Agriculture Reference
In-Depth Information
effects of the deflation. This can be seen from the first column of Table
A10.5. The real depreciation is substantial and the deflation required is of
the order of 2 per cent per year. The producton real wage rses by half
ths and employment falls. Investment demand responds to the expectaton
of hgher real returns to nstalled captal n the future by shftng outward
(Figure 10.6). The loss of tariff revenue drives the government deficit higher,
reducing domestic saving, and further reinforcing the outward shift of the
net foreign investment demand (NFI) curve. But the rigidity of the capital
controls causes ths to smply push up the domestc nterest rate and so
real investment falls. Output falls in all sectors except beverages, energy,
manufacturing and transport. Manufacturing gains in the short run for the
same reasons it gains in the long run—cheaper imported inputs. Therefore,
under these polcy crcumstances the net gans from trade reform are not
robust in the short run—at least when pessimistic assumptions are made
about productvty effects and servces reform.
If the capital controls are removed, the corresponding liberalisation
shock is as depicted in Figure 10.7 (the results are shown in column 2 of Table
A10.5). Here, reduced protection also yields a gain in allocative efficiency
but this time it is large enough to generate a net gain in GDP, reinforcing
the rghtward shft n the net mports curve n the lower dagram. In ths
case, however, the absence of capital controls allows investment to flow
in, responding to the increase in the expected long-run return on installed
capital. The increased inflow on the capital account relaxes the balance
of payments constrant n the lower dagram and allows a shft toward net
mports. The net effect on the real exchange rate depends on whether
the capital account shift, which raises the net supply of foreign goods, is
larger or smaller than the ncrease n ther net demand due to the tarff
reduction and the rise in domestic income. In this case, the increase in net
demand is dominant and the real exchange rate still depreciates, albeit to
a lesser extent than in the presence of capital controls. Thus, when capital
controls are weak or non-existent, trade liberalisation attracts increased
inflows on the capital account in order to mitigate the real depreciation
and associated GDP price deflation that are its inevitable consequences.
In the thrd column of Table A10.4 the target of monetary polcy s the
GDP price, so that the nominal exchange rate is allowed to depreciate.
This removes the deflation that must accompany a fixed exchange rate and
