AN EXPLORATION OF THE INTERDEPENDENCIES BETWEEN THE REAL EXCHANGE RATE AND

THE SIZE OF THE TRADABLE SECTOR IN A SMALL OPEN

ECONOMYZarzosa Valdivia Fernando and Pentecost Eric

Arnoldshain Seminar XI, University of Antwerp 2013

CONTENT Introduction: An Australian Model focused on the

structural real exchange rate (SRER=PT/PN) (and the economic structure?)

Microfounded Model: Assumptions SRER and the Tradable goods share in GDP

(Tshare): Inter-relationships and equilibrium relationships

Effects of exogenous shocks on the SRER and Tshare

Conclusions

INTRODUCTION: AN AUSTRALIAN MODEL

T

N

A

IA

0

SRERA

=

PT/PN

PPF

TA

NA

Salter-Swan Model:

Fundamentals: SRER-Ec. Structure

• TFPX, TFPM, TFPN

• K-L

• TT

• DS (debtss-transfers)

MICROFOUNDED MODEL: ASSUMPTIONS

Rational economic agents, CES Pref, Cobb-Douglas T, Linear N

Three goods: two tradable goods (Primary and Manufacturing) and one non-tradable goods

Two factors with a constant endowment: labour and capital Perfect factor mobility between sectors Exogenous debt service (interest payments) and transfers

to GDP, Exogenous terms of trade Perfectly competitive goods and factor markets

SRER AND TSHARES

0 Tshare

SRER

SRER0 E0

Tshare0

TshareC

, ,( ) ( )

DS DST TSRER d Tshare d DS

Larger Tshare, creates an excess supply of T excess demand for N, SRER

must diminish to switch expenditure from N-T and restore eq CA, Nmkt

SRER AND TSHARES

0 Tshare

SRER

SRER0 E0

TshareP

Tshare0

( ) ( )

ˆ ˆ (1 )

X M NX M X M

L K TT X TT M

d Tshare TFP TFP SRER TFP

L K TT

X M X MP X P M P X P MTshareGDP wL rK

SRER AND TSHARES

0 Tshare

SRER

SRER0 E0

TshareP

Tshare0

TshareC

, ,( ) ( )

DS DST TSRER d Tshare d DS

( ) ( )

ˆ ˆ (1 )

X M NX M X M

L K TT X TT M

d Tshare TFP TFP SRER TFP

L K TT

SRER AND TSHARES

0 Tshare

SRER

SRER0 E0

TshareP

Tshare0

TshareC

, ,( ) ( )

DS DST TSRER d Tshare d DS

( ) ( )

ˆ ˆ (1 )

X M NX M X M

L K TT X TT M

d Tshare TFP TFP SRER TFP

L K TT

Neary and Purvis (82)

Rodrik (2008) and

van der Ploeg (2010,2011)

SectorProductivity

TransfersDevelopment

Models

SRER AND THE TSHARE RESPONSES TO SHOCKS

Exogenous shocks Linkages

Variables

Sector TFP shocksFactor

endowmentsTerms of

trade

Debt service minus

transfersPrimary Manu-

facturingNon-

tradables

TFPX TFPM TFPN L K TT DS SRER Tshare

SRER + -Tshare + + + - - ?+ +SRER - - + + + ?- +Tshare + + - - - ?+ +Xshare + - - ? ? + +Mshare - + - ? ? - +The first two rows correspond to the relationships of the TshareC and TshareP lines, respectivelyThe third and fourth row are the equilibrium relationshipsThe last two rows shows the response of the equilibrium share in GDP of the primary and manufacturing sectors to exogenous shocksA “+” indicates a positive effect, a “-” a negative one and a “?” an ambiguous effect; signs in subscripts are valid relationships when TT improvements appreciate the SRER

Dutch Disease

SRER, TSHARE AND TFPX

0Tshare(=θT

)

SRER

θT0

SRER0

TshareP

E0

θTd0

TshareC

d X M

X M N

P X P MTshareP X P M P N

θTd0 T X M T X M T( ) (1 ) (1 )d

X M Nd Tshare TFP TFP TFP TT SRER

SRER, TSHARE AND TFPX

0

E01

Tshare(=θT

)

SRER

θT0

SRER0

TshareP

(TFPX0)

EPE+

E0 E02

θT01 θT02θT1

SRER1

RME+

θTd0

(X0)

E1

θTd01

(X01)

θTP

(TFPX1)

TFPX1 >TFPX0

SE-TE+

TshareC

01 0 (1 )XX X TFP

d X M

X M N

P X P MTshareP X P M P N

θTd0

is derived from

SRER, TSHARE AND FACTOR ENDOWMENTS (L)

0

SRER

θT02

SRER0

TshareP(L1)

E02

E0

θT0θT1

SRER1

RME-

θTd0

E1 TshareP(L0)

L1 >L0

SE+ TE-

TshareC

Tshare(=θT

)

SRER, TSHARE AND TERMS OF TRADE (TT)

0

E01’

Tshare(=θT)

SRER

θT0

SRER0

TshareP

(TT0)

EPE+

E0

E02

θT01 θT02θT01’

SRER01

E1

TshareP

(TT1) case

(a)

TT1 >TT0

RME+

SE-TE+

E01

PE+

θT1

SRER1

TshareC

θTd0

(TT0)

E02’

E1’

θT02’θT1’

RME-SE-

TE-

TshareP

(TT1) case (b)

Case (a)

Case (b)

SRER1’

SRER, TSHARE AND DEBT SERVICES-TRANSFERS (DS)

0

E1

Tshare(=θT)

SRER

θT1

SRER0

E0SRER1

E02

θT0

DS1 < DS0

θT02

TshareP

TshareC

(DS0)

TshareC

(DS1)

EME-

SuE+ SE-=TE-

θTd0

EFFECTS OF EXOGENOUS SHOCKS IN AN ECONOMY

Extraordinary Profits effects

Price effects

Resource Movement

effects

Expenditure Movement

Effect

Substitution Effects

Spending effects

Total Effects

Tradable share SRER

TFPX + + - + Inc. App.

TFPM + + - + Inc. App.

TFPN - - + - Dim. Dep.

TT + ++ - + Inc. App.

- + - Dim. Dep.

DS + - + + Inc. Dep.

A plus (minus) indicates that the corresponding shock increases (decreases) the tradable shareInc. and Dim. indicates that the tradable share increases or diminishes, respectivelyApp. and Dep. refer to appreciation and depreciation, respectively

CONCLUSIONS

Theoretically: SRER, Tshares are simultaneous determined

Role of Fundamentals: TFPs, L-K, TT, DS; ∆TT and ▼DS may give rise to the Dutch Disease

Measuring resource allocation as the change in the Tshare, the EPE, PE, EME, RME, SuE, SE of exogenous shocks are identified and distinguished

THANK YOUBEDANKT!

AN AUSTRALIAN MODEL: TFPT

T

N

A

IA

0

SRERC

SRERA

SRERA

PPF

PPF’

B

C

TA TB TD

IB

NA =NB

TC

DND

NC

AN AUSTRALIAN MODEL: EFFECTS

T

N

A

IA

0

SRERC

SRERA

SRERA

PPF

PPF’

B

C

TA TB TD

IA

NA =NB

TC

DND

NC

EPE RME

SE

TE

NC N

T*

T T

N N

P SPSRERP P

TC

Structural real exchange rate (SRER)

*T TP SP

Universidad

Nacional de Córdoba

NC N

T*

T T

N N

P SPSRERP P

TC

SRER and RERPPP

**PPP

SP SRERRER fP SRER

Domestic

ForeignGoods

exogenous

Theoretical Microfounded Model: Main Relationships

Producers assumptions

Consumers Assumption

No consumersdecisions

Consumers: CES Preferences

Determinants Cobb-Douglaspreferences

No producers decisions

T and N goods are endowed SRER model only

Goods endowments, TT, CAMRDF

Goods endowmentvariations equal to sector

TFPs changesSRER model only Sector TFPs, TT,

CAMRDF

Producers

Cobb-Douglas technology in the T sectors

Linear technology in the N sector

SRER model only (assuming

constant Tradable shares)

Sector TFPs, factor

endowments, TT, CAMRDF

Linear technolgoy in the N sector

SRER-Tradableshare

interdependences

Sector TFPs, factor

endowments, TT, CAMRDF

SRER model only (‘variable tradable

share’)

CES technolo-gy in the N sector

Flexible RFPs

SRER-RFPsinterdependences

plus SRER-Tradable shares

interdependences

Sector TFPs, factor

endowments, TT, CAMRDF

SRER-RFPsinterdependences

RFPs Rigidities

SRER-uinterdependences

plus SRER-Tradable shares

interdependences

Sector TFPs, capital

endowments, TT, CAMRDF

SRER-u interdependences

T= Tradable goods (sector), N= Non-tradable goods (sector), SRER= Structural real exchange rate, RFP= Relative factor prices, u= unemployment rate, TFP= Total factor productivity, TT= terms of trade and CAMRDF= -Debt obligations

ARGENTINA TODAY:

SRER(log(100-u))

0Tshare

SRER

SRER0E0GM

L(SRER)

TshareP

log(100-u)L0

E0GE

Tshare0

TshareC

(SRER)

ProducedRequired

Dollars required to correct

the current account

L1L2

Unemployment

expected

12

Real Depreciation required (▼PN or devaluation) or Productivity, Inv, ▼ gov.spending that falls in non-tradables

ˆ ˆ ˆ* 0

ˆ 0ˆˆ 0

PPPRER S P P

SRERP S

A212

SRER1

ARGENTINA TODAY:

SRER(log(100-u))

0Tshare

SRER

SRER0E0GM

L(SRER)

TshareP

log(100-u)L0

E0GE

Tshare0

TshareC

(SRER)

ProducedRequired

Dollars required to correct

the current account

L1L2

Unemployment

expected

12

Real Depreciation required (▼PN or devaluation) or Productivity, Inv, ▼ gov.spending that falls in non-tradables

Aggravate

US$: reserve

ˆ ˆ ˆ* 0

ˆ 0ˆˆ 0

PPPRER S P P

SRERP S