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Lecture Notes ECON 437/837: ECONOMIC COST-BENEFIT ANALYSIS Lecture Seven

Lecture Notes ECON 437/837: ECONOMIC COST-BENEFIT ANALYSIS Lecture Seven. Economic Cost of Foreign Exchange (EOCFX) and Shadow Price of Non-Tradable Outlays (SPNTO). Definition of EOCFX and SPNTO.

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Lecture Notes ECON 437/837: ECONOMIC COST-BENEFIT ANALYSIS Lecture Seven

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  1. Lecture Notes ECON 437/837: ECONOMIC COST-BENEFIT ANALYSIS Lecture Seven

  2. Economic Cost of Foreign Exchange (EOCFX) and Shadow Price of Non-Tradable Outlays (SPNTO)

  3. Definition of EOCFX and SPNTO • These variables (EOCFX and SPNTO) are estimated to measure the value of the distortions created when funds are sourced in the capital market and used to purchase either tradable goods, or non-tradable goods. • These actions are repeated many times for each project and are identical for such actions across projects. • It is efficient to estimate these variables once for a country and use the same values repeatedly as needed. • To make the estimates we do not include the specific distortions on the particular tradable or non-tradable good. These effects are included when we estimate the economic cost of the specific item.

  4. Estimation of EOCFX and SPNTO under two situations: • Project already has raised funds (e.g. foreign aid) and spends them on tradable and non-tradable goods. • Project raises funds in capital markets and spends funds on tradable and non-tradable goods

  5. Economic Cost of Foreign Exchange • When the values for the tradable inputs and outputs are expressed in units of domestic currency at the domestic price level, the foreign exchange effect of the change in the demand (or supply) of tradable commodities must be converted into domestic currency. • Conversion should take place at the “shadow exchange rate”, or economic price of foreign exchange (Ee). • If there are no distortions on the demand or supply of tradable goods, and if the exchange rate is determined by market forces, then the economic price of foreign exchange is equal to the market exchange rate (Em).

  6. Economic Cost of Foreign Exchange with Distortions (cont’d) Partial Equilibrium Model: Distortions that affect international trade are considered, but no account is made for how purchase of foreign exchange is financed. • Trade Distortions: These distortions will change the demand and/or supply of foreign exchange such that the market exchange rate no longer measures the economic price of foreign exchange. For example, • Tariffs:lower the market demand for foreign exchange and cause Em to be less than Ee • Export Taxes:Decrease the market supply of foreign exchange and cause the Em to be greater than Ee • Export Subsidies: Increase the market supply of foreign exchange and cause the Em to be less than Ee • Indirect taxes: This will impact the demand and supply of both tradable and non-tradable goods • Value added taxes • Excise taxes

  7. All goods are divided into three types: 1. Importable 2. Exportable 3. Non-Tradable Goods • Importable and exportable goods are referred to as tradable goods. • Prices of tradable goods are determined by international markets and expressed in units of a foreign exchange currency. • Domestic prices of such goods are determined by multiplying the internationally given import price PwI or theexport pricePwE by the market exchange rate EM, i.e. PDI =EMPwI, PDE=EMPwE

  8. As the world prices of these goods are fixed, their domestic prices, and the quantity domestically demanded or domestically supplied of these goods will depend on the real exchange rate. • These quantities can be expressed in units of foreign exchange. • Importable and exportable goods can be aggregated to make market for tradable goods. • Equilibrium in tradable goods market also means that there is equilibrium in foreign exchange market. • This market will determine the country’s real exchange rate.

  9. Demand for Tradable Goods • Equals demand for importable goods plus demand for exportable goods Demand for ImportableDemandfor Exportable Demand for Tradable Goods Goods Goods EMEM EM DT =DI+DE DI DE Q (FX) Importable Q (FX) Exportable Q (FX) Traded • Because the world price of importable and exportable goods are given to country, the demand for tradable goods is a function of the real exchange rate.

  10. Supply of Tradable Goods • Equals domestic supply of importable goods plus domestic supply of exportable goods. Domestic Supply ofDomestic Supply of Domestic Supply of Importable Goods Exportable Goods Traded Goods EM SI EM SE EM ST=SI+SE EM0 EM0 EM0 DT QSI QSE QST Q(FX) Importable Q (FX) Exportable Q (FX) Tradable Exchange rate is determined by the demand and supply of tradable Goods. QDT = QST

  11. Demand for Foreign ExchangeAn equivalent way to see how the exchange rate is determined as to draw the demand for imports and supply of exports Importable Market Demand for Imports P SImportable EM _ EM0EM0 EM1DImportable E1 DM QIS Import QID Importable(QFx)QFXD The demand for imports = Demand for importable goods - Supply of importable goods Demand for Foreign Exchange = Demand for Imports QFxD = QID - QIS

  12. Supply of Foreign Exchange Exportable Market Imports and Exports PSExportable SX EM0 EM1 E1 DM DExportable QED Export QES Exportable(QFx) QFXD/S QFxS = QES - QED = Supply of Foreign Exchange = Supply of Exports = SX

  13. Total Economy = Market for Tradable Goods plus Market for Non-Tradable Goods Tradable Goods Non-Tradable Goods EM ST SNT E0 PNT DT DNT QT0 Q(FX) QNT0 • Given the amount of capital and labor in country, GDP = Quantity Supplied of Tradable goods + Quantity Supplied of Non-tradable goods. • Price of non-tradable goods is fixed as the numeraire price in the economy, real exchange rate becomes the relative price of tradable to non-tradable goods. • Market equilibrium is determined by the relative prices. • Changes in exchange rate will cause the demand and supply of non-tradable goods to shift. This is the relative price effect on demand for a good.

  14. Full Employment and Equilibrium in Tradable and non-Tradable Goods Markets Tradable Goods Non-Tradable Goods EM ST0 SNT E0 PNT DT0 DNT QT0 Q(FX) QNT0 GDP = QT0 + QNT0 Full Employment Think of tradable goods and non-tradable goods as two large composite goods QST = QDT QSNT = QDNT

  15. Equilibrium in Foreign Exchange Market Importable Exportable Market for Foreign Exchange EM SISX SE E0 DI DE DX QSI QDI QDE QSE QFX0 ImportExport • Equilibrium in tradable goods market and foreign exchange market. QDI + QDE = QDT, QSI + QSE = QST • In equilibrium, QDT = QST • Hence, QDI+QDE= QSI+QSEQDI-QSI = QSE-QDE Imports = Exports

  16. Exchange Rate: # of units of domestic currency per unit of Foreign Exchange S0fex Ee=Em D0fex Q0 Quantity of foreign exchange US$ Em= Market Exchange Rate Ee= Economic Exchange Rate S0fex = Supply of foreign exchange as derived from supply of exports D0fex = Demand for foreign exchange as derived from demand for imports Ee = Ws*Em + Wd*Em as Ws +Wd = 1 then Determination of Market Exchange Ratewith No Distortions Ee = Em

  17. Exchange Rate • Case One: Funds available to purchase foreign exchange • Import Tariff = Tm S0 E0m(1+Tm) m1 E E m0 Dt+project D0 Dt (net of tax) Quantity of Foreign Exchange Traded d1 s1 Q Q0 Q Ee = Ws * Em +Wd * Em(1+Tm) Determination of Exchange Rate with Import Tariff

  18. m1 E E m0 Determination of Exchange Rate with Export Subsidy Exchange Rate • Case Two: • Export Subsidy = kx S0 S0+export subsidy E1m(1+kx) E0m(1+kx) D0 + Project D0 Quantity of Foreign Exchange Traded s1 d1 Q Q0 Q Ee = Ws*Em*(1+kx)+ Wd*Em

  19. Exchange Rate • Case Three: • Export Tax = tx S0+export tax S0 m1 E E1m(1-tx) E m0 E0m(1-tx) D0 + Project D0 Quantity of Foreign Exchange Traded s1 d1 Q Q0 Q Ee = Ws*Em*(1-tx)+ Wd*Em Determination of Exchange Rate with Export Tax

  20. Case Four • Current Account in Equilibrium • Import Tariff = Tm • Export Tax = tx Exchange Rate A B Tariff St S m1 E Export Tax L E m0 J D H G F Dp Dt s1 Q Quantity of Foreign Exchange Traded d1 Q Q0 Ee = Ws*Em*(1-tx) + Wd*Em*(1+Tm) Determination of Exchange Rate with Import Tariff and Export Tax

  21. S A B J L K N H D m1 m0 E E M G DP F Dt s0 s1 d1 d0 Q Q Q Q Determination of Exchange Rate with Distortions and Capital Flows Exchange Rate • Case Five: • Balance of Payments Deficit Sustained through Capital Inflows • Import Tariff = Tm • Export Tax = tx St Quantity of Foreign Exchange Traded Ee = Ws*Em*(1-tx) + Wd*Em*(1+Tm) Conclusion: No change in basic estimation procedure.

  22. s = s - d * (Qd/Qs) Ws - d * (Qd/Qs) = s - d * (Qd/Qs) Wd Economic Price of Foreign Exchange Trade Distortions • An increase in demand for imported inputs will cause a (slight) depreciation in the domestic currency, which in turn will cause a reduction in imports and an increase in exports. • The economic value of the foreign exchange required by a project is determined by the economic values of the forgone imports and increased exports. Example: The main trade distortions are tariffs on imported goods and taxes on exports. The economic price per unit of foreign exchange is Ee = Ws*Em*(1-tx) + Wd*Em(1 + Tm) Where Ws = The proportion of an extra unit of foreign exchange that is met by an increased supply of exports: Wd = The proportion of an extra unit of foreign exchange that is met by a reduction in other imports:

  23. FEP = Calculation of Foreign Exchange Premium Under Special Conditions If the elasticity of foreign exchange supply (s) is equal to the elasticity of foreign exchange demand (d): s = - d Then, a simple way to calculate the foreign exchange premium is: Tariff Revenues + Export Subsidies - Export Taxes Value of Imports + Value of Exports

  24. Application of Foreign Exchange Premium • To value tradable goods at economic prices, the CIF prices of importable goods, or the FOB prices of exportable goods should be converted into domestic prices using the economic exchange rate (Ee). In financial analysis: PfI = EmPwI, PfE = EmPwE In economic analysis: PeI = EePwI, PeE = EePwE • Alternatively, this valuation at economic prices can be achieved by adding a foreign exchange premium [(Ee/Em) - 1] per unit of foreign exchange demanded (or supplied) by a project.

  25. Premia for Foreign Exchange and Non-Tradable Outlays-- A General Equilibrium Analysis -- Introduce Project Financing • Project funds come from capital market • Project costs 600 • Funds obtained from the capital market for our project displace 600 of other demands • Assume reduction in other demand is a reduction of 400 in tradable demand and a reduction of 200 in non-tradable demand.

  26. Premia for Foreign Exchange and Non-Tradable Outlays (cont’d)-- A General Equilibrium Analysis -- Four alternative scenarios: • Project funds borrowed domestically and spent on tradable goods; • Project funds borrowed abroad and spent on tradable goods; • Project funds borrowed domestically and spent on non-tradable goods; • Project funds borrowed abroad and spent on non-tradable goods.

  27. Tradable Goods Markets-- Case A: funds borrowed domestically and spent on tradables -- B. Non-tradable Goods A. Tradable Goods

  28. Foreign Exchange Markets Importable Exportable Market for Foreign Exchange

  29. Case B: Funds Borrowed from Abroad and Spent on Tradables Step 1: No impact on domestic capital market due to borrowing from abroad Step 2: More foreign exchange to purchase tradable goods for project Tradable Goods Non-Tradable Goods E Step 2 Step 1 600 PNT E0 Q Supply of tradable goods (foreign exchange) increased by 600, Demand for foreign exchange increased by 600 with the Project. No Impact on Non-Traded

  30. Market for Foreign Exchange No change in exchange rate as change in demand for FX of 600 is offsetted by additional supply of FX of 600. Step 2 Step 1 600

  31. Tradable Goods Markets-- Case C: funds borrowed domestically and spent on nontradables -- Tradable Goods Non-Tradable Goods Assumption that |TD| =1.5 TS

  32. Foreign Exchange Markets 300 100 200 200 Assumption that |ID| = xS

  33. T0s T1s 600 T0d 360 240 Case D: Funds Borrowed from Abroad and Spent on Nontradables • More foreign exchange available in the economy • Impact on exchange rate Tradables Non-Tradables E E NT0s NT1s 600 PNT E0 E2 NT1d Change in demand for tradable goods is increased by 360, change in demand for non-tradable goods is decreased by 360. 240 360 NT0d Q NT2d Q0T Q Assumption is that |TD| = 1.5 TS

  34. Market for Foreign Exchange E X0s X1s 600 E0 E2 M0d 300 300 Q0T QFX 600 excess supply of FX from foreign borrowing results in falling real exchange rate to E2. This will cause the demand for imports to rise by 300 and the supply of export to fall by 300. Assumption that |ID| = xS

  35. TABLE 3 CALCULATION OF SHADOW PRICE OF NONTRADABLES OUTLAYS 600 of Project Funds Sourced Abroad And Spent on Non - Trad ables t m v t t v m h t Applicable v e m t is Distortion Alone v e h ia Change Due To (exclusion for Capital Market investment Sourcing e = 0.75) n.a. n.a. n.a. is Change Due To Real (exclusion for Exchange Rate investment Adjustment e = 0.33) ia Tradables Demand +360 v = .2 n.a. +72 +48 t Tradables Supply - 240 - n.a. n.a. t Import Demand +300 = .12 +36 +36 +36 m Export Supply -300 - n.a. n.a. Nontradables Demand - 360 v = .05 n .a. - 18 - 12 h Nontradables Supply +240 - n.a. n.a. Total Distortion Costs ( - ), +36 +90 +72 Benefit (+) Distortion Cost/ Project Expend. - .06 - .15 - .12 = Premium on Nontradables Outlays Shadow Price of Nontradable Outlays 0.94 0.85 0.88

  36. A Case of South Africa • A General Equilibrium Analysis • Take into account: - project funds sourced from the capital market (62.5% from displaced investment, 11.5% from household saving and 26.0% from foreign savings). - all distortions in import tariff, subsidy, value-added tax, and other indirect taxes.

  37. Table 2 Externalities Generated from Project Funds Sourced from Domestic Markets and Spent on Importables g and Spending Importables Exportables Non Capital Sourcin - Traded Domestic funds a) Project Demands for Importables +100.0 Displacement (K - Market) - 39.0 - 24.0 - 37.0 Effect of Real Exch Rate on Demand - 8.4 - 6.9 +15.3 Effect of Real Exch Rate on Supply +7.6 +14.1 - 21.7 Excess Deman d for Goods +45.0 - 45.0 0 -8.21% Total Distortion Costs: Import Tariffs = (45 - 100)*3.6% = - 1.98% Production Subsidies = - (-45)*0.6% = + 0.27% VAT = [( - 39 - 24)*0.156 + ( - 8.4 - 6.9)*0.804]*11.36% +[( - 37)*0.156 + (15.3)*0.804]*6.54% = - 2.09% Other Indirect Taxes = ( - 39 - 24 - 8.4 - 6.9)*5.63% = - 4.41%

  38. Premia on Tradables and Non-tradables in South Africa (Percentage) Funds Drawn from Funds Spent Funds Spent on Tradableson Non-Tradables Domestic Capital Source 8.21 3.06 Foreign Capital Source 0 - 5.15 Capital Market Weights 6.08 0.93 (D: 74%, F: 26%)

  39. Estimates of FEP and NTP for African Countries

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