Effects of Globalization on Poverty and Distribution in Argentina in the 1990s

Transcription

1 Effects of Globalization on Poverty and Distribution in Argentina in the 1990s Dario Debowicz 1 Supervised by Drs. Sherman Robinson, Howard White and Ricardo Gottschalk. 1. Introduction Channels described in the present international debate The case of Argentina A Financial CGE Model for Argentina ) Selection of categories for Activities, Factors and Representative Households 9 2) Production and Trade Block 10 3) Price Formation 12 4) Institutional Block 13 i. Households ii. Enterprises iii. Government ) Factor Markets 15 6) System Constrain Block and Market Closures 17 7) Financial Sphere 17 i. Households ii. Enterprises iii. Government iv. Commercial Banks v. Central Bank A Real-Financial SAM for Argentina Preliminar Simulation Experiments Conclusion and Research Agenda Bibliography Appendix I. Construction of the SAM Appendix II. Mathematical Statement of the Model Lecturer in Macroeconomics at University of Buenos Aires and Instituto Torcuato Di Tella. Research Assistant and tutor in Poverty and Inequality and in Globalization and Inequality at Institute of Development Studies. 1

2 1. Introduction To explain the effects of current and capital account liberalization and other relevant factors on variations in GDP, aggregate supply of money and other financial assets (public bonds, bank deposits in national and foreign currency, equity), level of employment and income distribution in Argentina, a macro CGE model is developed. A macro CGE approach seems to be the best one when evaluating economic policies that affect the economy with large indirect and second-round effects through changes in growth, in composition of GDP by sectors, in prices and in factor rewards. It allows for explicit modelling of goods and factor markets, with wages, prices and private incomes determined endogenously (Bourguignon and Pereira da Silva 2003, pages 12-18). More specifically, the model facilitates the understanding and quantification of the specific channels connecting economic liberalization and other shocks to the various outcomes over all the economy, taking into account the behavior of and the relation among the economic agents, as well as institutional and structural features. Having preliminary researched the macro sphere, and in order to capture the complexities of the Argentinean economy, I construct a dynamic real-financial macro CGE model for Argentina (the first one in Argentina with endogenous returns for financial assets). This is an empirical model which goes in the direction of filling the existing gap between Macro and CGE models(robinson 2006), trying to integrate their best elements in the light of the characteristics of the Argentinean economy during the nineties. This need comes from the perception that a set of critical elements were at stake here with several interlinkages which are worth highlighting, including structural adjustment (prone for CGE framework analysis); and massive changes in the stocks of financial assets and money which affected the whole economy, including relevant variations in GDP and the employment level (prone to be analyzed within the macro framework). The perceived close interaction between the different parts of the economy calls for the mentioned integration. The Argentinean case seems especially interesting since the period of liberalization was associated with a series of crises and a marked worsening of income distribution, which culminated in the collapse of the Convertibility Plan. It seems interesting to try to identify and quantify the effects of liberalization to evaluate if they were responsible for this series of crises and worsening of income distribution. Section 2 maps the channels highlighted in the present international debate on globalization. Section 3 explains the main features of how these channels were materialized in Argentina. Section 4 briefly considers models which provide building blocks for the construction of a macro-cge model for Argentina. Section 5 describes the SAM which is generated for informing this model. Section 6 briefly explains how calibration is done and describes some results coming from a preliminary simulation affecting the economy of Argentina during the period Section 7 concludes taking stock of what was done and formulating a research agenda. 2

3 2. Channels described in the present international debate To shed light on the effects of the specific aspects of globalization on growth and income distribution in pre-crisis Argentina during the Convertibility Plan (March 1991-December 2001), and having into account the most relevant spheres of globalization during this period, I will proceed by succinctly identifying in the literature and analyzing: the effects of trade liberalization on growth and income distribution the effects of capital account liberalization on growth and income distribution the most important transmission channels from trade and capital account liberalization to growth and income distribution Effects of Trade Openness on Growth In mainstream view trade liberalization is expected to have positive medium run and long run effects on growth. The former would come from liberalization producing changes in relative prices signals, which in turn generate a more efficient resource allocation (Taylor 2004; Winters, McCulloch et al. 2004). The latter would come from increased access to technology, improved access to intermediate and capital goods, benefits of increased scale and competition (Winters, McCulloch et al. 2004). However, these positive effects are not guaranteed (Winters, McCulloch et al. 2004). The link from trade liberalization to growth may be affected by: 1) the presence of market failures (e.g. sector specific learning by doing effects) (Wood and Ridao-Cano 1996; Rodriguez and Rodrik 2001); 2) the absence of accompanying sound demand policies, which may imply a switch in aggregate demand outside the liberalizing country, reducing the demand for the country s output and hence growth(stiglitz 2002). Besides, contractions in output, due to lack of incentives to investment, may prolong low growth dynamism. Finally, worsening terms of trade (possibly related to specialisation caused by trade liberalization) may lead to immesirising growth i.e. physical GDP going up but with its nominal value (and purchasing power) decreasing (Bhagwati 2004). Effects of Trade Openness on Income Distribution In the short run, openness to trade will affect income distribution by the increasing adoption of international prices. On the imports side, the competition of cheaper imported goods will erode the rents (profits, wages, land rents) of the domestic producers operating in the protected sector (Milanovic and Squire 2005), with the consequent alteration in income distribution. On the exports side, the action will come from a reduction in wedges (taxes and subsidies) not only to exports but also to inputs imported for the purpose of subsequent exporting. 3

4 If the adoption of international prices leads to an increase in net imports and real devaluation does not take place -e.g. because of capital inflows financing current account deficits at an uncompetitive fixed exchange rate- then i) net imports will be sustained, lowering aggregate demand for domestic production; ii) producers will shift to nontradables production. Both effects will potentially affect not only growth but also income distribution (Taylor 2004; Evans 2005). If compensating demand policies (e.g. fiscal or monetary policy) are absent and liberalization is done prior to the adoption of social safety nets, lost jobs will make income distribution get worse (Stiglitz 2002). Effects of Capital Account Openness on Growth Also, capital account liberalization comes with a significant increase in volatility of capital flows, which in turn makes the rate of growth less stable (Birdsall 1999; Wade 2001). Even worse, capital flows tend to move procyclically, providing an additional source of instability (Stiglitz 2002, p.143), and probably generating uncertainty, a loss in efficiency, and a lower trend growth (Gottschalk and Cirera 2003). The effects of capital account liberalization, particularly in the context of Latin America, are pretty well described by (Taylor 2004): in his view, which will be taken as a building block for modeling the effects of liberalization in Argentina, capital inflows have typically led to an appreciated real exchange rate, causing Dutch disease across LAC (Stiglitz 2002), with switch in aggregate demand outside the liberalizing country, increases in relative labour costs and job losses, reduced labour income, worsened income distribution and, in turn, even lowered demand for domestic goods. The appreciations come with high real interest rates which add to production costs and penalize capital formation, and with a switch of aggregate supply to the non-tradable sector, where the lack of competition of imports still allow for economic benefits (e.g. a positive mark-up on costs). The capital inflows are accompanied by domestic credit expansion and stimulus to aggregate demand, reducing domestic savings, and stimulating not only investment but also consumption with a high imports component and generating a speculative asset price bubble; sooner or later, the demand expansion finishes due to unsustainable external balance or capital outflow. Effects of Capital Account Openness on Income Distribution Even when this channel has not been mapped in the literature, some mechanisms have been described, and they were briefly outlined in last section ( Effects of capital account liberalization on growth ). They basically come from: 1) the effect of an appreciated real exchange rate on the demand for labour (Taylor, 2004), and 2) the potentially differential effect of economic expansions and contractions on different income groups (Birdsall 1999; Wade 2001). 3. The case of Argentina 4

5 1. The Convertibility Plan was put into practice in April 1991 in Argentina. It tightened national currency to dollar in a one-to-one relation, prohibited price indexation, and allowed contracts and payments in external currency. During its operation, commercial and financial opening was broadly implemented: while commercial opening included significant decreases in import tariffs and progress in the conformation of Mercosur free trade area, financial opening included reduction in restrictions to mobility to all forms of capital, with equal treatment to national and foreign capital; increase of deposits and credits in dollars, free entry of direct and portfolio investment, elimination of the barriers to the entry of foreign banks, free bank emission of negotiable titles in foreign currency and unrestricted entry of foreign capital in pension funds (Bustelo 2002; Damill, Frenkel et al. 2002) Following the financial liberalization, a flow of capital inflows was generated, allowing the economy to maintain its fix nominal exchange rate, with a real exchange rate which was appreciated at the beginning of the Plan according to (Damill, Frenkel et al. 2002). 3. To some extent, liberalization, in the context of this uncompetitive exchange rate (at least when compared to the precedent decade s one) and of significant foreign capital financing absorption, generated a switch in aggregate demand outside Argentina, increasing net imports, reducing the demand for the country s output and hence reducing growth.(damill, Frenkel et al. 2002; Taylor 2004). 4. Volatility of capital flows may have affected volatility of growth. It would be interesting to evaluate to what extent, as argued by (Damill, Frenkel et al. 2002) 3, capital inflows (mostly to the private sector in the first half of the decade and to the public sector in the second half), by increasing international reserves and the monetary base, stimulated bank deposits and bank loans, lowered the interest rate, and stimulated aggregate demand (consumption and investment) and hence output and growth, while the reduction in capital inflows (or capital outflows) generated opposite processes. 5. In turn, the performance of growth may have affected trade, a point suggested by a strong positive correlation between the volume of imports and the level of output found by Damill, Frenkel et al (2002). They argue that given the (increasing) imports coefficient, the higher the activity level was, the larger the deficit of the current account. 2 The specificities of the policies conducted during the Convertibility Plan are informed in Annex, organized as a Policy Matrix, taking account of the evolution of Capital Account Policy, Other Monetary and Financial Policies, Trade Policy, Fiscal Policy, Privatizations and Deregulations, and Labor Market Policy. 3 They find a statistical relationship between cyclical capital flows and the cyclical component of GDP in Argentina during the Convertibility Plan 5

6 6. The external debt of Argentina and the value of equity held by non-residents increased during the period, increasing the payments to the rest of the world in terms of interests, profits and dividends which increased during most of the Convertibility Plan (Damill, Frenkel et al. 2002)-. By this mechanism globalization may have eroded growth: more in detail, globalization may have led to capital inflows, which after generating an increase in aggregate demand in the short-run, may have implied a decrease in the net income of factors from abroad and, for given levels of GDP, reduced GNP, and hence the welfare level of residents. 7. It has been suggested that the liberalization with appreciation observed in this period generated a switch towards the production of non-tradable goods, an area where the lack of competition of imports still allowed for economic benefits (e.g. a positive mark-up on costs), which may have been accompanied by switches in the relative magnitude of full-time positions across sectors. Evidence reported by Damill, Frenkel et al (2002) has suggested that the commercial openness with appreciated real exchange rate switched the relative magnitude of full-time positions in favour of non-tradable sectors. 8. It has also been suggested that the appreciation also lowered the price of capital (basically a tradable factor of production) in relation to the price of labour (basically a non-tradable factor of production), generating imports and the gradual introduction of capital goods into the production process implying in turn the adoption of a labor-saving technology, or increases in labor-productivity, characteristic of the developed countries where these imports came from (Altimir and Beccaria 2000; Ramos and Martinez 2000; Damill, Frenkel et al. 2002). This process may have ended up generating a reduction in labour demand, with effects on total hours worked and on real wages, affecting labour income, and, in the relative absence of social safety nets, worsening income distribution. 9. It has been argued and econometrically tested by (Damill, Frenkel et al. 2002) that the adjustment of the relations between employment and output took place during , and that it manifested itself in the form of a slight decrease in the employment rate, and a significant decrease in full-time employment rate, so that both unemployment and underemployment (visible sub occupation) increased simultaneously. 10. It has been argued that the mentioned incorporation of technology into the production process biased labour demand in the direction of the more educated workers, a point which is raised by Milanovic and Squire (2005). It would be interesting to take into account the complementarity between imported capital goods and the educated labour force as factors of production. 11. As described by Altimir and Beccaria (2000), wages will be assumed to have changed similarly across different sectors following general patterns: with growth and initial reduction of inflation, wages across all sectors went up. Then, the 6

7 increase in unemployment led to stagnant wages. Besides, wages did not vary with productivity, or with output prices. 12. There was another factor affecting unemployment from labour supply, which was the incorporation throughout the nineties of women to the labour force (Damill, Frenkel et al. 2002). This factor may be important because of the indirect effect it potentially has on wages through affecting unemployment. 13. Altimir and Beccaria (Altimir and Beccaria 2000) suggests that when trying to explain the worsening of income distribution in Argentina during this period, it should be taken into account: i. Role of education: specially during second middle of decade, the education-premium of those with Tertiary /University education increased ii. Role of qualification: this is a characteristic of the occupation, by which occupied are classified in i) professional ii) technical & semi technical iii) non-qualified iii. Roles of unemployment and underemployment: unemployment has a direct role (on income of the unemployed) and an indirect one, by which real wages respond negatively to the unemployment rate. Underemployment has also a direct role on income distribution and may have an indirect role, too. 14. Last, but not least, it would be interesting to check what the effect of worsening of income distribution on aggregate demand (and hence on growth) was. If households in the bottom of the income distribution have a higher propensity to consume (something which is suggested by ENGHO1996/1997, National Survey of Expenditure of Households, where first forth deciles propensity s exceeds 0.90 and the richest decile has a propensity of only 0.64), changes in income distribution would be non-neutral in terms of consumption demand, and hence in terms of aggregate demand. More in detail, changes in favour of households in the richest deciles, with a lower propensity to consume, would imply a net reduction in the aggregate level of consumption and hence on aggregate demand, at least to the extent that investment demand does not change significantly in the opposite direction to consumption demand. 4. A Financial CGE Model for Argentina This section develops a financial CGE Model for Argentina, building on the literature review on the effects of current and capital account liberalization, on specificities of the Argentinean economy, and on a literature review of financial CGE models 4. The model which is constructed strongly builds on the following models: 4 A preliminary written document is available under request. 7

8 - The IFPRI Standard Model, a trade-focused CGE model which takes account of trade shocks on the economy, has a set of taxes levied by the government and incorporates imperfect substitutability between domestically produced and imported goods following Armington s view (Armington 1969), and imperfect transformability between supply to domestic market and exports is especially transparent in terms of the model s working, and is deeply rooted on micro and macroeconomic theory, but which holds no assets or money (Robinson 2006). - (Rosensweig and Taylor 1990; Naastepad 2002) models, where some agents allocate their financial assets behaving as constrained maximizers of CES utility functions 5, in an intent to reflect the perception that agents look at relative returns when deciding portfolio of assets and try to avoid corner solutions reflecting their risk aversion. - (Vos 1997) model, where asset revaluations are captured, dividends are taken into account in household s income, and where government investments respond to capital inflows, thereby capturing an element of the fiscal response literature. - IMMPA model (Agénor, Jensen et al. 2005), where value added is generated by combining skilled and unskilled labor, as well as public and private physical capital 6, and where assets and liabilities for each of the agents are clearly identified, including commercial banks and Central Bank. - (Bourguignon, Branson et al. 1989) model, which takes account of financial flows, and international trade, as well as growth and income distribution, in a dynamic way, giving a primary role to aggregate demand of goods and services in the determination of the growth rate, and reflecting the effects of financial flows on aggregate demand. The model presented here is a preliminary stage towards the development of the final model. Particularly, differently from the present version, in the final version: - Distributional measures of household income will be incorporated, which might imply accounting for the whole distribution of income as coming from the Permanent Household Survey in Argentina, using microsimulations, and probably a layered approach of macrocge and microsimulations, as in (Davies 2004). - Dynamic calibration will be applied, endogeneizing the parameters to track the time-paths of the main macroeconomic variables during the Convertibility Plan. - The effect of the stock of public infrastructure on productivity will be captured, specifically in the production functions of the private sector. - Inflation will be accounted for. - The collapse of the Convertibility Plan and the resulting wealth redistribution will be modeled. - The distribution rules used by profit-earner households and commercial banks to conform their financial portfolios will be reevaluated. - The transmission mechanisms from the financial to the real sphere will be reconsidered. 5 The arguments of the CES utility function are the returns of each asset e.g. for public bonds, it is the funds allocated to public bonds by the interest rate on public bonds. 6 As explained above, public capital will be incorporated in the future. 8

9 1) Selection of categories for Activities, Factors and Representative Households The selection of categories for activities, factors and representative households for the model is done intending to reflect the forces that affected income distribution during the analysed period in Argentina. Reflecting probably different pricing, distribution rules, and evolution of tariffs, the following sectors appear in the real part of the model: 1) Primary sector 2) Industrial sector except construction 3) Construction 4) Private service sector 5) Public service sector The distinction between tradable and non-tradables is done in terms of varieties produced by the private sector (see Trade Block), except for the commodities of construction and services sectors, which are assumed to be non-tradables. Commodities and activities are distinguished as usual, to reflect that a commodity can be produced by more than one activity and that an activity can produce more than one commodity. The financial sector, as usual in financial CGE models, does not have a separate production function - and its modeling is described in its associated section such that the financial part of the model can better focus on the interaction between savings and investment in a relatively simple way. Reflecting data availability, the distinction between formal and informal spheres is done at the level of factors in given activities and not of activities. The specification of factors and representative households is a key link for looking at the effects of shocks on income distribution. Factors are classified in capital and labor, and labor is sub-classified according to skills (skilled and unskilled) and formality (formal vs informal). Representative households (RH) take into account the main source of income of the household s main income recipient, dividing households according to the following categories: 1) Skilled wage recipient households 2) Unskilled wage recipient households 3) Profit-earner households 9

10 2) Production and Trade Block As can be seen in the diagram below, in productive sectors, domestic output supplies are, at the top level of the technology nest, CES functions 7 of quantities of value added and of aggregate intermediate input, reflecting imperfect substitutability between these two, allowing for example to take account for increases in imported inputs at the expense of domestic value added which occurred in Argentina (Bisang et al, 2000, p.401) following reductions in the relative price of imports. As in the value added function of the formal private sector of IMMPA (Agénor, Jensen et al. 2005), value added is generated by combining skilled and unskilled labor, as well as public and private physical capital 8. At the present stage, value added is generated by two aggregated factors which are imperfect substitutes: a skilled labor-capital input and an unskilled labor input. The former, in turn, is a function of skilled labor and the physical capital stock and the latter is a function of formal and informal unskilled labor. In all these function, constant elasticity of substitution (CES) functions are used, with the values of elasticities of substitution allowing to reflect the hypothesis that the relative decrease in the cost of physical capital provided incentives for enterprises in Argentina to substitute against unskilled labor by using physical capital and skilled labor. Specifically, and reflecting the evidence for middle-income countries referenced by (Agénor, Jensen et al. 2005, p.11), the elasticity of substitution between skilled labor and physical capital is taken to be lower than the elasticity among the unskilled 9. It is worthwhile to note that quantities produced by the private sector are determined by the interaction of supply and demand forces which are described later. The aggregate intermediate inputs are determined as Leontief functions of specific intermediate inputs, not allowing for substitution among inputs, as usual. To keep the model as simple as possible, and similarly to IMMPA model, no technical progress is assumed by now, and no transaction costs are explicitly modeled. Finally, and in the case of public services, public consumption of different commodities and factor wages are taken as exogenous, reflecting the perception that they are basically outcomes of policy decisions. 7 CES functions can produce a constant elasticity of substitution among its arguments which differs from one. In this function, the shift parameter indicates the state of technology, the share parameters account for the relative participation of each factor in the output (at existing relative prices), and the function exponent determines the value of the constant elasticity of substitution (the latter one is the inverse of the former one plus one), and has values which assures convexity to the origin. The function is homogeneus of degree one, so that a proportional increase in the arguments generates an increase of the same proportion on output i.e. returns to scale are constant. Average and marginal outputs are homogenous of degree zero on their arguments, such that increasing one factor at a time does not alter average or marginal output of that factor. Source: Chiang, A. C. (1987). Métodos Fundamentales de Economía Matemática. 8 As explained above, public capital will be incorporated in the future. 9 The mentioned reduced substitutability is justified also in terms of evidence for Argentina in Acosta, P. and L. Gasparini (2004). Capital Accumulation, Trade Liberalization and Rising Wage Inequality: The Case of Argentina. La Plata, Argentina:

11 Diagram: Production Technology Gross Value Added Xi (CES function) Value Added I (CES function) Intermediate Consumption I (Leontieff function) Public Capital (Infrastructure) Composite Input J 2 (CES function) Imported Domestic Unskilled Composite Input J u Composite Input J 1 (CES function) Formal Unskilled Skilled Composite Input J s Informal Unskilled Formal Skilled Informal Skilled Private Capital Concerning the trade sphere, tradable goods are allocated either to exports or to domestic sales, and imperfect transformability between these two is reflected through Constant Elasticity of Transformation (CET) functions. These functions are homologous to CES functions, just that they have negative elasticities of substitution or, in other words, they are concave to the origin. Optimal mixes between exports and domestic sales are achieved through the profit maximization of firms which behave as perfect competitors in the goods markets, taking prices of exports and of domestic sales as given and subject to the CET functions. As a result, in the presence of a fixed exchange rate decreases in the export-domestic price ratios provoke decreases in the export-domestic supply ratios. On the demand side, imports and domestic outputs are treated as imperfect substitutes, particularly using CES functions where the composite commodity supplied domestically is generated using domestic and imported commodities, i.e. Armington functions. Optimal mixes between imports and domestic outputs are achieved through expenditure minimization, given prices of imports and of domestic sales and subject to the CES functions. As a result, decreases in the import-domestic output price ratios motivate increases in the import-domestic demand ratios in the presence of a fixed exchange rate. Besides, increases in the activity level (keeping relative prices constant) generate proportional increases in imports and domestic output, worsening (the current account of) the balance of payments. 11

12 3) Price Formation Prices are endogenous in the model and reflect imperfect substitutability among commodities of different origins and destinations i.e. domestic outputs used domestically, imports, and exports. They respond to demand and supply forces, except for the varieties of commodities which are internationally traded. Variations in the commodity prices occur through Walrasian adjustment, in the sense that excess demands generate price increases and excess supplies generate price decreases. Even when it is true that some commodities have regulated prices in Argentina (basically the public services e.g. electricity, gas, etc), they do not represent a significant part of the value added produced by the Argentinean economy and, hence, are not relevant for the purpose of this model. Consequently, they are not distinguished in the model in order to keep the transmission mechanisms as simple as possible. Imports and Exports Prices Import prices in domestic currency are set for imported commodities, reflecting exogenous world import prices (in foreign currency), the nominal exchange rate -fixed at one Argentinean peso per dollar -, and import tariffs, but no transaction costs to keep the model as simple as possible. Export prices in domestic currency are set for exported commodities in an analogous way, reflecting exogenous world export prices (in foreign currency), the (fixed) nominal exchange rate, and export tax rates, the latter diminishing ceteris paribus the price which is perceived by producers. The world import and export prices are fixed because it is assumed that the share of world trade for Argentina is so small that it faces international supply and demand curves with perfect elasticity at the existent world prices. Prices of Composite Goods The prices of composite goods are determined implicitly, having into account that the value of absorption for each commodity (the quantity absorbed of the composite good by price of the composite good) is equal to the sum of the value of domestic spending on that domestic output and the value of imports, in turn multiplications of appropriate quantities and prices. Output Values The producer prices of outputs are also determined implicitly in a similar way, having into account that, for each commodity produced, the value of production (at producer prices) has to be equal to the sum of the value of exports and the value of domestic spending on domestic output. Aggregate Intermediate Input Prices 12

13 The aggregate intermediate input price at production sector level is given by the multiplication of the vector of intermediate input coefficients of each production sectors (which show the quantities of each commodity used per unit of aggregate intermediate input) and the vector of composite commodity prices, which allows converting this intermediate consumption into currency. Value Added Prices Value added prices at production sector level are also determined implicitly, taking into account that payments for value-added and intermediate consumption must fully exhaust total revenues for each production sector. Determination of Firm Profits directly linked to production These profits are determined by simply subtracting payments to labor from the activity revenues. In other words, they account for capital income, and are adjusted later by interest rate flows to get to before-tax firm profits. Consumer Price Index (CPI) and Inflation Inflation is captured in the model as the percentage variation of the Consumer Price Index (CPI), as in the IMMPA model, and is generated as a weighted average of the composite prices, with a Laspeyre index which accounts for the consumption pattern in Argentina. Differently than in IMMPA, the CPI is an arithmetic (and not a geometric) weighted average of the sector-specific prices. Expected inflation is assumed to be zero, given that the inflation rate in Argentina was near zero during the period. However, in the present version of the model, the CPI is fixed and acts as the numeraire in the economy, so that only relative price changes are modeled. 4) Institutional Block i. Households As explained above, households are classified in skilled, unskilled, and profit-earners, following the main income of the main income recipient of each household, which allows going from individual income to household income. This treatment is preferred over one where each household has factor ownership shares 10, because of the transparency the former treatment provides in terms of looking at changes in the income distribution in an economy like the Argentinean where it is perceived the most relevant changes in income distribution occurred at the factor level. 10 E.g. Bourguignon, F., W. H. Branson, et al. (1989). Macroeconomic Adjustment and Income Distribution: A Macro-Micro Simulation Model. OECD Development Centre Working Papers 1, OECD Development Centre. 13

14 Skilled households receive incomes from working in the private and public sector, and interest on domestic bank deposits net of interest on loans received from domestic banks. Unskilled households receive the same flow of incomes, plus government transfers. Profit-earner households receive incomes from profits shared by companies to residents, and from interests on domestic bank deposits, public bonds, and deposits abroad, net of interest on loans received from domestic banks. HH Expenditures and Savings When determining household consumption levels, it should be noted that capital inflows in Argentina may have had a critical role in the consumption boom in the beginning of the nineties, and probably after the 1995 Tequila crisis. A relevant transmission channel was associated with the currency regime, by which the capital inflows generated automatic increases in the money supply and, through the financial system, in the currency held by households. This, in turn, allows consumers to increase their spending, capturing the presence of liquidity constraints which affect private consumption. The right way of capturing this mechanism in a modeling exercise is still an open question. The standard treatment of the consumption function in the macro & CGE literature reflects either disposable income theory or disposable income compounded with permanent income theory (through coefficients on disposable income and net wealth) 11, but none of these considers the explicit inclusion of currency holdings constraining the households consumption level. To account for this, the consumption function in this model explicitly depends not only on current disposable income but also on a currency holdings index, affected in turn by money supply, and, hence, by capital inflows and outflows 12. Once the consumption level by household type is determined, household consumption on specific goods is derived from the maximization of a Stone-Geary utility function subject to a total consumption level, generating a Linear Expenditure System (LES) which determines the allocation of consumption spending over the different available goods. Finally, the fraction of income (already net of interest payments) which is not allocated to consumption is allocated to savings, fueling the household s net wealth. ii. Enterprises Private enterprises earn incomes directly linked to production from selling goods, and make payments for the inputs and the labor (skilled and unskilled including taxes) they use 13. These profits are adjusted by taking into account the interests that firms earn from 11 Without endogeneizing the effect of the variable credit constraint on consumption, the household consumption level usually depends both on household disposable income and on household net wealth, reflecting a compromise between disposable and permanent income consumption theories. 12 In a later stage I plan to model consumption as an intertemporal decision which takes into account the expected returns of different financial assets, in turn a function of capital flows. 13 The flows financing physical investments come from savings by the different actors in the economy (domestic and not), who own shares in the enterprises. The mentioned actors benefit when the capital gains derived from these real investments are realized. 14

15 bank deposits, and interests paid for bank loans, getting to before-tax profits. After this, firms pay tax on their profits and receive transfers from the government, getting to aftertax profits. Finally, enterprises keep a fraction of these profits and transfer the rest to the share holders. iii. Government Reflecting the main characteristics of government revenue in Argentina, the government gets its income from tax collection including taxes to value added, to firm s profits, to labour payments, to imports, and to exports, all relevant in terms of revenue and/or redistributive effects. The value added tax (VAT) is relevant from both points of view, being regressive since it taxes consumption, and the poorest deciles in Argentina unsurprisingly show a higher propensity to consume. VAT is modeled as an activity tax 14. Profit taxes, following tax regulation, is calculated as a percentage of before-tax profits, and affects domestic firms (banks profits are indirectly taxed since private service enterprises, which are transferred the bank profits, are taxed). The most important labour taxes are those charged to employee and employers (and not to self employee), which are basically proportional to the gross wage in the formal sector. The literature suggests just summing what is charged to employee and employer, since what matters is the wedge between labour production cost and labour "pocket" remuneration, and this is what is done in the model (see SAM section). It is probably the case that the reduction of labour taxes occurred in Argentina affected income distribution in the benefit of workers and against capital, even when probably other things worsened the situation of workers by far more (e.g. the uncompetitive exchange rate). Public primary expenditures include a series of exogenous components: public consumption, public investment (which increase the stock of public capital in the economy), the public wages, and public transfers (particularly, to the unskilled households). To get to the overall expenditures of the government, the primary expenditures are summed to payments of interests by the government on its debt, which includes public bonds. Primary and overall balances of the government are calculated with the difference of primary and overall expenditures, respectively, to government revenue, with the overall balance being financed by public bonds emission (see financial section). 5) Factor Markets The labor market has a public and a private component, which is distinguished at the level of activities. Labor is also classified according to skills (skilled vs unskilled) and to formality (formal vs informal). Labor in the formal sector pays taxes to labor, and shows a degree of real wage rigidity, while labor in the informal sector does not pay taxes to labor and its wages adjust fully so that unemployment in that sector is avoided. This 14 Ideally, it should be modelled as an ad valorem tax on final consumption sales, such that it is consistent with Argentinean taxes, where VAT is not charged either to exports or to investment, and where the VAT is translated through the productive chain until the final consumer. 15

16 segmentation of the labor market introduces a mechanism which may induce employers to shift activity to the informal sector with adverse effects on tax revenue- when faced with incentives to do so. The integration of a formal and an informal sector accounts for the fact that labor market regulations and other distorsions, which are present only in the formal economy of the model, may be binding only for a segment of the labor market, with wages exhibiting a certain degree of flexibility, but allowing also for the presence of unemployment. Given the high presence of unskilled but not of skilled in the informal labor market in Argentina, only the unskilled are allowed to work in the formal or the informal submarkets 15. For skilled and unskilled labor, total supplies grow following the population growth rates. To allocate these exogenous labor supplies into formal and informal markets, supply functions in the formal labor market are introduced, which account for incentives to move from the informal to the formal labor submarket in the tradition of Harris and Todaro (1970), - depending on the expected incomes-, with an elasticity of migration flows with respect to expected wages, and taking into account the probabilities of finding a job in each sector. While in the informal labor market this probability is assumed to be one - because workers can always find a job there at the existing wage -, an eventual positive unemployment rate is allowed in the formal labor market. The supply functions take into account imperfect mobility between formal and informal submarkets, given by absence or poor functioning of institutions to process and provide relevant information on job opportunities to jobseekers, which impede workers in the informal sector to engage in on-the-job search. Searching for a job in the formal submarket requires, literally, being physically present at the doors of potential employers (Agénor, Jensen et al. 2005,p20). To capture this imperfect mobility, the supply function incorporates a speed of adjustment parameter, which introduces persistence in flows from informal to formal market (and vice versa). In the formal private labor market, rates of unemployment are calculated for skilled and unskilled. Wage curves (where increases in the unemployment rate over the natural unemployment rate make the wage decrease) are assumed to derive the wage for skilled and unskilled in this sector, reflecting the observed procyclicality of the real wage in Argentina, which is theoretically justified in terms of the Shapiro & Stiglitz efficiency wage model 16 or others mentioned in (Blanchflower and Oswald 1994), and, as mentioned earlier, the fact that wages changed in Argentina in a similar way across different sectors, following general patterns i.e. they did not vary with productivity or with prices. It should be mentioned that the wage curve is essentially different from the Phillips-curve: while the former relates levels of unemployment and real wages, the latter relates the level of unemployment and the rate of growth of nominal wages(agénor, Jensen et al. 2005,p18). 15 A similar treatment can be found in IMMPA model, where a high perceived disutility of work or a fear of an adverse signaling effect on future employers detract from looking for a job and/or working in the informal sector. 16 In this model unemployment is a substitute for monitoring. Other models explain the procyclicality of the real wage, too. 16

17 Finally, demands for skilled and unskilled in formal and informal sector are derived from the maximization of short-run profits subject to the production function constraints. In the mentioned maximization, the estimated marginal costs of labor (for skilled and unskilled) are compounded by the pocket wage and the tax rate. The cost of financing labor is not explicitly taken into account in the labor demand function, to keep the model simple 17. 6) System Constrain Block and Market Closures The Armington function composite is demanded by domestic actors, specifically by household s and government final consumption, private and public investment, and by intermediate consumption, with prices adjusting in a perfectly competitive context to provoke equilibria in the goods markets. In the markets of factors, as was explained in last section, the market for existing physical capital and informal labor adjust fully through wage variations which assure full employment, and the formal labor market has some wage rigidity, getting to an equilibrium with unemployment. Differently than in IFPRI Standard Model, where either savings are investment-driven or investments are savings-driven, in this model both the marginal propensity to save of households and the overall level of investment are endogenous, with the model reaching a closure via the marginal propensity to save depending indirectly on the liquidity present in the economy (as explained above in HH Income and Expenditure section). The government has exogenous tax rates with flexible public savings. Concerning the rest of the world, in the base scenario fixed exchange rate- the nominal exchange rate is fixed (as was in Argentina during the Convertibility Plan), with flexible foreign savings, while in the flexible exchange rate scenario it is the international reserves variation the one which is fixed -at zero, reflecting lack of intervention of the Central Bank in the exchange market. 7) Financial Sphere The actors participating in the financial markets of the model are households, firms, the government, commercial banks, the central bank and non-residents. They hold different assets and liabilities. To define which these are, I took into account the main characteristics of the financial markets in Argentina. A market not only for public bonds but also for private equity exists. Government bonds and foreign assets are not held by skilled and unskilled households, because of assumed informational difficulties and 17 Given that part of the working capital is financed by past retained profits, and part by domestic banks loans, a financial cost should ideally be included and take into account the interest rates that enterprises pay on loans and receive on deposits. 17

18 transaction costs for these actors in entering to associated markets, which overall provides a transmission channel from the financial sector to income distribution 18. Particularly, foreign assets are held only by profit earner households and domestic banks, and public bonds only by profit-earner households, domestic banks and the foreign sector. Households allocate their assets (financial wealth plus bank loans) in cash holdings, domestic bank deposits, deposits abroad, and government bonds (these last two only in the case of profit earner households). Firms allocate their financial assets (net worth plus borrowings from domestic banks) in domestic bank deposits 19. Government only asset is non-financial (capital in infrastructure), and finance its overall deficits allocating a flow of bonds into the economy 20. Commercial banks receive deposits from domestic households, domestic firms and nonresidents, borrow from the central bank (i.e. get rediscounts), hold required reserves and public bonds and lend to domestic firms and households. The central bank, besides, holds foreign reserves and stocks of public bonds and loans to commercial banks in the assets side, and the monetary base, in the form of cash in circulation and required reserves, plus debt with non-residents in the liabilities side. Given that all the period was characterized by a fixed nominal exchange rate, and assuming that the agents trusted the promise of the Central Bank of keeping the parity and did not expect a nominal depreciation of the domestic currency during the period, no difference is made by now in terms of the currency denomination of the assets/liabilities 21. The financial balance sheets of the domestic institutions present in the model, together with the main physical capital owned by the mentioned institutions, are presented now for better illustration of portfolio options of the main economic actors in the model. Assets Domestic equity Public bonds Deposits at domestic banks Deposits abroad Cash holdings Households Liabilities Domestic borrowing Financial wealth 18 Which might be specially relevant when taking account of the maxi-devaluation when the country exited the Currency Regime. 19 While it does not make much sense for a firm to get a loan and deposit it at the bank at a lower interest rate until it has to be repaid, deposits of enterprises in banks and loans from banks to enterprises in the same sector are observed due to: a) different periods of loans and deposits and b) some enterprises getting loans while others depositing funds into banks. 20 Reflecting the main motion idea of the ISS Money and Finance Project, capital flows to the public sector (in this case in the form of changes in public bonds held by the foreign sector) will be assumed later to be supply determined, generating (instead of just filling) public deficits. The idea of exogenous international capital was at the heart of the iss money and finance project, which sought to correct the imbalance where many macro models saw the capital account as a balancing item which adjusted to current a/c. this view was also applied to aid by Howard White in the early 90s, with the main idea that aid creates deficits rather than fills them. 21 This will be re-evaluated in the future. 18