Agriculture Reference
In-Depth Information
Indeed, the effects range from the contraction alluded to in the introduction
through to a substantal short run expanson.
The effects of captal controls and the choce of the monetary
polcy target
In broad terms, the behaviour of the model in the short run with rigid capital
controls retained can be represented as in Figure 10.6. The upper diagram
represents the domestc captal market and the lower one the domestc
market for foregn products. These markets are lnked by the requrement
that, for a balance of payments, net flows on the capital account must
mrror those on the current account. Net demand for foregn products
(the downward sloping line in the lower diagram, NM=M-X) depends on the
relative price of foreign goods. For this purpose we define the real exchange
rate as n Equaton 1 as the common currency rato of the prce of home
goods to the prce of foregn goods. Net mports depend postvely on ths
real exchange rate and negatively on its inverse (the common currency,
foregn to home product prce rato). Ths excess demand curve s shfted to
the right by an increase in GDP, Y, or a reduction in protection, τ. The real
exchange rate s then determned by the balance of payments requrement
that net inflows on the capital account must equal net outflows on the
current account, KA=-CA=NM=M-X.
12
The trade liberalisation reduces τ and shifts NM to the right. With tight
capital controls, the current account balance cannot change. The shock
therefore rases the relatve prce of foregn goods n the home market and
deprecates the real exchange rate. If the nomnal exchange rate s the
target of monetary polcy and the home economy s small by comparson
wth ts tradng partners (P* s unaffected) then a
fall n P
Y
(a deflation) is
requred. Ths must be brought about by a monetary contracton n defence
of the exchange rate. To the extent that wages adjust more sluggshly than
product prices, the deflation causes the real wage to rise. Were the real
depreciation the only consequence of the liberalisation shock, its effects
would be contractionary. Fortunately, this need not be the case. The trade
reform brings gains in allocative efficiency.13
13
However, when capital controls remain rigid and the exchange rate is
fixed, these allocative gains are insufficient to offset the contractionary
