Developing Countries and Other Small Open Economies with

Developing Countries and Other Small Open Economies with Nontraded Goods IMQF course in International Finance Caves, Frankel and Jones (2007) World Trade and Payments, 10 e, Pearson

Introduction • What would be the optimal strategy for small open, developing economy (SOE) that needs to improve its trade balance? – – Devaluation? Contractionary demand policy? • If the SOE is small and the PPP holds, than by definition, devaluation cannot change relative prices • Prices of traded goods taken as exogeneous (as it is a SOE), but nontraded goods are now introduced too – Relative price effect + real money balance effect

Outline • Output and consumption of traded and nontraded goods • Expenditure shock and the nontraded goods market • Monetary approach with nontraded goods – – Reserves inflow Dutch disease Effects of increase in money supply in nontraded goods model Effects of devaluation

Output of Traded and Nontraded Goods • Examples of nontraded goods – Services: barber services, dry cleaning, utilities, etc. – Goods: highly perishable food – Other goods if there are prohibitive trade barriers or transportation costs are very high (in some distanced countries) • As it is an SOE, it cannot affect the terms of trade, so traded goods can be aggregated together • Production possibility curve – Combination of goods that can be produced, considering the available inputs (labor and capital) –. . . it is bowed-out, due to diminishing return to shift of labor from traded to nontraded goods and the other way around • Relative prices given by the flat line ( – • being nominal prices of nontraded and traded goods respectively) When price of of nontraded goods is low, these goods are cheap compared to the price of traded goods, and the budget line is steap If all resources are employed, the output of nontraded goods is determined where the relative prices line is tangent to the production possibility curve

Output and Consumption of Traded and Non-Traded Goods

Consumption of Traded and Nontraded Goods • Trade balance is the difference between traded goods produced and traded goods consumed – • The rest of the World will consume all traded goods offered by SOE (the quantity remaining after domestic consumption), at the going World price Pattern of consumption drawn from indiference curve – – Slope of indiference curve indicates marginal rate of substitution between traded and nontraded goods (it’s convex due to diminishing MRS) The combination consumer will choose is derived at the point where the relative prices line is tangent to the indiference curve • If that point is the same as the point where the relative prices line is tangent to production possibility curve, what would be TB?

Consumption of Traded and Nontraded Goods • Ependiture A and income Y, measured in terms of traded goods • Government cuts income tax or increases spending, so A is rising. Consumers and producers face the same relative prices (no taxes and subsidies on goods). • Consumption of traded and nontraded goods determined where the budget line is tangent to indiference curve (move from point S to point F) • Consumption of both goods exceeds output – trade deficit (for traded goods) and excess demand (nontraded goods)

Expenditure and the Relative Price of Nontraded Goods MAINTAINING MARKET EQUILIBRIUM IN THE TRADED GOODS MARKET • Initial position is trade balance (TB=0) • As expenditures rise, the country slips into trade deficit, because at least a part of additional expenditures is used to buy imported goods – – • What would have to happen, after increase in expenditure, to restore trade balance? – • Rise in private expenditures: deterioration of TB = marginal propensity to spend on traded goods times increase in expenditures Rise in government expenditures: import content can be either higher (military weapons, construction of equipment, etc. ) or lower (education and health services) – depends on the structure Increase in relative price of traded goods (e. g. if country devalues), will reduce excess demand for traded goods – this is equivalent to making the relative price line steeper Rise in price of tradable goods, makes real wages ( ) lower than marginal product of labour. These firms hire more workers until real wages equilibrate with marginal product of labour – In full employment model this also raises wages in nontraded goods production sector, making these companies to fire workers – until we reach new equilibrium (point X) – quantity of produced traded goods has risen

Expenditure and the Relative Price of Nontraded Goods • What would be the impact on consumption of tradables? – – – • Substitution effect: decrease in consumption due to rise in relative price of traded goods Income effect: increase in consumption of traded goods Rise in expenditures raises budget line, but increase in relative price of traded goods makes it sticked to point A and rotating (becoming steeper). New equilibrium can be left or right from the point F – depending on the slope of indiference curve Trade balance is production of traded goods minus consumption of traded goods – – Even if consumption of traded goods fails to decline, TB would improve because of unambiguously positive effect on production The net effect on TB= production effect + substitution effect – income effect (distance from X to B). This net effect can outweight the initial negative effect of rise in expenditures on TB (via imports)

Equilibrium in the Traded Goods Market • Point S – external equilibrium (TB=0) and internal equilibrium (no excess supply and demand of nontraded goods) – – – Rise in expenditures – shift to the right (point F is trade deficit position as expenditures on traded goods have risen) We need substantial rise in prices of traded goods to restore equilibrium (from F to B) For each level of A, there is a corresponding change in the relative price that is necessary to maintain trade balance (BB curve)

Expenditure and the Relative Price of Nontraded Goods MAINTAINING MARKET EQUILIBRIUM FOR NONTRADED GOODS • • It is uncertain if rise in expenditures will be accompanied by decrease in relative price of nontraded goods (we need devaluation to make sure that this happens) There is an excess demand for nontraded goods (X-B), triggering employment and inflation concerns – – – Excess demand is In order to reduce excess demand we need to increase relative price of nontraded goods – but again there are both effects on production (higher price of nontraded goods boosts production) and the effect on consumption (income and substitution) Change in relative price induces shift of resources along the production possibility curve, from traded to nontraded sector, until reaching point of tangency X (less steep relative price line), triggering rise in production of nontraded goods Rise in relative price of nontraded goods shifts demand (consumption) away from nontraded to traded goods (from X to G) If rise in relative price of nontraded goods is sufficiently large, rise in production and decline in consumption will be sufficient to eliminate excess demand for nontraded goods

Increase in Expenditure, Followed by Increase in Relative Price of Non-Traded Goods

Expenditure and the Relative Price of Nontraded Goods • There is a set of combinations of – These points constitute the upward-sloping internal balance schedule NN • • Why upward-sloping? Because increase in expenditure must be accompanied by rise in relative price of nontraded good to eliminate excess demand External balance schedule (BB) and internal balance schedule (NN) divide policy instruments into four quadrants („ 4 zones of economic unhappiness“) – – • , that give an equilibrium in nontraded goods Trade deficit and excess demand for nontraded goods (I) Trade deficit and excess supply of goods (II) Trade surplus and excess supply of goods (III) Trade surplus and excess demand (IV) Only in point S, there are internal and external balances – Latin America 1974 -82 were in point F (high government spending induced excess demand for nontraded goods and trade deficit, financed by means of borrowing from abroad. In order to be able to pay the loans and interest, they had to devalue, slipping into quadrant III…

Equilibrium in the Non-Traded Goods Market

Monetary Approach with Nontraded Goods • What would happen if the government does not undertake policy action to tackle trade deficit and excess demand for nontraded goods? – Two automatic mechanisms to be set in motion • • • In response to excess demand producers of nontraded goods would raise the prices, thus increasing relative price of nontraded goods and restoring equilibrium – – • Increase in prices of nontraded goods International reserves flows If there is excess supply of nontraded goods, the process will be very slow, as it requires fall in prices, inducing prolonged recession and unemployment To speed up the process, the government can take policy actions: devaluation and increase in expenditures Bo. P deficit translates into reserves loss, thus reducing money supply with contractionary effects on expenditures – decline in expenditures diminishes Bo. P deficit – – Government action to decline in reserves: cut in expenditures and/or devaluation Bo. P surplus triggers rise in reserves and increase in expenditures, thus boosting imports and bringing Bo. P back to equilibrium

Adjustment with Excess Supply of Nontraded Goods

Monetary Approach with Nontraded Goods Dutch Disease • Natural resource boom or commodity boom can trigger buoyant inflow of reserves – becuase the prices are temporairly above the long-run equilibrium or because the new deposits of goods have been discovered • This can cause real appreciation of the currency, causing a loss of competetitiveness for exports of tradable goods • Real appreciation forms – – Under the fixed exchange rate: reserve inflows make money supply rising, thus boosting wages and prices of nontraded goods – so the real appreciation happens through inflation Under the floating exchange rate regime: reserve inflows make money supply rising, thus triggering nominal appreciation • The case of Colombia – exchange rate tends to move with the international price of coffee

Monetary Approach with Nontraded Goods Dutch Disease • Commodity boom triggers rise in government revenues (directly or via taxes and royalties), thus enabling increase in government spending, which makes further upward preassure on the prices of nontraded goods – • Resources are crowded out from tradable goods manufacture, to the sector experiencing commodity boom and the nontraded sectors (such as construction) Why is Dutch Disease a disease? – – If commodity boom is more temporary than the government has thought, so when the deposits are exhausted or the prices are reverted, the country is left with atrophied exports sector, „white elephant“ investment projects, bloated government payrolls, unwanted real estate projects and large international debts – with impairing effects for long run growth „Natural resource curse“ – countries rich in natural resources can experience lower long-run economic growth than those without

Monetary Approach with Nontraded Goods EFFECTS OF INCREASE IN MONEY SUPPLY IN THE NONTRADED GOODS MODEL • Two assumptions of the nontraded goods model – – • Prices are flexible: excess demand induces rise in prices, which clears the market and restores equilibrium (and vice versa) Reserve flows are not sterilized: reserve flows are limited to the size of the trade balance Effects of increase in money supply: excess demand for nontraded goods and trade deficit – – – Producers react by increasing prices of nontraded goods (equivalent to increase of relative price of nontraded goods) – moving vertically from point F until we reach NN line (excess demand eliminated, but trade deficit is still there and widened) Trade deficit triggers fall in reserves, and consequent decline in money supply and expeditures. Relative price of nontraded goods must decline to eliminate excess supply – thus bringing the country back to trade balance In the long run monetary expansion changed nothing except the composition of the central bank’s balance sheet: the original expansion in domestic credit has been offset by an equal decrease in the central bank’s holdings of international reserves

Monetary Approach with Nontraded Goods EFFECTS OF DEVALUATION • Devaluation should improve Bo. P in two ways – – • Devaluation boosts price of traded goods (stated in domestic currency). If for some reason, the price of nontraded goods rise by the same percent, there is no change in relative price – • Contractionary effects on expenditures Decrease in relative price of nontraded goods Rise in price of traded goods reduces real money supply, resulting in excess demand for money (move from S to H under the last Figure), which makes HHs and companies cutting back their spending to restore their level of real money balances In terms of the first Figure, reduction in expenditures means inward shift of the budget line, so the new equilibrium (where indiference curve is tangent to the budget line) is inside the production possibility frontier – – Consumption of both traded and nontraded goods declines, causing trade surplus (due to decline in consumption of traded gooods) and excess supply of nontraded goods Excess supply of nontraded goods, their relative price needs to fall

Monetary Approach with Nontraded Goods EFFECTS OF DEVALUATION • The price of nontraded goods does not rise by the same proportion as the price of traded goods • Decline in the relative price of nontraded goods yields the second positive effect on the trade balance: more traded goods are produced and fewer are consumed – • Trade surplus is larger in point E, where both effects operate that at the point H, where only the real balance effect operates Country running trade surplus faces reserve inflows, which causes rise in expenditures, thus reducing the trade surplus – However, prices of nontraded goods also rise to eliminate what would be the excess demand. Money continues to flow into the country and expenditures continue to rise until trade balance is restored

Monetary Approach with Nontraded Goods EFFECTS OF DEVALUATION • To have an effect on the trade balance some variables need to be sticky in the short run (they need to be restricted from jumping discontinuously) – • Sticky variable is the stock of foreign reserves Sticky variable adjusts over time – – – International reserves adjust via the Bo. P Price level adjusts via excess demand When all adjustments are complete, all nominal magnitudes have increased by the same percent as devaluation, which means that no real magnitudes have changed