lecture notes econ 437/837: economic cost-benefit analysis lecture seven
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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. - PowerPoint PPT PresentationTRANSCRIPT
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Lecture Notes
ECON 437/837: ECONOMIC COST-BENEFIT ANALYSIS
Lecture Seven
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Economic 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, 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.
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Estimation of EOCFX and SPNTO under two situations:
1. Project already has raised funds (e.g. foreign aid) and spends them on tradable and non-tradable goods.
2. Project raises funds in capital markets and spends funds on tradable and non-tradable goods
• 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).
Economic Cost of Foreign Exchange
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Partial Equilibrium Model: Distortions that affect international trade are
considered, but no account is made for how purchase of foreign exchange is
financed.
1.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
Economic Cost of Foreign Exchange with Distortions (cont’d)
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• 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 Pw
I or the
export price PwE by the market exchange rate EM, i.e.
PDI =EMPw
I, PDE=EMPw
E
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• 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.
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Demand for Tradable Goods
• Equals demand for importable goods plus demand for exportable goods
Demand for Importable Demand for Exportable Demand for Tradable
Goods Goods Goods
EM EM 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.
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Supply of Tradable Goods
• Equals domestic supply of importable goods plus domestic supply of exportable goods.
Domestic Supply of Domestic Supply of Domestic Supply of Importable Goods Exportable Goods Traded Goods EM S I EM SE EM ST=SI+SE
EM0 EM
0 EM0 DT
QSI QS
E QST
Q(FX) Importable Q (FX) Exportable Q (FX) Tradable
Exchange rate is 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 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 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
• 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.
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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) QNT
0
GDP = QT0 + QNT
0 Full Employment
Think of tradable goods and non-tradable goods as two large composite goods
QST = QD
T QSNT = QD
NT
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Equilibrium in Foreign Exchange Market
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 tradable goods market and foreign exchange market.
QDI + QD
E = QDT, QS
I + QSE = QS
T
• 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 Ratewith No 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: Funds available to purchase foreign exchange
• 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 Import Tariff
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Case Two:• Export Subsidy = kx
D0
S0
S0+export subsidy
Quantity of Foreign Exchange Traded
Exchange Rate
D0 + Project
Q0
s1QQ
d1
m1Em0
E
E0m(1+kx)
E1m(1+kx)
Ee = Ws*Em*(1+kx) + Wd*Em
Determination of Exchange Rate with Export Subsidy
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Case Three:• Export Tax = tx
D0
S0+export tax
S0
Quantity of Foreign Exchange Traded
Exchange Rate
D0 + Project
Q0
s1QQ
d1
m1Em0
E
E0m(1-tx)
E1m(1-tx)
Ee = Ws*Em*(1-tx) + Wd*Em
Determination of Exchange Rate with Export Tax
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Case Four• Current Account in Equilibrium• Import Tariff = Tm
• Export Tax = tx
Ee = Ws*Em*(1-tx) + Wd*Em*(1+Tm)
Quantity of Foreign Exchange Traded
Q0
D
d1
Q
Dt
G
F
Tariff
L
J
Export Tax
Qs1
Dp
m1Em0
E
St S
Exchange Rate
AB
H
Determination of Exchange Rate with Import Tariff and Export Tax
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Determination of Exchange Rate with Distortions and Capital Flows
Case Five:
• 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 PremiumUnder 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 ExportsFEP =
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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).
In financial analysis: PfI = EmPw
I, PfE = EmPw
E
In economic analysis: PeI = EePw
I, PeE = EePw
E
• 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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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.
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Premia for Foreign Exchange and Non-Tradable Outlays (cont’d)
-- A General Equilibrium Analysis --
Four alternative scenarios:
a) Project funds borrowed domestically and spent on tradable goods;
b) Project funds borrowed abroad and spent on tradable goods;
c) Project funds borrowed domestically and spent on non-tradable goods;
d) Project funds borrowed abroad and spent on non-tradable goods.
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Tradable Goods Markets-- Case A: funds borrowed domestically and spent on tradables --
Ts
0
Td0
Eu
Td1
E0 E1
QT1
Td2
QT2 QT
0 QNT1 QNT
0
NTd0
NTd1
NTs0
Exchange Rate
NTs1
QNT2
200 400
200
Price of Non-tradables
P0
QT QNT
80 120 80 120
A. Tradable Goods B. Non-tradable Goods
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Foreign Exchange Markets
Xs0
Md0
Qfxd Qfx
s
Id1
Id0
Jd0
Jd1
Xs1
Md2
Md1
Is0
Js0
Qsi0 Qdi
0 Qdi1 Qse
0 Qde0 Qde
1
E1
E0
Exchange Rate
200
Exchange Rate
Exchange Rate
Qfx Qi Qe
100 300 100 100 300
Importable Exportable Market for Foreign Exchange
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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 Demand -120 vt = .20 n.a. -24 -16
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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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
600
E
E0
Q
sT0 sT1
dT0
dT1
TQ0TQ1
Step 1Step 2
PNT
sNT0
dNT0
NTQ0
Tradable Goods Non-Tradable Goods
Supply of tradable goods (foreign exchange) increased by 600, Demand for foreign exchange increased by 600 with the Project.
No Impact on Non-Traded
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Market for Foreign Exchange
600
sX 0 sX1
dM 0
dM1
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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Tradable Goods Markets-- Case C: funds borrowed domestically and spent on nontradables --
NTd0
NTd1
NTd2
NTd3
NTs0
NTs1
Ts0
Td0
Td1
E0
E2
QNT2 QNT
0 QNT1 QT
0 QT1
Exchange Rate
QT QNT
400 200 400
Price of Non-tradables
PNT
240 160 160 240
QNT3
Tradable Goods Non-Tradable Goods
Assumption that |TD| =1.5 T
S
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Foreign Exchange Markets
100300
dM 0
dM1
200 200
FXQ0
2E
0E
sX1
sX 0E
FXQ
Assumption that |ID| = x
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)
Tradables Demand -400 vt = .2 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 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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Case D: Funds Borrowed from Abroad and Spent on Nontradables
• More foreign exchange available in the economy
• Impact on exchange rate
Change in demand for tradable goods is increased by 360, change in demand for non-tradable goods is decreased by 360.
Tradables
T0s
T1s
T0d
600
360 240
Q0T
NT0s
NT1s
NT0d
600
240 360
PNT
NT2d
Non-Tradables
NT1d
E0
E2
E
Q
E
Q
Assumption is that |TD| = 1.5 T
S
Market for Foreign Exchange
X0s
X1s
M0d
600
300 300
Q0T
E0
E2
E
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| = x
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.
Change Due To Real (exclusion for Exchange Rate investment Adjustment eia = 0.33)
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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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
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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.
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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
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Table 2 Externalities Generated from Project Funds Sourced from Domestic Markets and
Spent on Importables
Capital Sourcin g 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 Total Distortion Costs: -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%
Premia on Tradables and Non-tradables in South Africa (Percentage)
Funds Drawn from Funds Spent Funds Spent
on Tradables on 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%)42
Estimates of FEP and NTP for African Countries
Country Parameters Effective Tax and Subsidy Rates (%) Premiums (%)
D-Fund Imp/Tr in Cap-
Ext
ImportDuty
Export Tax
VAT-Trade
VAT-Nontrad
Excise Subsidy FEP NTP
VAT Countries
Ethiopia 0.74 0.92 7.00 0.00 8.05 1.89 2.25 0.26 6.64 -0.24
Ghana 0.68 0.92 8.50 0.42 9.34 2.20 3.64 0.06 7.87 -0.86
Ivory Coast
0.76 0.92 14.33 5.33 4.61 1.09 1.15 0.78 9.50 +1.54
Keynes 0.72 0.92 4.90 0.06 11.54 2.72 7.21 0.04 8.65 -0.57
Mauritius 0.76 0.89 3.79 0.00 12.75 3.00 2.94 0.52 5.71 -0.35
Rwanda 0.70 0.92 5.80 0.00 7.76 1.83 2.70 4.89 5.86 -0.52
Senegal 0.64 0.92 6.09 0.00 14.66 3.45 3.37 5.85 7.91 -1.68
Tanzania 0.68 0.92 3.75 0.00 14.08 3.31 0.54 0.00 3.94 -0.80
Uganda 0.76 0.92 4.10 0.05 8.29 1.95 0.05 0.00 8.46 0.00
Zambia 0.76 0.92 5.00 0.00 10.03 2.36 5.04 0.37 7.66 -0.05
Countries with General Sales Tax System
Egypt 0.78 0.92 4.00 0.18 6.20 1.93 2.00 8.93 5.07 +0.47
Seychelles
0.73 0.92 3.19 0.00 13.50 9.00 4.36 0.00 6.23 +0.72
Congo 0.65 0.92 7.71 0.44 4.96 1.86 1.50 0.00 7.78 +0.81
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