Notes on the Premia for Foreign Exchange and Nontradables Outlays

• Published date: 16 October 2007
• Pages: 203-221
• Date: 16 October 2007
• DOI: https://doi.org/10.1016/S0193-5895(07)23009-X
• Author: Arnold C. Harberger

NOTES ON THE PREMIA FOR

FOREIGN EXCHANGE AND

NONTRADABLES OUTLAYS

Arnold C. Harberger

ABSTRACT

This paper modifies the ‘‘standard’’ methodology for calculating the

economic opportunity cost of foreign exchange (EOCFX), so as to

incorporate into its calculation the distortions involved in the act of

‘‘sourcing’’ in the capital market the funds that will be spent by the

project. Once we take these ‘‘sourcing’’ distortions into account, we are

logically forced to pursue two parallel calculations. The first, EOCFX

traces the results of sourcing money in the capital market and spending it

on tradables. The second, the shadow price of nontradables outlays

(SPNTO) traces the results of sourcing money in the capital market and

spending it on nontradables. Supporting arguments and illustrative

calculations are presented in the paper.

The need for a separate ‘‘shadow price of nontradables outlays’’ (SPNTO)

emerged in the process of joint work by Glenn P. Jenkins and myself. Our

task was to supply the ‘‘national parameters’’ (economic opportunity costs

of capital, foreign exchange, labor, etc.) for both Argentina and Uruguay.

Research in Law and Economics, Volume 23, 203–221

Copyright r2007 by Elsevier Ltd.

All rights of reproduction in any form reserved

ISSN: 0193-5895/doi:10.1016/S0193-5895(07)23009-X

203

These were to be used in the economic evaluation of a project for a bridge

over the Rio de la Plata between the two countries. We simply had to take

into account the value-added taxes (VAT) of these countries, both of which

had rates of over 20%. But we quickly discovered that actual VATs fell very

unequally on tradables and nontradables. It was in pursuing the

consequences of this differential value-added taxation that we discovered

that one was really forced by plain logic to employ an SPNTO side-by-side

with an ‘‘economic opportunity cost of foreign exchange’’ (EOCFX), even if

there were no VATs, or if the VAT struck tradables and nontradables

equally. This paper develops the ideas that originated in the above scenario.

It is designed so as to provide a format that can be followed by anyone

trying to implement the new conceptual framework.

Economists often assume, in valuing nontraded goods, that all of the

release of capacity to meet a project’s demand is accomplished through a

mechanism of price adjustment – a rising price displacing some demand that

would otherwise be present, and at the same time stimulating an increase in

the quantity supplied. In short, they analyze the adjustment process using a

partial equilibrium, supply-and-demand scenario. Such a scenario is valid:

(a) when the demand and supply for the good or service in question are not

substantially affected by the way in which the project funds are (assumed to

be) raised, and (b) when the distortions that are involved in the raising of

these funds either do not exist (or are unimportant), or are taken into

account at some other stage of the analysis. In what follows, we will deal

with these two provisos in turn, focusing initially on the project’s demand

for tradable goods.

When a project’s total outlays are listed, they naturally fall into two great

categories – tradables and nontradables. We handle each of these broad

categories separately. Fig. 1 shows the supply and demand for tradables as a

function of the real exchange rate E. For the moment, we assume that there

are no distortions in either sector.

When we analyze the demand (here assumed to be 600) that goes to the

tradables market, we do not assume that we move upward on the price axis

to point E

u

, where there is a gap of 600 between Ts

0and Td

0, the quantities of

tradables demanded and supplied. That would in effect be applying a

simple, partial-equilibrium approach, but it would not be appropriate here.

Instead, we must take into account the fact that in raising 600 of funds we

have displaced the demand for tradables by some fraction (say 2/3) of this

amount, and the demand for nontradables by the rest (the other 1/3).

Our scenario, then, is that we shift the demand curve for tradables to the

left by 400, and simultaneously insert a wedge of 600 between that new

ARNOLD C. HARBERGER204