Chapter eight: Responses of the surplus to external shocks under flexible exchange rates and rationing

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In this Chapter we analyze how the surplus of a developing economy responds to external shocks when the policy regime allows flexibility in the exchange rate or when imports are rationed under a rigid exchange rate.

The crisis in many LDCs during the period of the late 1970s and early 1980s arose because of lack of appropriate responses to external shocks. In most cases the shock was associated with a decline in the external terms of trade.

Table 17 exhibits the changes in the basic economic magnitudes for our 20 stylized economies, under the assumption that there is a 10 percent decline in the foreign price of agricultural exports, and the exchange rate is allowed to vary to keep the external balance constant (and equal to zero). It can be seen that the exchange rate depreciates but by less than 10 percent in all cases, in order to maintain the external balance. This implies a lower internal terms of trade of agriculture, and lower volume of imports.

Domestic production shifts are guided by the price of agriculture relative to the production cost of non-agriculture. The decline in the nominal wage of workers, induced by lower agricultural prices, to an extend counterbalances the increased cost of imports in non-agriculture. The net effect on non-agricultural production, however, appears to be negative in all cases. This implies that labour demand in non-agriculture might be positive or negative, depending on relative prices between labour and imports. Hence, despite external terms of trade declines, it might be possible that agricultural production is slightly enhanced and this appears to be the case in some of the economies in Table 17.

In all cases the GDP is seen to decline by large amounts, and the surplus also appears to decline. It is only for our "least developed economy" (number 11 ) where the surplus increases, but at the cost of huge GDP declines and welfare losses for workers.

Table 18 presents the responses of the same economies under a 10 percent decline in the price of exports, under the import rationing regime A_r. By comparing the figures in this table with those of Table 17 several notable patterns emerge. First, in all cases the induced increase in the implicit tariff is much larger than the devaluation of the exchange rate in Table 17. Second, production of agriculture declines more, and production of non-agriculture less (or increases more), compared to the case of Table 17. This is because the full brunt of the external decline in the price of agriculture is born by the domestic price of agriculture in the absence of exchange rate adjustment. The release of agricultural labour enhances the production of non-agriculture, and counteracts the impact of the increase in the implicit tariff.

The volume of agricultural exports and the volume of imports in most cases decline more (or increase less). However, the volume of surplus in all cases is much larger under this regime compared to the flexible exchange rate regime. The reason is mainly the large increase in implicit tariff revenue.

The decline in GDP is smaller under this regime, compared to the decline under flexible exchange rate. The reason is that now agricultural production, which is valued at the smaller world prices, declines more and hence the loss in internationally valued income is less.

Table 17 Responses to a 10 percent decrease in the world price of agriculture under flexible exchange rates for 20 stylized economies

Table 18 Responses to a 10 percent decrease in the world price of agriculture under import rationing

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