Selective policies under a structural foreign exchange shortage

Abstract

Standard adjustment programs emphasize excessively demand-reducing adjustment mechanisms in economies facing a binding external constraint. The main policy instrument used to induce expenditure-switching and supply effects is the exchange rate. Despite its evident relevance, this instrument by itself cannot deal with the diversity of elasticities and transmission mechanisms. In the first section of this paper we provide evidence to show a clear non-first-best economic situation in Latin America during the eighties. The region exhibits significant maladjustments in the size and composition of output and demand, with a concomitant underutilization of installed capacity and a strong reduction in investment. In the second section we provide some theoretical examples on how changes in the size and composition of fiscal revenues and expenditures may help in reducing the undesired effects of external adjustment processes. We also argue that an active exchange rate policy may generate adverse fiscal effects if not accompanied by an adequate change in taxes and/or expenditures. These examples consider a model where output of non-tradable goods is sensitive to the size and composition of domestic demand while output of tradable goods is sensitive solely to relative prices. The difference in transmission mechanisms is the basis to argue for a greater diversity of policy instruments involved in adjustment programs – or selective policies.