Trade and Tax Policy, Inflation and Exchange Rates

The eight chapters of this volume have been grouped into two parts. Part A contains chapters which are mainly monetary in character, whereas real aspects of international economics are treated in Part B. It goes without saying that this is only a device for structuring the field. In substance most chapters reveal the close connections between real and monetary aspects.

Monetary policy usually enables policymakers to quickly but temporarily achieve various real goals like high employment, financing of the budget deficit, attainment of balance of payments objectives and low interest rates. In the process, high-powered money is increased fueling inflation. To offset this policy bias, various institutional mechanisms that reduce the ability of governments to freely expand the money supply have been tried. Among them, an important device, which is gaining popularity recently, is the granting of sufficient independence to the Central Bank in conjunction with an unequivocal mandate to focus on the attainment of price stability.

This paper surveys alternative ways to characterize independence and also can be considered as validating the more general proposition that the design of policymaking institution matters.

The paper provides an overview of the role of the fiscal imbalances and the ensuing public debt in explaining major episodes in Israel’s recent economic developments. The main conclusions from the Israeli budgetary developments may have more general validity: (a) deficits lead to inflation and stopping inflation requires elimination of deficits; (b) a major effect of inflation is a large shift of the tax burden from capital to labor; and (c) shocks to labor supply, such as massive labor inflow through immigration, can be absorbed without worsening government finances, when the labor and the housing markets are sufficiently flexible.

Following inflation stabilization programmes where a fixed exchange rate is used as an anchor, a number of countries have gradually shifted towards a regime of increased flexibility. In particular, Chile, Israel and Mexico have adopted for a few years a regime of crawling exchange rate bands. This article documents and analyzes their unique experience. Of immediate concern is the question whether the shift from fixed to crawling bands is perceived as the signal of a tilt towards policy relaxation. On the contrary, it could be seen as a way of restoring external competitiveness after a period of real appreciation. The evidence collected in this article supports the latter view. As a way of moving towards a sustainable equilibrium, the shift to crawling bands is found to have a stabilizing influence on financial markets, on inflation expectations, and on the passthrough from exchange rates to prices.

The international transmission of economic disturbances is analysed in a three-country world where two countries have no macroeconomic impact on a third country but are large enough to influence each other under a system of mixed exchange rates — a system that combines the fixed exchange rates (FERs) among two EC member countries (Germany and France) and the flexible exchange rates (FLERs) towards a third country, the rest of the world (USA). We find that a positive output demand shock originating in Germany or France has a positive effect on domestic output, but, due to a special third country effect, is likely to produce a contractionary impact on foreign output (negative transmission) while the total effect on the world economy is expansionary. Money supply shocks in either Germany or France have identical effects on the output of the two countries. The FLER component of the MER regime serves as an important tool for dampening the impact of US shocks on the output of the EC.

When governments meet in the international arena, their actions reflect the political situations at home. Previous studies of trade relations have focused on governments that are immune from political pressures and that act as benevolent servants of the public interest. Here we introduce domestic politics into the analysis of international economic relations. We study the interactions between national leaders who are concerned both with providing a high standard of living to the general electorate and collecting campaign contributions from special interest groups. Our analysis sheds light on the determinants of the structure of protection in non-cooperative and cooperative policy equilibria.

This paper presents a model describing the policy decision framework confronting governments seeking to effect transition of their economies from prior socialism to a free-market private-property economy. Fundamental elements of this transition are (i) change from the socialist trade regime under which domestic enterprises did not confront import competition (nor domestic competition for that matter), and (ii) privatization of the formerly socialist enterprises. We consider circumstances where governments have as an objective a liberal trade regime, sought because of the traditional efficiency case for an open economy — with the additional benefit, not present when the domestic market is competitive, from exposure of a sole domestic producer to discipline of import competition. The government that we model bases its policies on broadly consensual economic principles and policy advice. Government officials do not seek to take advantage of incumbency to provide policy favors in exchange for political support or personal remuneration, and the pursuit of efficiency objectives is not compromised by political competition that can lead to policies favoring domestic interest groups. Nonetheless, as we shall elaborate, the formulation of policy is subject to the need to maintain a minimum level of electoral support. A substantial literature motivated by real-world observation views policies as endogenous to the political process via the self-interest motives of policy makers.¹

Optimal tariffs in the presence of foreign factor ownership are derived and interpreted. Three types of optimal tariffs are considered: the analogue (with foreign factor ownership) of the standard optimal tariff (terms of trade improvement), the second best optimal tariff (distortion reducing) and the general optimal tariff. The general optimal tariff is equal to the analogue of the standard optimal tariff if foreigners do not own factors in the home country. In this case the optimal tariff is negative if and only if trade pattern reversals occur. The general optimal tariff may be positive in the presence of foreign factor ownership in the home country even if trade pattern reversals occur. Foreign factor ownership may explain the existence of import or export subsidies in many countries. This explanation is an alternative to rent shifting or the existence of a foreign monopoly which supplies the domestic market.

The paper discusses the main arguments for destination- versus origin-based commodity taxation in the European Community’s Internal Market. Destination-based solutions distort commodity trade in the Community because cross-border purchases by final consumers can only be taxed in the origin country. On the other hand, an origin-based general consumption tax is neutral in a European context and it can be combined with destination-based taxation in third countries in a non-distortionary way. Furthermore, it is shown that the introduction of capital mobility does not affect the neutrality of an origin-based consumption tax. Finally, the paper addresses the administrative and political implications of a switch to the origin principle in the European Community.