Updated: Nov. 29.,2006 Lecture Notes ECON 622: ECONOMIC COST-BENEFIT ANALYSIS Lecture Seven

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Updated: Nov. 29.,2006

Lecture Notes

ECON 622: ECONOMIC COST-BENEFIT ANALYSIS

Lecture Seven

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Cost of Foreign Exchange (EOCFX) and Shadow Price of

Non-Tradable Outlays (SPNTO)

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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

(EOCFX), or non-traded goods (SPNTO).

• These actions are repeated many times for each project and are

identical for such actions across projects.

• It is efficient and to estimate these variables once for a country and

use the same values repeatedly as needed.

• To make the estimates general we do not include the specific

distortions on the particular traded or non-traded good. These

effects are included when we estimate the economic cost of the

specific item.

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Estimation of Economic Exchange Rate and Premium of Foreign Exchange under two situation:

1. Project already has raised funds e.g. foreign aid and spends them on traded goods.

2. Project raises funds in capital markets and spends funds on

a. Traded goods (Premium of Foreign Exchange)

b. Non-traded goods (Shadow price of non-traded outlays (SPNTO))

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• When the numeraire is the 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).

Cases:

1. Market Exchange Rate

• 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).

Economic Cost of Foreign Exchange

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2. Trade Distortions

– Trade 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

3. Indirect taxes will impact the demand and supply of both traded and non-

traded goods

- Value added taxes

- Excise taxes

Economic Cost of Foreign Exchange (Cont’d)

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• All goods are divided into three types:

1. Importable

2. Exportable

3. Non-traded 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 PIw or the export price PE

W by the market exchange rate EM i.e. PD

I =EMPIw, PD

E=EMPEw

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• As the world prices of these goods are fixed their

domestic prices, and the quality domestically demanded

or domestically supplied of these will depend on the real

exchange rate (inflation =0)

• Their quantities can be expressed in units of foreign

exchange.

• Importable and Exportable goods can be aggregate to

make market for tradable goods.

• This market is also the market for Foreign Exchange.

• This market will determine the country’s real exchange

rate.

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Demand for Traded GoodsEquals Demand for Importable Goods plus Demand for Exportable Goods

Demand for Importable Demand for Exportable Demand for Traded

Goods Goods Goods

EM EM EM

DT=DI+DE

DI DE

Q (FX) Importable $FX Q (FX) Exportable $FX 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.

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Supply of Traded Goods

Equals Domestic Supply of Importable Goods plus Domestic Supply of Exportable Goods

Domestic Supply Importable Domestic Supply Exportable Domestic Supply Traded

Goods Goods Goods EM S I EM SE EM ST=SI+SE

EM0 EM

0 EM0 DT

QSI QS

E QT Q(FX) Importable Q (FX) Exportable Q (FX) Tradable

Exchange rate determined by the demand and supply of tradable Goods

QDT=QS

T

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Demand for Foreign Exchange

An 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

_

EM0 EM

0

EM1 DImportable E1 DM

QIS Import QI

D Q Importable(QFx) QFXD

The demand for imports=Demand for importable goods-Supply of importable goods

Demand for Foreign Exchange=Demand for Imports

QFxD=QI

D-QIS

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Supply of Foreign Exchange

Exportable Market Imports and Exports

P SExportable

SX

_

EM0

_

EM1 E1

DM

DExportable

QED Export QE

S Q Exportable(QFx) QFXD/S

QFxS=QE

S-QED=Supply of Foreign Exchange =Supply of Exports=SX

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Total Economy=Market for Tradable Goods plus Market for Non-Tradable Goods

Tradable Goods Non-Tradable Goods

EM ST SNT

E0 PNT

DT DNT

QT

0 Q(FX) QNT0

• Because there is a given amount of capital and labor in country, GDP=Quantity Supplied of Tradable goods + Quantity Supplied of Non-tradable goods.

• Price of non-traded goods is fixed as the numeraire price in the economy (market equilibrium determined by relative prices).

• Real Exchange rate determined in traded goods market.• Real Exchange rate is the relative price of Traded to Non-Traded Goods.• Changes in exchange rate will cause the demand and supply of Non-Traded goods to

shift. This is the relative price effect on demand for a good.

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Full Employment and Equilibrium in Tradable and non-Tradable Goods Markets


EM ST0 SNT

E0 PNT

DT0 DNT

QT0 Q(FX) QNT

0

GDP=QT0+QNT

0 Full Employment

Should think of tradable Goods and Non-Tradable Goods as two large composite goods

QST=QD

T QSNT=QD

NT

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Economic Equilibrium

Importable Exportable Market for Foreign Exchange

EM SI SX

SE

E0

DI

DE DX

QSI QD

I QDE QS

E QFX0

Import Export

Equilibrium in Traded goods market also means that there is equilibrium in foreign exchange market.

QDI +QD

E =QDT

QSI+QS

E=QST

In equilibrium QDT=QS

T

Hence QDI+QD

E=QSI+QS

E QDI-QS

I=QSE-QD

E Imports=Exports

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Determination of Market Exchange RateNo Distortions

Exchange Rate: # of units of domestic currency per unit of Foreign Exchange

Quantity of foreign exchange US$

Ee=Em

S0fex

D0fex

Q0

Ee=Em

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

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Case One: Project already has funds from Foreign aid

• Import Tariff = Tm

Quantity of Foreign exchange Traded

Q0

D0

d1 QQ

Dt (net of tax)

s1

Dt+ project

m1Em0

E

S0

Exchange Rate

E0m(1+Tm)

Ee = Ws * Em +Wd * Em(1+Tm)

Determination of Exchange Rate with Distortions

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Case Two:• Export Subsidy = kx

D0

S0

S0+export subsidy


Exchange Rate

D0 + Project

Q0

s1QQ

d1

m1Em0

E

E0m(1+kx)

E1m(1+kx)

Ee = Ws * Em * (1+kx) + Wd*Em


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Case Three:• Export Tax = tx

D0

S0+export tax

S0


Exchange Rate

D0 + Project

Q0

s1QQ

d1

m1Em0

E

E0m(1-tx)

E1m(1-tx)

Ee = Ws * Em * (1-tx) + Wd*Em


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Case Four• Market Determined Exchange rate • Current Account in Equilibrium• Import Tariff = Tm

• Export Tax = tx

Ee = Ws *Em * (1-tx) + Wd * Em * (1+Tm)


Q0

D

d1

Q

Dt

G

F

Tariff

L

J

Export Tax

Qs1

Dp

m1Em0

E

St S

Exchange Rate

AB

H


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Determination of Exchange Rate with Distortions and Capital Flows

Case Five:

• Market determined Exchange Rate

• Balance of Payments Deficit Sustained through Capital Inflows

• Import Tariff = Tm

• Export Tax = tx

Ee = Ws * Em * (1-tx) + Wd * Em * (1+Tm)

Quantity of Foreign Exchange Traded

Conclusion: No change in basic estimation procedure.

St

Exchange Rate

H

Q

A

d1QQ

Dt

G

D

L J

s1

S

s0

F

K

MDP

B

Qd0

m1Em0E

N

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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:

s

s - d * (Qd/Qs)=Ws

s - d * (Qd/Qs)

- d * (Qd/Qs)=Wd

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Calculation of Foreign Exchange Premium

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 ExportsFEP =

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Example for Indonesia (1991)

The Economic Cost of Foreign Exchange is calculated as follows:

Where:Ee = Economic exchange rateEm = Market exchange rate = 1,950.3 Rp/$1.0Ws = Weight on supply = 0.33Wd = Weight on demand = 0.67t x

adj = Weighted average rate of tax on price-responsive exports = 0.00157Tadj = Weighted average rate of tariff on price-responsive, non-re-

exported imports = 0.0919Therefore,Ee = 0.33 * 1,950.3 * (1-0.00157) + 0.67 * 1,950.3 * (1+0.0919) = 2,069.38Foreign Exchange Premium (FEP) = Ee/Em - 1 = 0.061

Note: The market exchange rate is obtained from International Financial Statistics, October 1992. Data for oil and non-oil imports and exports, and for re-exported imports, are from the Central Bureau of Statistics. Data for government imports are from the Quarterly Report of Balance of Payment, April 1992, Central Bank of Indonesia. Data for import duty and export tax are obtained from Ministry of Finance, Nota Keuangan 1992/93.

Ee = Ws * Em* (1 - t xadj) + Wd * Em * (1 + Tadj)

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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).

• 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.

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Economic Cost of Foreign Exchange

Step1: Project Borrow 600 from Domestic Capital Market


EM ST0 SNT

400 200

E0 PNT

DT1 DT

0 DNT1 DNT

0

QT0 Q(FX) QNT

0

Assume: Demand for tradable goods is reduced by 400 and demand for Non- traded by 200. Total borrowing funds =Total reducing in demand for goods and services.

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Step 2: Borrowed funds used to purchase 600 of traded goods


ST

0 SNT0

Eu

E0M PNT

DT2

DT DT

0 DNT1 DNT

0

QT1 QT

0 QT2 Q(Fx) QNT

1 QNT0

Suppose all 600 is spent on Traded goods hence demand for Traded good shift from DT1 to

DT2 .At the exchange rate of E0 there is now an excess demand of traded goods of QT

2-QT

0 or 200 and in the Non-traded goods market there is an excess supply of Non-traded goods of QNT

0-QNT1 or 200

600

400 200200

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Step 3: Exchange rate rises to E11 to reduce excess demand in Tradable goods market and excess supply in Non-Tradable goods market.


EM SNT1

ST0 SNT

0

E1

E0 PNT

80 120 DT2 120 80

DT1 DT

0 DNT

1 DNT2 D

NT0

QT

0 QT1 Q(FX) QNT

1QNT2QNT

0

Final Impact: Reduction in Tradable goods demand 400+120=520

Reduction in Non-Tradable goods demand 200-120=80

400 200

Assumption is that |TD| = 1.5 T

S

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Step 1:Equilibrium in Market for Foreign Exchange

Importable Exportable Market for Foreign Exchange EM SI SX

0

SX

1

300 100 300 100

E0 DI

0

DI1 DE

0 DM0

DE1 DM

1

QSIQDI

1 QDI0 QDE

1QDE0 QS

E QFX0

Imports Exports

Reducing in demand for Traded goods of 400 is assumed to reduce demand

for importable goods of 300 and a reduction in demand for exportable goods

by 100. Hence, reduction in demand for traded goods of 400 gets translated

into a reduction of demand by imports of 300 and an increase in supply

exports of 100.

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Step 2: Equilibrium in Market for Foreign Exchange

With the purchase of 600 of Traded goods (importable) there is an excess

demand for foreign exchange of QFxD-QFx

S or 200. Hence exchange rate must rise

to E1. This will cause the supply of export to increase by 100 and the demand for

import to decrease by 100.

Assumption that |ID| = x

S

100100

600

300 100

1E

0E

E XS0XS1

MD0

MD2MD1FXQ0

FXSQ

FXQ1FXDQ

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Financing of a Project by Borrowing from Abroad and Using Funds to Buy Traded Goods

Step 1: No impact on consumer demand due to borrowing from Abroad Step 2: More Foreign Exchange to purchase traded goods for Project

600

E

E0

Q

TS0 TBS 0

TD0

TPD 0

TQ0TQ1

Step 1Step 2

PNT

NTS0

NTD0

NTQ0

Traded Goods Non-Traded Goods

Change in supply of traded goods (foreign exchange) increased by 600 and Change in demand for foreign exchange increased by 600 with the Project

No Impact on Non-Traded

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Market for Foreign Exchange

600

FXS0 FXS1

FXMD

PFXMD

0Q 1Q

Step 1Step 2

FXQ

0E

E

No change in exchange rate as change in demand for FX

of 600 is offsetted by additional supply of FX of 600

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TABLE 1 CALCULATION OF ECONOMIC OPPORTUNITY COST OF FOREIGN EXCHANGE

600 of Project Funds Sourced in Capital Market And Spent on Tradables m

vt

m vh

Applicable m vt eis

Distortion Alone vh eia

Change Due To (exclusion for Capital Market investment Sourcing eis = 0.75)

Tradables Demand -400 vt = .20 n.a. -80 -20

Import Demand -300 m = .12 -36 -36 -36

Export Supply +100 - n.a. n.a. n.a. Nontradables Demand -200 vh = .05 n.a. -10 -2.5

Change Due To Real (exclusion for Exchange Rate investment Adjustment eia = 0.33)


Tradables Supply +80 - n.a. n.a. Import Demand -100 m = .12 -12 -12 -12

Export Supply +100 - n.a. n.a. Nontradables Demand +120 vh = .05 n.a. +6 +4

Nontradables Supply -80 - n.a. n.a. Total Distortion Costs (-), -48 -156 -82.5 Benefit (+) Distortion Cost/ Project Expend. .08 .26 .1375 = Premium on Tradables Outlays EOCFX/ 1.08 1.26 1.1375 Market Exchange Rate

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Estimation of Shadow Price of Non-Tradable Outlays (SPNTO)Financing of Project by Borrowing from Domestic Capital Market and

Used to Purchase Non-Traded Goods

Step 1: Projects Borrows 600 from Domestic Capital Market

400

E

QFX

TS0

TD1

TD0

TQ0

PNT

NTS0

NTD0

NTQ0


0E

200

NTD1

Assume: Demand for tradable goods is reduced by 400 and demand for Non-traded by 200. Total borrowing funds =Total reducing in demand for goods and services.

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Step 2: Borrowed Funds from Domestic Capital Market Used to Purchase 600 of Non-Traded Goods

400

E

QFX

TS0

TD1

TD0

TQ0

PNT

NTS0

NTD0

NTQ0


0E

200

NTD1

NTD2

400

NTQ1NTQ2

600

Suppose all 600 is spent on Non-Traded goods. Hence demand for Non-Traded goods shifts from D1

NT to D2NT. At an exchange rate of E0

M there is an excess supply of Traded goods of 400 (Q0

T-Q1T) and an excess demand for Non-

Traded goods of 400 (Q2NT-Q0

NT) .

TQ1

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Step 3: Exchange Rate Falls to Increase Demand for Traded Goods and Reduce Supply of Traded Goods Tradable Goods

400

E

QFX

TS0

TD1

TD0

TQ0

PNT

NTS0

NTD0

NTQ0


0E

200

NTD1

400

NTQ1NTQ2TQ1

240 160 160 240

NTS1

NTQ3

NTD2

NTD3

Final EquilibriumDemand for traded goods has decreased by - 400 + 240 = -160Demand for non-traded goods has decreased by -200 - 240 = -440 Total= -600

2E


S

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Step 1:Equilibrium in Market for Foreign Exchange Markets

Importable Exportable Market for Foreign Exchange EM SI SX

0

SX

1

300 100 300 100

E0 DI

0

DI1 DE

0 DM0

DE1 DM

1

QSIQDI

1 QDI0 QDE

1QDE0 QS

E QFX0

Imports Exports

Reducing in demand for Traded goods of 400 from 600 of raising funds in

capital market is assumed to reduce demand for importable goods of 300 and

a reduction in demand for exportable goods by 100. Hence, reduction in

demand for traded goods of 400 gets translated into a reduction of demand by

imports of 300 and an increase in supply exports of 100.

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Step 2:Equilibrium in Market for Foreign Exchange Markets

100300

MD0

MD1

200 200

FXQ0

2E

0E

XS1

XS0


With the purchase of 600 of non-traded goods there is an excess supply of 200 of foreign exchange. Hence exchange rate must fall to E2

M . This will cause the supply of exports to fall by 200 and the demand for imports to increase by 200.Foreign Exchange Market EquilibriumStep 1: Reduction in demand for imports 300 Increase in Supply for exports 100Step 2: Increase in demand for imports 200 Reduction in Supply for exports 300Net Impact: Demand for Imports reduced by 100 Supply of Export reduced by 100 Total = 200

E

FXQ


S

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TABLE 2 CALCULATION OF SHADOW PRICE OF NONTRADABLES OUTLAYS 600 of Project Funds Sourced in Capital Market And Spent on Nontradables

m

vt

m vh

Applicable m vt eis

Distortion Alone vh eia

Change Due To (exclusion for Capital Market investment Sourcing eis = 0.75)


Import Demand -300 m = .12 -36 -36 -36

Export Supply +100 - n.a. n.a. n.a. Nontradables Demand -200 vh = .05 n.a. -10 -2.5


Tradables Demand +240 vt = .2 n.a. +48 +32

Tradables Supply -160 - n.a. n.a. n.a. Import Demand +200 m = .12 +24 +24 +24

Export Supply -200 - n.a. n.a. n.a. Nontradables Demand -240 vh = .05 n.a. -12 -8

Nontradables Supply +160 - n.a. n.a. n.a. Total Distortion Costs (-), -12 -66 -10.5 Benefit (+) Distortion Cost/Project Expend. .02 .11 .0175 = Premium in Nontradables Outlays Shadow Price of Nontradables Outlays 1.02 1.11 1.0175

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Financing the Project by Borrowing from Abroad and Using Funds to Buy Non-Traded Goods

• Step 1: No impact on consumer demand due to borrowing from abroad.

• Step 2: More foreign exchange available to purchase traded goods by others.

Change in demand for traded goods is increased by 360, change in demand for non-traded goods is decreased by 360.

Traded

S0T

S0T+BF

D0I

600

360 240

Q0T

S0NT

S1NT

D0NT

600

240 360

PNT

D2NT

Non-Traded

D1NT

E0

E1

E

Q

E

Q


S

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SXFX

SXFX

DMFX

600

300 300

Q0T

PNT

E0

E1

E

QFX

600 excess supply of FX from foreign borrowing results in falling

real exchange rate to E1. This will cause the demand for imports

to rise by 300 and the supply of export to fall by 300.


S

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TABLE 3 CALCULATION OF SHADOW PRICE OF NONTRADABLES OUTLAYS

600 of Project Funds Sourced Abroad And Spent on Non-Tradables m

v t

m vh

Applicable m v t eis Distortion Alone v h eia

Change Due To (exclusion for Capital Market investment Sourcing eis = 0.75) n.a. n.a. n.a.


Tradables Demand +360 vt = .2 n.a. +72 +48

Tradables Supply -240 - n.a. n.a. Import Demand +300 m = .12 +36 +36 +36 Export Supply +300 - n.a. n.a. Nontradables Demand -360 vh = .05 n.a. -18 -12

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

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• s1 = share of project funds sourced by displacing the demand for importables,

• s2 = share of project funds sourced by displacing the demand for exportables,

• s3 = share of project funds sourced by displacing the demand for nontradables,

• f1 = fraction of a gap between the demand for imports and the supply of exports

that is closed by a movement along the demand function for imports as the

real

exchange rate adjusts to bring about equilibrium,

1 = fraction of a gap between the demand and the supply of tradables that is

closed by a movement along the demand function for tradables as the real

exchange rate adjusts to bring about equilibrium,

• gd = fraction of project funds effectively sourced in the domestic capital market

• gf = (1-gd) = fraction of project funds effectively sourced in the foreign capital

market

General expressions for premia on foreign exchange and shadow price of non-tradable outlays

Definitions:

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M = the uniform tariff rate on imports,

• vt = the rate of value added tax on domestic consumption of tradables,

• vh = the rate of value added tax on the domestic consumption of non-

tradables,

• Cs = share of reduced expenditure from the capital market sourcing of funds

that

are taxed by VAT, i.e. consumption. Cs = (1-eis)

• Ca = share of reduced expenditure from the adjustment of the exchange rate

that are taxed by VAT, i.e. consumption Ca = (1-eia)

• eis = share of reduced expenditure due to funds sourced through the capital

market that is excluded from the VAT base (i.e. investment)

• eis = share of reduced expenditure due to exchange rate adjustment that are

excluding from the VAT base (i.e. investment)

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TABLE 4 GENERAL EXPRESSIONS FOR PREMIA ON TRADABLES AND NONTRADABLES

(Project Funds Sourced 100% in Domestic Capital Market) With Uniform Import Tariff ( m) Alone:

Premium on Tradables = (s1 + f1s3)m

Numerical Check: .08 = [0.5 + 0.5(.33)](0.12) Premium on Nontradables = [s1 - f1(s1+s2)]m

Numerical Check: .02 = [0.5 - 0.5(.67)](0.12) With Uniform Import Tariff ( m) Plus Value Added Taxes (vt and vh)

(No Credit For Investment Goods) Premium on Tradables = (s1 + f1s3)m + (s1+s2)vt + s3vh + 1s3(vt-vh)

Numerical Check: = .08 + (.67)(0.2) + .33(0.05) + 0.6(.33)(0.15) .26 = .08 + .1333 + .0167 + .03 Premium on Nontradables = [s1-f1(s1+s2)m] + (s1+s2)vt + s3vh - 1(s1+s2)(vt-vh)

Numerical Check = .02 + .1333 + .0167 - (.6)(.67)(0.15) .11 = .02 + .133 + .0167 - .06 With Uniform Import Tariff ( m) Plus Value Added Taxes (vt and vh)

With Credit for Investment Goods Premium on Tradables: = [(s1+f1s3)m] + cs[(s1+s2)vt+s3vh] + ca[1s3(vt-vh)]

Numerical Check: = .08 + (.25)[.1333+.0167)] + (.67)(.03) .1375 = .08 + .0375 + .02 Premium on Nontradables: = [s1f1(s1+s2)]m + cs[(s1+s2)vt+s3vh]

- ca[1(s1+s2)(vt-vh)]

Numerical Check: = .02 + (.25)(.1333+.0167) -.67[.6(.67)(.15)] .0175 = .02 + .0375 - .04 Note: cs = (1-eis)

ca = (1-eia)

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TABLE 5 GENERAL EXPRESSIONS FOR PREMIA ON

TRADABLES AND NONTRADABLES (Project Funds Sourced 100% Abroad)

With Uniform Import Tariff (m) Alone Premium on Tradables = zero Premium on Nontradables = -f1m Numerical check -.06 = -(.5)(.12) With Uniform Import Tariff ( (m) Plus Value Added Taxes (vt and vh) (No Credit For Investment) Premium on Tradables = zero Premium on Nontradables = -f1m - 1(vt-vh) Numerical Check -.15 = -(.5)(.12) - (.6)(.15) With Uniform Import Tariff (m) Plus Value-Added Taxes (vt and vh) With Credit For Investment Premium on Tradables = zero Premium on Nontradables = -f1m - ca1(vt-vh) Numerical Check -.12 = -(.5)(.12) - (.67)(.6)(.15) Note: cs = (1-eis)

ca = (1-eia)

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TABLE 6 WEIGHTED AVERAGE PREMIA WITH “STANDARD”

CAPITAL MARKET SOURCING gd = fraction of project funds effectively sourced in the domestic capital market

gf = (1-gd) = fraction of project funds effectively sourced in the foreign capital market

PREMIA ON TRADABLES AND NONTRADABALES

Project Funds Sourced From: Both Markets gd = .7

Applicable Distortions Domestic Capital Market Foreign Capital Market gf = .3

m = .12

Project Funds Spent On Tradables .08 -0- .056 Nontradables .02 -.06 -.004 m = .12, vt = .20, vh = .05

Project Funds Spent On Tradables .26 -0- .182 Nontradables .11 -.15 .032 m = .12, vt = .20, vh = .05, eih = .75, eia = .33

Project Funds Spent On Tradables .1375 -0- .09625 Nontradables .0175 -.12 -.02375

TABLE 6 WEIGHTED AVERAGE PREMIA WITH “STANDARD”

CAPITAL MARKET SOURCING gd = fraction of project funds effectively sourced in the domestic capital market

gf = (1-gd) = fraction of project funds effectively sourced in the foreign capital market

PREMIA ON TRADABLES AND NONTRADABALES

Project Funds Sourced From: Both Markets gd = .7

Applicable Distortions Domestic Capital Market Foreign Capital Market gf = .3

m = .12

Project Funds Spent On Tradables .08 -0- .056 Nontradables .02 -.06 -.004 m = .12, vt = .20, vh = .05

Project Funds Spent On Tradables .26 -0- .182 Nontradables .11 -.15 .032 m = .12, vt = .20, vh = .05, eih = .75, eia = .33

Project Funds Spent On Tradables .1375 -0- .09625 Nontradables .0175 -.12 -.02375

48

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.

49

Table 1 Impact of Capital Extraction and Spending on Project Inputs in South Africa

Capital Sourcing and Spending Importables Exportables Non-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 Demand for Goods +45.0 -45.0 0 Domestic Funds b) Project Demands for Exportables +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 Demand for Goods -55.0 +55.0 0 Domestic Funds c) Project Demands for Non-Tradables +100.0

Displacement (K-Market) -39.0 -24.0 -37.0 Effect of Real Exch Rate on Demand +14.3 +11.8 -26.1 Effect of Real Exch Rate on Supply - 12.9 -24.0 +36.9 Excess Demand for Goods -11.8 +11.8 0 Funds Borrowed from Abroad d) Project Demands for Non-Tradeables +100.0

Displacement (K-Market) - - - Effect of Real Exch Rate on Demand +22.7 +18.8 -41.5 Effect of Real Exch Rate on Supply -20.4 -38.1 +58.5 Excess Demand for Goods +43.1 +56.0 0

50

Table 2 Externalities Generated from Project Funds Sourced from Domestic Markets and

Spent on Importables

Capital Sourcing and Spending Importables Exportables Non-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 Demand for Goods +45.0 -45.0 0 Externalities: 8.21% 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%

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Table 3 Summary of Externality

(Percentage)

Funds Drawn from Funds Spent on Funds Spent on Tradables Non-Traded

Domestic Capital Source Foreign Capital Source Capital Market Weights (Domestic: 74%, Foreign: 26%)

-8.21 -3.06

0 +5.15 -6.08 -0.93

Updated: Nov. 29.,2006 Lecture Notes ECON 622: ECONOMIC COST-BENEFIT ANALYSIS Lecture Seven

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