The Model: Tradables, Non-tradables, and Semi-tradables in Trade Models. Shantayanan Devarajan Jeffrey D. Lewis Jaime de Melo Sherman Robinson

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1 The Model: Tradables, Non-tradables, and Semi-tradables in Trade Models Shantayanan Devarajan Jeffrey D. Lewis Jaime de Melo Sherman Robinson

2 Macroeconomic Adjustment GDP = C + I + G + E - M GDP + (M E) = C + I + G production + trade balance = absorption Trade shocks and structural adjustment: Expenditure reduction versus Expenditure switching 2

3 Modeling Issues The specification of goods as tradable, nontradable, traded, and nontraded. The Armington specification in CGE models. The role of the exchange rate in CGE models. Real versus financial exchange rate. 3

4 Purchasing Power Parity: PPP Exchange Rate R r = R π P Rˆ r = Rˆ + ( ) πˆ Pˆ Rˆ r = 0 Rˆ = Pˆ ˆ π 4

5 PPP Exchange Rate R has units of domestic currency per $US. R is a depreciation of the exchange rate. 5

6 Problems If all goods are tradable, then PPP is trivial. All prices set by world prices. Law of One Price. PPP must measure relative prices of tradables and nontradables. Harberger, Edwards, Srinivasan. Underlying Salter-Swan model. 6

7 Salter-Swan Model Tradables T 1 T 3 absorption cut T 1 T 2 C A T 3 T 2 structural adjustment N 1 N 2 structural adjustment T 3 B Borrowing N 2 N 1 Non-tradables 7

8 Problems Hard to define tradables and nontradables empirically. Most sectors have some trade. Purely nontraded goods are a very small share of GDP. Requires dichotomous classification of goods: purely tradable or nontradable. 8

9 Law of One Price Given commodity arbitrage, all traded goods will have the same price in all markets. Very powerful assumption. Common in neoclassical trade theory. Project analysis. Theory of comparative advantage. 9

10 Law of One Price 1. All domestic prices of tradables are set by world prices. 2. Any change in the price of an import is immediately transmitted to price of corresponding domestic good. 3. Tariff policy is very powerful. Immediately affects price of domestically produced goods. 10

11 Law of One Price 4. Should observe extreme specialization in production. 5. Should never observe two-way trade (cross hauling). 6. Trade shares are not important. Only tradablility matters. 11

12 Problems Implications of Law of One Price are all false empirically. Changes in world prices and tariffs are only weakly transmitted to domestic markets. Do not observe extreme specialization. 12

13 Problems Observe two-way trade in most sectors, and at very fine levels of disaggregation. Trade shares are clearly important. Sectors with large trade shares are more affected by changes in world markets. 13

14 Armington Insight Specify traded goods as imperfect substitutes for domestic goods with the same sector classification. Allow degrees of tradability rather than dichotomous classification. Armington model provides a good theoretical and empirical framework for analyzing trade policy. 14

15 1-2-3 Model 1 country, 2 activities, 3 commodities 2 activities, producing D and E. E not consumed domestically. Additional commodity, M, consumed domestically but not produced. 15

16 1-2-3 Model Aggregate GDP (X) is fixed. Full employment model. Trade balance set exogenously. World prices of M and E are fixed. Total absorption (Q) is endogenous. 16

17 Basic CGE Model Flows ( S ) 1. X= G ED, ; Ω ( D σ ) S 2. Q = F M, D ; D Y 3. Q = q P E 4. = g2 P, P S D M 5. = 2, D f P P D x 6. Y= P X+ RB ( e d) ( m d) Prices ( ) 9. P = g P, P x e d 1 ( ) 10. P = f P, P q m d R 1 Equilibrium Conditions D S 12. D D = 0 D S 13. Q Q = P P m e = = R pw R pw e m = m e pw M pw E B17

18 Basic CGE Model Identities x e d S P X P E+ P D q S m d D P Q P M + P D q Y P Q D 18

19 Basic CGE Model Endogenous Variables E: Export good M: Import good D S : Supply of domestic good D D : Demand for domestic good Q S : Supply of composite good Q D : Demand for composite good Y: Total income P e : Domestic price of export good P m : Domestic price of import good P d : Domestic price of domestic good P x : Price of aggregate output P q : Price of composite good R: Exchange rate Exogenous Variables pw e : world price of export good pw m : world price of import good B: Balance of trade σ: Import substitution elasticity Ω: Export transformation elasticity 19

20 SAM for Model Activities Commod Hshld World Activities d D P D e P E Commodities q D P Q Households x P X RB World m P M Total d S P D e + P E q S P Q Y 20

21 E/D = k (P E / P D ) Ω E P E = R pwe PD /PE D

22 M/D = k (P D / P M ) σ M P M = R pwm PD /PM D

23 1-2-3 Programming Model ( σ ) Maximize Q= F M, D; D with respect to: MED,,, D subject to: ( ) x λ Shadow Prices 1. G ED, ; Ω X technology = P / P 2. S S x q pw M pw E + B balance of trade λ = R / P m e b q 3. D D domestic market λ = P / P D S d d q 23

24 1-2-3 Model M P D /P M P M M=P E E D E P D /P E D

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27 External Shocks, Structural Adjustment, and the Real Exchange Rate Shantayanan Devarajan Jeffrey D. Lewis Sherman Robinson 27

28 Simple Model (1) X = G( D, E; Ω) (2) Q = F( D, M ; σ ) 28

29 1-2-3 Model (3) E D e Ω P = k2 P d (4) M D d σ P = k1 P m 29

30 1-2-3 Model (5) (6) P P e m = R π = R π e m (7) π m e M = λπ E 30

31 Variables and Parameters Variables E, M, D, Q, P d, P e, P m, R Parameters or exogenous variables ο m, ο e, κ, X, ρ, Ω ( ) e B= λ 1 π E so B= 0 λ = 1 8 variables, 7 equations Choice of numeraire. Often R 1. 31

32 32 ( ) ( ) m m e e e m d e m d R P R P E M P P D E P P D M π π π λ π σ ˆ ˆ ˆ ˆ ˆ ˆ ˆ ˆ ˆ ˆ ˆ ˆ ˆ ˆ ˆ ˆ ˆ ˆ ˆ + = + = + + = + = Ω = Real Exchange Rate Change

33 Equilibrium Domestic Price ˆ = 1 σ πˆ + +Ω πˆ + ˆ λ d m e P ( ) ( 1 ) ( 1 ) σ +Ω R 1 Rˆ = 0 33

34 Case 1 Case 1: πˆ m = πˆ e = πˆ 0, ˆ λ = 0 Then: Rˆ = Pˆd ˆ π PPP calculation is ok. 34

35 Case 2 Case 2: σ or Ω Model collapses to small open economy with all goods tradable. d P is tied to world price. 35

36 Case 3 Case 3: πˆ m = πˆ e = 0, ˆ λ > 0 Implies: Pˆ d > 0 real appreciation "Dutch disease" case. 36

37 Case 4 Case 4: ˆ λ = 0, πˆ m > 0, πˆ e = 0 If σ < 1 Pˆ d < 0 (depreciation) If σ > 1 Pˆ d > 0 (appreciation) and trade volume falls. 37

38 Case 5: Lerner Symmetry m e If: ˆ π 0, ˆ π = ˆ λ = 0, Rˆ = 0 Then: ˆ ˆ ˆ ( σ 1) P P = P = ˆ π σ +Ω ( ) ( ) e m If: ˆ π 0, ˆ π = ˆ λ = 0, Rˆ = 0 Then: d e d m ˆ ˆ ( 1) d e σ e P P = ˆ π σ +Ω The effect is symmetric, and Lerner symmetry holds. 38

39 Equilibrium PLD EXR Rˆ + ˆ d P ( ) σ πˆ m + Ωπˆ e ( ) πˆ m πˆ e σ + Ω ˆ λ σ + Ω = σ + Ω PLD exchange rate world inflation terms of trade trade balance 39

40 Equilibrium Real EXR Rˆ r = Rˆ P ˆ d ( ) σ πˆ m + Ωπˆ e σ + Ω Differential inflation = ( ) πˆ m πˆ e σ + Ω Terms of trade ˆ λ σ + Ω Trade balance 40

41 Purchasing Power Parity R r = R π P Rˆ r = Rˆ + ( ) πˆ Pˆ 41

42 Offer Curves in the Model 42

43 Standard Offer Curve M π e / π m Offer of exports for given world prices E 43

44 1-2-3 Model Offer Curve M σ = 1 σ > 1 σ < 1 E 44

45 1-2-3 Model Offer Curve Slope of offer curve depends on import substitution elasticity. Length of offer curve for a given domain of changes in world prices depends on both import substitution elasticity and export transformation elasticity. 45

46 1-2-3 CGE Model with Consumption, Government, and Investment Shantayanan Devarajan Delfin S. Go Jeffrey D. Lewis Sherman Robinson Pekka Sinko 46

47 1-2-3 CGE Model Real Flows ( S ) 1. X= G ED, ; Ω ( D σ ) S 2. Q = F M, D ; 3. D Q = C+ Z + G E 4. = g2 P, P S D 5. M = f P 2, P D D ( e d) ( m d) 47

48 1-2-3 CGE Model m m 6. T = t R pw M q q D + t PQ y + t Y e e + t P E 7. = + + g 8. S= sy + RB + S x q Y P X tr P re R ( y) t 9. CP = 1 s t Y 48

49 1-2-3 CGE Model Prices ( ) 10. P = 1+ t R pw m m m ( ) 11. P 1+ t = R pw e e e ( ) 12. P = 1+ t P t q q ( ) 13. P = g P, P x e d 1 ( ) 14. P = f P, P 15. R 1 q m d 1 49

50 1-2-3 CGE Model Equilibrium Conditions D S 16. D D = 0 D S 17. Q Q = = m e pw M pw E ft re B t 19. P Z S = 0 q q g 20. T P G tr P + ft R S = 0 50

51 1-2-3 CGE Model Identities x e d S P X P E+ P D q S m d D P Q P M + P D 51

52 Endogenous Variables E: Export good M: Import good D S : Supply of domestic good D D : Demand for domestic good Q S : Supply of composite good Q D : Demand for composite good P e : Domestic price of export good P m : Domestic price of import good P d : Domestic price of domestic good P x : Price of aggregate output P q : Price of composite good P t : Sale price of composite good R: Exchange rate T: Tax revenue S g : Government savings Y: Total income C: Aggregate consumption S: Aggregate savings Z: Aggregate real investment Exogenous Variables pw e : world price of export good pw m : world price of import good t m : Tariff rate t x : Export tax rate t q : Sales tax rate t y : Direct tax rate tr: Government transfers (real) ft: Foreign transfers to government re: Foreign remittances to private sector s: Average savings rate X: Aggregate output (GDP) G: Real government demand B: Balance of trade σ: Import substitution elasticity Ω: Export transformation elasticity 52