Ahammad, M. Helal Uddin
Description
Bangladesh is a poor country that has not performed well in economic terms since
independence. It was hoped that industrialization would lead to rapid growth, but
protectionist import-substitution policies failed to deliver industrial development.
Following the trend toward identifying policy problems as being key to growth, this
study sets out to examine the effects of foreign exchange and trade policies on
industrial development.
An ORANI-type computable general equilibrium model,...[Show more] CGE-B89, for the
Bangladesh economy (on a 1989 database) was developed for policy analysis. The
model was simulated for an exogenous inflow of foreign aid to estimate the shadow
exchange rate. It was then simulated for changes in the official exchange rate, money
supply, tariffs and export subsidies.
Simulations were designed for the short-run in identical economic
environments. For each simulation two alternative assumptions about the labour
market were made: fixed nominal wages in the presence of involuntary Keynesian
unemployment and aggregate employment fixed by the exogenous supply of labour.
The macroeconomic and sectoral effects were analysed, and the aggregate welfare
gain (or loss) was evaluated for each exogenous change.
Harberger's fundamental equation of applied welfare economics (Harberger
1971) was used to disaggregate the change in welfare, due to a small change in an
exogenous variable, into the direct welfare impact of the change and indirect gains
(or losses) from alleviating (or exacerbating) distortions in all other markets. To
apply Harberger's fundamental equation, it was necessary to extend his analysis to
allow for intermediate goods, terms of trade effects, indirect taxes on consumption
and intermediate inputs, production subsidies, exchange controls and wage rigidity (for simulations in which changes in involuntary Keynesian unemployment are
allowed).
In the case of shadow price of foreign exchange, the direct effect on welfare
of a costless increase in foreign exchange availability of US$1, due to increased
foreign aid, is the value of US$1 at the official exchange rate (taka 32.14). The
indirect effects equal the sum, across all distorted markets, of the change in distorted
activity multiplied by the excess of marginal social benefit of that activity over its
marginal social cost. For example, in the case of tariffs, the marginal social benefit of
an extra unit of imports is domestic price, while the marginal social cost is the world
cif import price (exogenously given in the model). Therefore the gap between the
marginal social benefit and marginal social cost is the amount of the tariff, and the
indirect benefit of additional foreign aid in alleviating tariff distortions is the tariff
times the rise in imports due to the increased foreign aid availability. In the case of
Keynesian unemployment, the indirect benefit is the difference between wage and the
disutility of labour (assumed to be zero in the model) times the change in
employment.
With rigid nominal wages in the presence of involuntary Keynesian
unemployment, the indirect effect on welfare of a costless increase in foreign exchange
availability was estimated to be more than 30 per cent of the official exchange rate.
This percentage also measures the extent by which the shadow exchange rate
exceeded the official exchange rate. The shadow exchange rate was 15 per cent above
the official exchange rate when the nominal wages were flexible and aggregate
employment was fixed at the base-year level.
Model results suggested that the inflow of foreign aid would raise households'
welfare at the expense of reduced production in the tradable sectors. Foreign aid inflow would cause a fall in the real exchange rate, defined as the ratio of the price of
tradable goods to the price of nontradable goods. Production of most of the
importables and exportables would decline against a substantial expansion in the
nontradable sectors.
In a small open economy with a unified exchange rate and no exchange
controls, a devaluation of the exchange rate increases the money stock through the
Hume mechanism. But such a causality does not take place in an economy
confronting exchange controls under a dual exchange rate system (involving an
exogenously fixed official exchange rate and the market determined secondary
exchange rate). In such an economy, changes in money supply and changes in the
official exchange rate may be viewed as two separate policy tools to affect the
secondary exchange rate premium, and hence implicit taxes on imports and exports.
Production and consumption decisions in the economy are thus influenced.
The study explored the consequences of two instruments for exchange rate
unification: devaluation of the official exchange rate and a contraction of the domestic
money supply. Simulations of the devaluation of the official exchange rate and
increases in money supply have suggested that a devaluation of approximately 2 per
cent or a contraction of domestic money supply by 2 to 2.5 per cent would unify the
exchange rates. When aggregate employment is fixed, devaluation and money supply
contraction would both reduce the aggregate implicit taxes on exports, and would
lead to a deterioration in the international terms of trade. As a result, welfare would
fall. In other words, unification of the exchange rates in the absence of optimal export
taxes is estimated to be welfare worsening. A nominal contraction (or expansion)
degenerates (or produces) a Keynesian stimulus under conditions of sticky nominal
wages. As a result, a contraction in the domestic money supply would be welfare
worsening, and a devaluation which is equivalent to a monetary expansion would be welfare augmenting in conditions of wage rigidity. But a 2 per cent devaluation, which
would unify the exchange rates, would raise households' welfare, albeit by only 0.14
per cent of the base-year GDP at market prices.
An equiproportional reduction of tariffs was found to be welfare improving.
Both exports and GDP at market price rose. Simulation results, however, suggested
that the welfare gains from a 10 per cent equiproportional reduction in tariffs were
quite small as a proportion of base-year GDP: only 0.11 per cent under the assumption
of nominal wage rigidity and 0.02 per cent under the exogenously fixed aggregate
employment assumption.
Simulation results also showed that the equiproportional reduction of the
Export Performance Benefit entitlement rates was welfare worsening. The
simultaneous reductions in the Benefit entitlement rates and tariffs by the same
percentage, however, were welfare augmenting. All exports except jute experienced a
rise. This seemed to reveal the inadequacy of the Benefit Scheme in overcoming the
deleterious effects of nominal protection on exports. The results also showed that the
elimination of subsidies under the Benefit Scheme had to be accompanied by a
reduction in nominal protection to raise welfare and exports.
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