively the shares of GDP accounted for by a other (mainly government) domestic, export, and im

73

rted) in indw&ry j’s purchases of i for

s in the total

purchases

of

ct~r P in the total primary factor costs of industry j fq total Iabour costs. IO.

ucticrn cc&s repreLented by intermediate puts of occupation q, fixed capital, and land.

of domestic goA t absorbed by, inputs to for capita! creation (2), by househoids (3), d*mands (5). f0

the to:al sales of imported gooj i absorbed by. inputs to uctisn ( t ) and for capital creation (21, by households (31, and demands (5). IO.

pkqment of ocwpation q accounted for in industry q in the ecun~my’s total labour cost, respectively. IO. for by other demand

J,

and

for good i from

unded for by imported good i (Miz)r the for by exported commodity i NXount imports (M), and the a

74

---_lll

Exogenous variable sele~tioa and values for each experiment.‘ -Option

0

0 0 0 0

0 0 0 0 0 0 0

0 0 0 0 -2s 0 Q

0 0 Q

0 0 0

0

0

0

0 0 0 0 0

0

0

0

0 0 0

0 0

0

0 0 0

0 0

-2s 0 0

0

f! 0 0

- 1.21

0

- 112.17 0 0 0

0

0

0 “Total exogenous variabies=4g+ 2h+r +6 for each experiment. These are made up of a wmmun set of 4g+ 211-kr+ 3 variabks which are exogenous in ail experiments and a further selection of 3 variables. “Fcr variables labels, see table A 2. ‘We allow the model to explain exports for the major export commodities, i.e., those whose saks pattern is such that their domestic prices can be regarded as being set by their colYespoading world prices. For other commodities, exports are determined exogenously with t k model endogenising the corresponding expo.-t subsidy/tax variable. [Note from (13) that if Ui k exogenous then pi1 wikl tend to move with J&. If vi is cndogenous then pi 1 will move independently of &.j dTo achieve a 10 srmnt increase in the ad valorem rat2 of protection for commodity i we need to increase the model vatiable representing the percentage change in one plus the ad valorpm rate of prutet;tion, i.e., ti, by IO@,/l + q) percent, where q is the base period ad valorem rate of protection for commodity i.

ehrman, JR, 1972, Sectdrai elasticities of substitution between capital and tabour II a cfe&~ning eu~nom): Time series anaiysis in the case of postwar Chile, Econometric 40, qo. 2, 31l- 325. C~rbo, V. and P. Weller, 1979, La sustituci& de trabajo, capital human0 y capital fkico I n la hdustria manufacturera Chiiena, Estudios de Ewnomia 14, Segundo semestre, 17-43. Dick, I-I, S. Gupta, ‘T‘h.Mayer and IX? Vincent, 1983, The short-run impact of fluctuating primary commodity prices on three developing economies: Colombia, Ivory Coast and Kenya, World Development 11, no. 5,405-416. Dixon. P.B., B.R. Parmenter, J. Sutton and D.P. Vincent, 1982, ORAN?: A mul[tisectoraI model Jstr:jiian occmmy (North-Holland, Amsterdam). 1981, The C’Mean experience in trade reform: A prog~ss repijrt on the ~onsq LI~PIC’SS and implications, Papr p,resented to the C’onferencT on the Free Trade !Movernent &IILatin America, Hamburg, June 21-24.

H Dick et al., Stobilisakion strategies in Chile

75

F8scher, B. and Tb. Mayer, 2981, On the structuraiist view of inflahon in some Latin American c~\intries A reassmm s .. The Developing Economies 19, no. 1, 39-51. IMF, 1980, fntematir nrrl fir mcial statistics IWashing‘on, IX’). Lasaga. M.. 1981,l‘h~: co y x industry in the Chilean economy (Heath, Lexington, i\lA). lLlu& C., M. POW& I m; RA Wtifims, f977, Patterns ia household demand and savings (OX&RI t.kdxmit y Pi s:t, Mm York). Ntir M.T. md ‘3 olidegwu, 1981, Copper and Zambia (Heath, Lexington, MA). Preside&a dc la Rzpribia;a, 1977, Oficina de P?anificaciitinNational, matriz de insumo --Pwducto de la Ernst I a Chilena (Santiago dt Chile). Priovolos, T., 1981, ( bff’ ; .nd the Ivory Coast (Heath, Lctiagton, MA). Repribka de CMe, lnstitu o Nacwnal 4e Estadisticas, Encuesta national dei empleo (Santiago

de Chile). ‘hborga, kf., 1978, Estruztura de co xuuno y .grupo social (Departamento Univcrsldad de Cbile, S : 1tia go de C tile).

Je Economia,