The Shadow Exchange Rate in an Economy with Trade Restrictions Author(s): Trent J.

Bertrand Source: Oxford Economic Papers, New Series, Vol. 26, No. 2 (Jul., 1974), pp. 185-191 Published by: Oxford University Press Stable URL: http://www.jstor.org/stable/2662220 Accessed: 03/12/2010 06:36
Your use of the JSTOR archive indicates your acceptance of JSTOR's Terms and Conditions of Use, available at http://www.jstor.org/page/info/about/policies/terms.jsp. JSTOR's Terms and Conditions of Use provides, in part, that unless you have obtained prior permission, you may not download an entire issue of a journal or multiple copies of articles, and you may use content in the JSTOR archive only for your personal, non-commercial use. Please contact the publisher regarding any further use of this work. Publisher contact information may be obtained at http://www.jstor.org/action/showPublisher?publisherCode=oup. Each copy of any part of a JSTOR transmission must contain the same copyright notice that appears on the screen or printed page of such transmission. JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range of content in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new forms of scholarship. For more information about JSTOR, please contact support@jstor.org.

Oxford University Press is collaborating with JSTOR to digitize, preserve and extend access to Oxford Economic Papers.

http://www.jstor.org

THE SHADOW EXCHANGE RATE IN AN ECONOMY WITH TRADE RESTRICTIONS By TRENT J. BERTRAND1
is widelyarguedthat in less developed economies the officialforeign exchange rate does not reflect social value of foreign the exchange because of widespread restrictionson trade. Accordingly,it has been suggested that a 'shadow' exchange rate be calculated foruse in project evaluations and other government decision-makingprocesses. In this paper, the traditionalformula the 'shadow' exchangerateis derivedforan economy for withtrade restrictions (sectionI) priorto showingthat the appropriateness of this formuladepends cruciallyon the underlying objectives of government trade policies (section II). The methodologyemployedis to set out an explicitoptimization problemwhichis first used to derivethe traditional formula the shadow rate. This also permits for objectivesofthegovernment underlyingtrade policies to be explicitly introduced into the analysis throughadditional constraints and the model adjusted in this way permits the derivationofan adjusted shadow exchangerate wherein thoseobjectives are taken into account.
IT

modities:

We firstderive a formulafor the 'shadow' exchange rate that closely correspondsto that suggested in the Unido guidelines [7] and in the writingsof Balassa [2], Harberger [5], Schydlowsky[6], and Bacha and Taylor [1]. It is assumed that welfare,U, is a functionof consumptionof n com-

U U(=

) ...,

(1)

where Ci is the consumptionof the ith commodity. The level of grossoutputs in the economyis constrainedby the assumed differentiable gross productionpossibilityfrontier T:
T(X.1) ...,)Xn) <

?-

(2) (3)

The relationshipbetween gross and net outputs is definedin relation (3): [I-A]X
=

where I is the identitymatrix,A is the n x n matrix of input-outputcoX efficients, is a vector of gross outputs, and x is a vector of net outputs. -r The net productionpossibilityfrontier is therefore

(x1-

a.,,...,Xn-nj

) = r(x1,...,xX) 0<

(4)

1 Financial in this support writing paperis acknowledged the Institute Economic from of Research, Queen'sUniversity.

186

THE SHADOW EXCHANGE

RATE

inputsfrom where-r obtained by subtracting is output used as intermediate the gross outputs.' The budget constraintin relation (5) EPi Ci Pi XiPj aji Xj+8 (5)

flows and trade, the value of the conindicates that with interindustry sumptionbundle evaluated at world prices in foreignexchange units, Pi, cannot exceed the value of the gross output minus the value of intermediate inputs plus the value of an exogenously determinedamount of foreignexchange S. The variable 8 is introduced into the budget constraint to permit the effectsof a small variation in foreignexchange availability to be analysed. Denoting value added per unit in the production process of the ith commodityas 7ri(again measured in foreignexchange units) we have
pTi

Pi-

ajiPj;

(6)

substituting relation (6) into relation (5), we obtain

Pi E Ci <

riXi+S;

(7)

but since the value of net output equals the sum of total factorpayments (7) can also be writtenas
i

E C, < Pi

E, i

xis+S;

(8)

since the difference betweenconsumptionand net output gives the amount of importsif positive and exports if negative, relation (8) may be read as the balance of payments constraintforthe economy. Domestic prices in domestic currencyunits, pd, and domestic values added, rra are definedin relations (9) and (10):
2d1
-rd

i1

t)

(9) (10)

r7Tj(1?+z)

rate of exchange and tj and zi are the percentage where r is the official differences between world and domestic prices and values added with conversionat the official exchange rate. If there are no foreignexchange controls, no prohibitive tariffs,no quotas and if import activities are competitive,then tj is the nominal import (or export) tariff(or subsidy) and zi is the effective (or import (or export) tariff subsidy). Otherwise,tj and zi are the actual price and value added distortions.
1 The assumption of (a) fixed input-output coefficient, (b) constant returns to scale, factor intensitycan (c) concave-contouredproduction functions,and (d) that no efficient factorintensitiesfor othergoods, is sufficient be writtenas a linear combination of efficient to assure the functionsT and i- employed here. See Ethier [4] for a discussion of the implications of relaxing (a).

T. J. BERTRAND

187

With social welfare defined by relation (1) with consumption levels constrainedby the two alternative sets of constraints((2) and (7) or (4) and (8)) dependingon whetherwe deal with net or gross outputs, changes in social welfare(dW) may be writtenas dW or
=

UidC,-A1( UU dC,-A1(
E

rPdCirP. dCi--

,rPidx

rd8)

A2(Eidx) TidXi)

(11) (IIa)

dW =

rridXi-rdi)-A2(

where Al and A2 are the Lagrangian multipliersdefiningthe impact of marginal variations in budget and production possibility constraintson the objective function. Welfare maximization by consumersand profitmaximization by producers assure that1 (12) Ui AlrPi(1?+t), A rPi(1?ts)
2

(13) (14)

Ti A rjvi(l+Zi).
2

Definingdy as the moneymeasure of the change in real income (that is, = the dW/A, dy),we can use (12-14) in (1 1) and (I I a) to determine shadow rate of foreignexchange: dy or
dy
= i

E
pi dti

E 7r

d3M]

(15) (16)

Z dX ]

Thus the 'shadow' rate ofexchange differs from official the rate ofexchange a percentageamount equal to a weightedsum ofprice disparities, where by the weightsare changes in trade flows2(relation 15) or consumptionand grossoutput changes (relation16) broughtabout by the marginalchangein foreign exchange availability.
1 Consumersfacing perfectly competitivemarkets will maximize U(Ci,..., Cn) subject to given consumptionpossibilities. Formingthe Lagrangian expressionand settingthe partial derivative with respect to a change in CQyields (12) since the Lagrange multiplierin this problem will give the marginal utility of income which is assumed equal to the social evaluation given by A1. Similarlyproducersoperatingin perfectly competitivemarketswill maximize the value of net outputs EPi(1 +ti)xi subject to the net production possibilities set or value added EvT(l +zi)Xi subject to the gross production possibility set. The of Lagrangian multiplierin these problemsgives the dollar unit effect easing the production possibilityconstraintwhich equals A2/A1. 2 Trade flows are denoted by Mi = C -xi. Note that by the balance of payments constraint (8), 1 PI(dMi/d5) = 1 so that the weights attached to the price disparities in (15) i sum to unity.

188

THE SHADOW EXCHANGE

RATE

While, on the assumptionsmade, (16) is equivalent to (15), it is included to aid the comparisonwith the revised estimate of the 'shadow' rate when objectives of trade policies include affectingresource allocation in the domestic economy. Relation (15) correspondsmost closely to the usual calculation of a shadow rate. Differencesin these formulationsusually turn on the derivationof the weights. Schydlowskysuggeststhat a workable approximation is that marginal importswill be identical to average importsand thus the latter can be used in weightingprice differences [6]. Balassa [2], Harberger [5], and Bacha and Taylor [1] suggest that elasticitiesbe estimated to definethe effects exchange rate changes resulting of fromthe altered supply of foreignexchange. The UNIDO guidelines [7] requirean estimateofhow the foreign exchangewillbe used, but the details of how the weightingscheme is to be derived are leftunspecified. In this paper, concernis with how taking the objectives of trade policies into considerationaffectsthe shadow rate formulasratherthan with the problem of derivingthe weightingscheme. II The preceding analysis does not allow in any way for the objectives underlyingtrade tax or subsidy policies that lead to the divergences between domestic and world price levels. In this section, I illustratethe nature of the required adjustment to the formulawhen the rationale of policies underlyingtariffs explicitlyintroduced. For these purposes,it is is assumed that trade restrictions employed both to alter the pattern are it of consumptionand to affectthe allocation of resources. Specifically, is assumed that the governmentseeks to restrictconsumptionof particular commoditiesthat may be termed luxury goods and are denoted by the subscript I and desires to encourage a specifiedlevel of value added in priorityindustriesdenoted by the subscripth. These policy objectives can be introducedas additional constraintsto the equation sets (1), (4), and (8) to yield

S.t. ErPi Ci -,
i T7(Xl)

max U =U(C1, ..... , C.),

i

r,7iXi

rS< O.

.(17)

(18)
(19)

.... ,Xn) -< 0,......

rP1C,<
z h

K1,

(20)

>1 r7rTXh K2.

(21)

Formingthe Lagrangian and settingthe partial differentials with respect to consumptionof necessaries (i.e. non-luxury goods denoted by subscript in), consumptionof luxuries, gross output of priorityand non-priority

T. J. BERTRAND

189

(denoted by subscriptg) industriesequal to zero,we obtain the first-order conditions for maximizing social welfare: rPm Um Al
O. 0
=

(22)

U- AlrP-A3rP, AlrTh?+A4rTh -A2 T

0,
0,

(23)
(24)
(25)

= 0. A2i Alr7Tg Using these first-order conditions,we obtain

UM rP(+I U, rP,(1+A3/Al)
and
_

(26)
(27)

Th

r7T~l

rlTh(l1?A4/Al)

which,in conjunctionwithrelations(12) and (14), showthat ifzero nominal and effectivetariffsare applied to non-luxurygoods and non-priority activitiesthe optimallevel oftariff affect to consumptionon a luxurygood, rate on priority equals A3/Al the optimallevel ofeffective and tariff indust,, tries to affectresourceallocations, Zh, equals A4/Al. These resultsare of interestin themselves. If it is possible to group final goods or productionactivities by priorityrank according to government objectives of alteringconsumptionor resource allocation, these relations show that an equal nominal rate of protectionshould be applied to conrate ofprotecsumergoods in the same priority groupand an equal effective tion should be applied to activities in the same priority group.' Although and productionactivities, onlytwo groupshave been used forconsumption this treatmentcould easily be extended with as many rankingsas desired using a consumption or production constraint for each group with its Lagrangian multiplierdefining the optimal nominal or effectivetariffin the mannerestablished here forthe two-priority case. We can again definethe change in welfareas

dW = 2 UidCi-A,( l

rPidC- E r7TidXi-rd )-A2( E TidXi)

3(

I dC1)-A4(

rlThdXh)

(28)

and by substitutionfromrelations (12) and (14), solve for the shadow exchange rate dy

[rs=r 1+

'

Pi(ti-t*) d=

7i (Zi-z*)

do ]

(29)

Relation (29) is central to our analysis. In contrastto the traditional

1 Extensions forthis resulton the optimal structure effective assumprates on differing of tions concerningthe resourceallocation objective are discussed in [3].

190

THE SHADOW EXCHANGE

RATE

it formulas, is not appropriateto use price or value added divergencesto weight marginaltrade flowsor consumptionand production changes for the exchange rate adjustment when rational objectives underlie trade and the restrictions.These objectives supportan optimal systemof tariffs relevant adjustmentto the marketexchange rate must be carried out by between actual prices and values added in weighting with the distortions the the domesticeconomyand the levels that would resultfrom application of an optimal trade policy. implicitlyassumed that all In the traditionalformulas,it is therefore If the alternativeextremeassumptrade restrictions socially harmful. are has tionthat the government instituteda fullyoptimal set oftrade restrictionsis made, relation(29) indicatesthat no adjustmentto the marketrate ofexchangeis required. In reality,neitherof these two conditionsis likely to hold. The adjustmentthen can onlybe made on the basis of knowledge or assumptionof the optimal structureof trade restrictions.However, it would seem preferableto set out explicitly what is assumed about the of optimality these other governmentpolicies ratherthan to leave hidden in implicit the traditionalformula.' theassumptionofcompleteirrationality Since the issue raised here concernsthe optimalityof trade restrictions, it should be noted that this is not the same issue discussed in the UNIDO guidelinesas to whetherthe weightingscheme used should reflectactual changes in consumptionor should reflectchanges that the government with would view as desirable. The formuladerived here is not in conflict the position taken in the UNIDO guidelineson this latter question.
Project analysis should in our view, reflect what will (or, more realistically, what is likely to) happen, not what ought to happen. The shadow price of foreign exchange thus depends on how increments of foreign exchange will be divided among alternative uses, not on the wishful thinking of the project analyst who perceives (or misperceives) the irrationality of the overall policy framework in which he operates. [7, p. 218]

While our argumentagrees that the actual or most-likely changes in consumption and production must be used, the project analyst should not system. Thus, in the ignorethe benefitsfelt to be achieved by the tariff an example is given where the shadow price of foreign UNIDO guidelines exchange is set very high because there is a large domestic-worldprice difference the luxurygood cognac and a large share of marginalforeign for exchange is directedtowards importsof this good. This gives rise to the
1 Several limitations to the above formula should be noted. These mainly involve of simplification the problem by ignoring (a) other qualificationsfor government-induced arguments,(b) other policy measures by which the price distortionssuch as optimal tariff might influenceconsumptionsand production decisions such as consumption government and productiontaxes and subsidies as opposed to trade taxes, and (c) the implications of non-traded commodities which would make the identificationof price distortionsmore complex.

T. J. BERTRAND

191

anomaly that foreign exchange is valued more highlythe greateris its use forimportswith very wide price divergencesresultingfromefforts the by governmentto restrictthese imports. In the formulation suggestedhere, the lower social valuation placed on consumptionof luxury goods underof lyingthe policy constraint (20) leads to a social discounting the consumption benefitsindicated by market prices by the amount of the optimal tarifft* which will correctlyreduce the social value of foreignexchange directedtowards these commodities. JohnsHopkins University
REFERENCES of current theories',Q.J.E., May 1971. 2. BALASSA, B., 'Estimating the shadow price of foreignexchange in project appraisal' (mimeo.,Oct. 1972). 3. BERTRAND, T. J., 'Decision rules for effectiveprotection in less developed
economies', A.E.R., Sept. 1972.

1.

BACEA,

E., and TAYLOR, 'Foreign L., exchange shadow prices:a critical review

4. ETHIER, W., 'Generalequilibrium theoryand the conceptofeffective protection' in Grubeland Johnson[eds.], Effective Protection Theory, Geneva, 1971. 5. HARBERGER, A., 'Survey of literatureon cost-benefit analysis for industrial project evaluation', in Evaluation of IndustrialProjects,New York, UJNIDO, 1968. 6. SCHYDLOWSKY, D., 'On the choice of a shadow price for foreignexchange', Guidelines Project Evalua7. UNIDO (P. Dasgupta, A. K. Sen, and S. Marglin), for tion,New York, 1972.
Harvard University Development Advisory Service, Economic Development Report No. 108, 1968.