impact of external price shocks on the oil-based developing economies

Journal of Economic StudiesEmerald Article: Impact of External Price Shocks on the Oil-based Developing EconomiesAli F. Darrat, M. Osman Suliman

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Journal of Economic Studies 17,6

36

Impact of External Price Shocks on the Oil-based Developing Economies

Ali F. Darrat and M. Osman Suliman Louisiana Tech University, and Grambling State University, Louisiana,

USA

The worldwide economic upheaval during the past decade has been, wholly or partly, attributed to the famous OPEC price shock. One consequence has been a revival of interest in the macroeconomic analysis of such an exogenous OPEC shock. However, very little attention has been paid to the impact of external price shocks on the OPEC economies themselves. A recent exception is Pesaran (1984), who examines some macroeconomic policy issues in an oil-exporting economy with foreign exchange control. However, Pesaran's model specifies the demand for real balances (a major equation in the model) as being interest-sensitive, which is irrelevant to most oil-based economies. Other studies by Neary and Purvis (1982) and Buiter and Purvis (1983) are relevant only to economies with matured (developed) financial markets. Earlier, Metwally and Tamschke (1980) examined the impact of oil exports on economic growth in several Middle Eastern countries, arguing that oil receipts had an insignificant effect on the non-oil side of the countries studied. However, Metwally and Tamschke's model lacks theoretical foundations and, due to its total neglect of the demand side of the economy, its equilibrium analysis is only partial in nature.

The present study examines the impact of export and import price changes on the real side of oil-based developing economies within a general equilibrium theoretic framework and makes contributions to the debate in several respects. First, the model is based on a macroeconomic general equilibrium analysis. As such, the model incorporates endogenous income and price responses and takes explicit consideration of all sectors of the economy. Second, the model has two traded goods (exports and imports) and a non-traded good. Most previous studies in this area consolidated exportables and importables into one class of "traded" good since any quantity of exportables may be exchanged for importables at the relative price determined by the given terms of trade. However, as pointed out by Black (1976), a fall in the terms of trade could change the definition of "traded" goods. That is why this model uses two "traded goods" in order to envisage fluctuations in the external terms of trade. Third,

The authors, whose names appear alphabetically, wish to thank W.E. Witte and two anonymous referees of this Journal for many helpful comments. An earlier version of this article was presented to the 1989 MAEF meeting in Jackson, Mississippi. Comments from the meeting participants are gratefully acknowledged. Any remaining errors are solely our own.

Oil-based Developing Economies

37

the model directly considers the inherent open and small economy nature of the oil-based economies[l]. In the model, although the ultimate burden of adjustment falls on the endogenous domestic prices, some other structural adjustments are also allowed. Thus, the adjustment process is based on the neoclassical macro theory in conjunction with the structuralist micro view.

This article examines the extent of vulnerability (stability) of the real side of the oil-based economies to external price disturbances in the polar, but realistic, case where the economies are highly open (non-traded goods are negligible). This approximates the situation of economies such as Saudi Arabia, United Arab Emirates, and Kuwait. Interestingly, we find that the more open the economy is, the more insulated the real side becomes against foreign price shocks[2]. The remainder of the article is organised as follows. The next section briefly outlines the model. The third section presents a theoretical analysis of external price disturbances. Some empirical evidence is then reported in the fourth section. Concluding remarks are provided in the fifth and final section.

The Structural Model For simplicity, we assume that our small open economy exports only to one country (UK) and imports only from one country (USA). The model comprises the following equations:

Output: X = X(Px, Pn) x1 > 0, x2 < 0 (1) Ns = S(Px, Pn) s1 < 0, s2 > 0 (2)

Demand: I = I(Pm, Pn, Y) + m1 < 0, m2 > 0, m3 > 0 (3) Nd = D(Pm , Pn, Y) d1 > 0, d2 < 0, d3 > 0 (4) Y = PxX + PnN - (5)

Prices: Px = + s (6) Pm = + t (7) r = (8)

Assets: F = (in dollars) (9) M = F + G - T (10) G = Pn + Pmgm + sX (11) T = + tI (12)

where the signs of the partial derivatives of the respective variables are given at the side of the relevant equations, and a bar on any variable indicates


38

exogeneity. The variables are defined as follows: X = supply of tradables (exports); Ns = supply of non-tradables; I = domestic demand for imports in nominal terms; Nd = domestic demand for non-tradables in nominal terms; Y = nominal income; Pn_ = domestic price of non-traded goods; Px = domestic price of exports; P = foreign price of exports; Pm = domestic price of imports; = foreign price of imports; = real government expenditures on imports; = real government expenditures on non-traded goods; G = nominal total government expenditures; T = nominal taxes; = real taxes; t = import tariff, s = export subsidy; M = change in money supply; F = change in foreign reserves; = capital imports from the US; = capital imports from the rest of the world; = nominal domestic exchange rate in terms of the dollar; = dollar price of the British pound; rs = nominal domestic exchange rate in terms of the British pound.

Relationships (1) and (2) are output equations showing the supply functions of tradable (exports) and non-tradable (domestic) goods. Supply functions are specified in terms of the absolute prices of tradables and non-tradables to reflect the fact that such economies place heavy emphasis on the tradable goods (oil) relative to the smaller non-traded goods sector. Thus, prices in the two sectors can be treated as independent. Furthermore, it is assumed that labour supply (especially foreign) is infinitely elastic and hence wages can be assumed fixed.

In the above model, the import-competing sector on the production side and export consumption on the demand side are assumed negligible[3]. We also abstain from using imports as intermediate goods in order to focus on the impact of external disturbances on the domestic economy.

The domestic demand functions, in nominal terms, are assumed to depend on prices and nominal income in addition to government expenditure. The demand functions are also assumed differentiable and homogeneous of degree zero in the nominal variables. Hence, we can use prices of non-traded goods as a numeraire. As equation (5) indicates, direct taxes are imposed explicitly on non-traded goods, a significant portion of which is services. Deflating by the prices of non-traded goods (Pn) is allowed by the zero-homogeneity of the demand function. Moreover, Pn is used since the broader Consumer Price Index measure is contaminated to a larger extent with heavy government subsidies particularly in the oil-based economies. Equations (6) and (7) state that domestic prices of traded goods are equal to the external (exogenous) price times the relevant nominal exchange rate of home currency plus any (endogenous) export subsidy and import tariffs[4].

The financial structure is described by equations (9)-(12). In the oil-based economies, the banking system is rudimentary and largely under government control. Each country has a central bank and a few commercial banks that provide the primary source of financial intermediation. For the most part, other credit facilities are drawn through government institutions which extend (typically interest-free) long-term loans to the public.

The absence of diversified financial intermediaries has weakened the invest-ment component of national income despite the availability of sufficient domestic


39

savings. Indeed, a high percentage of these savings are directly spent on imports of final goods. This replacement of savings by imports suggests that the marginal propensity to save is negligible while the marginal propensity to import is high. In this case, the sum of the marginal propensity to import and the marginal propensity to consume domestic goods should equal one. In the extreme case of total openness (zero non-traded goods), the marginal propensity to import becomes unity.

Capital mobility, in the Fleming-Mundellian sense, is very low in the oil-based economies. There is a low substitutability between domestic and foreign securities since the financial market is extremely thin and lacks any network of security brokers and dealers. In addition, the forward market is non-existent. Primary assets consist of high-powered money and physical capital stock. In such situations, the financial market becomes unable to efficiently mobilise savings. Consequently, monetary policy cannot easily induce accommodating flows of funds to finance payments imbalances. As a result, our analysis emphasises the goods market parameters in the equilibrium process. Important among these parameters are the supply and demand elasticities of traded and non-traded goods, the marginal propensity to spend and to save out of income, and the degree of openness on the supply and demand sides. Furthermore, in an economy where trade generates most of national income and where asset substitutability is largely irrelevant, the assets market becomes rather negligible.

Equation (9) is a balance of payments relationship. It explains the change in foreign reserves as the value of net exports plus the exogenous net value of capital inflows. External balance under fixed exchange rate can be achieved in this model, for example, by a system of trade controls which ensures that net exports are equal to the exogenous net value of capital inflows. These controls are modelled as endogenous adjustments of import-tariff (t) and of adjustable subsidies (s) in the domestic price of oil exports. Consequently, the equality between domestic and world prices is upset by these controls. This implies that the bulk of external balance adjustments is attained through induced changes in the domestic prices of traded goods.

Equation (10) in the system provides the budget constraint for the government and for the banking system on a consolidated basis. In an economy where money is the main (perhaps the sole) asset, the capital account in the balance of payments is rather dormant and foreign reserves move primarily with merchandise trade (X-I). The equation explains changes in money supply as the sum of monetary changes resulting from debt monetisation and from policies aiming at financing trade imbalances. Clearly, this equation assumes zero sterilisation, a reasonable assumption in the context of underdeveloped capital markets. Changes in government loans to the private sector cannot be treated separately since they are government determined. These circumstances endogenise money supply in the model. Money demand is also endogenous as implied by the budget constraints of the public and private sectors. In equilibrium, the change in excess demand for money is zero (by Walras' Law)[5]. As equation (10) implies, for Walras' Law to hold, any excess flow supply (demand) for traded and non-traded goods shoud be equal to the excess flow


40

demand (supply) for money. Thus, if available money stock exceeds the desired holdings, then asset holders would want to increase their spending on traded and/or non-traded goods such that a balance of payments deficit (and/or government budget deficit) ensued to reduce their money holdings. Meanwhile, to maintain the balance of payments constraint (and/or monetise government deficit) the endogenous trade restriction (nominal taxes or government spending) will move to offset any payments or government budget imbalances.

Equation (11) defines nominal government expenditures as the sum of government expenditures in the traded and non-traded goods sectors. Nominal taxes are given in equation (12) as the sum of direct taxes on non-traded goods (e.g. port fees) plus indirect taxes in the form of import tariffs.

Equilibrium Conditions The model contains 12 equations and 13 endogenous variables, namely: X, N, I, Y, Pn, Pm, Px, F, M, G, T, t (or s), and r. The exogenous variables are: and s (or t).

The solution of the model assumes that, in equilibrium, the oil economies are constrained by a zero balance of payments (F = 0), allowing no feedbacks from the balance of payments to the domestic money supply. Observe that, besides the zero balance of payments constraint, another is M = 0 implying that the government budget deficit is accommodated (monetised) by the monetary authorities. Of course, one way of obtaining payments balance is through adjustment of the endogenous tariff in the model[6].

Given F = 0, the model reduces to six equations in six unknowns: X, N, Pn, IM, y, and t. The price equations (6) and (7) can be substituted for directly in the supply and demand functions. Thus, we are left in equilibrium with equations (1) to (5) and the external balance equation (9).

The six equilibrium equations are summarised below after normalising the homogenous demand functions (using the domestic price of non-traded goods, Pn, as a numeraire):

X = X(Px, Pn) x1 > 0, x2 < 0 (13) Ns = S(Px, Pn) s1 < 0, s2 > 0 (14) IM = IM(Pm/Pn, 1, y) + m1 < 0, m3 > 0 (15) DN = D(Pm/Pn, 1, y) + d1 > 0, d3 > 0 (16) y = (Px/Pn) X + N - (17) F = 0 = _ (18)

where Px = + t; and IM = real imports. In attempting to analyse the direction of change and the magnitude of stochastic

external price shocks on the real side of the economy, we should first decide on a reasonable level of abstraction. First, for convenience, we assume that the initial prices (including the exchange rate) are unity, while initial import tariffs and the domestic oil price subsidies are zero[7]. In addition, all savings are substituted for by imports making the sum of the marginal propensity to


41

import plus the marginal propensity to consume home goods equal to one (i.e. m3 + d3 = 1). In the extreme case of total openness (N0 = 0), the marginal propensity to import is also one. Further, cross effects between export output and non-traded goods output are assumed to be zero. Finally, the responses of real imports and real non-traded goods to changes in their own prices are assumed to be of equal magnitudes (i.e. m1 = d1 in absolute value). This derives from the equality of the marginal rate of substitution to the relative price ratio. That is, Pm/Pn = 1 = -dN/dIM. This implies that dN = dIM, or d1 = m1 (in elasticity form, this can be written as ndN0 = nmIM0, where nd is the elasticity of demand for non-traded goods and nm is the elasticity of the demand for imports).

External Price Disturbances Differentiating totally the six equilibrium equations (13)-(18), rearranging in matrix form, and using the signs of the respective partial derivatives, we can solve for the endogenous variables in terms of the exogenous variables. That is (a zero subscript indicates initial values):

(19)

The determinant of the Jacobian is: (20)

The system is stable since the determinant is positive, and so are the system eigenvalues[8]. Using the four assumptions, the determinant reduces to:

D = X0d1 > 0 = X0ndN0 > 0 (in elasticity form) (20')

The Impact of Oil Price Shocks on the Oil-based Economies Solving the above system for the percentage change in real variables in response to the percentage change in foreign export price, we obtain the following solutions:


42

(21)

In elasticity form:

(21')

By the same procedure, the solutions for real non-traded goods, real income, and real imports are simplified below in equations (22), (23), and (24), respectively:

(22)

(23)

(24)

Clearly, foreign export prices will, ceteris paribus, have an unambiguous positive impact on real exports. The magnitude of the impact depends on the export supply elasticity. Because of the negligible non-traded goods sector and the consequent zero cross effects between exports and non-traded goods, non-traded goods are completely immune to changes in foreign export prices. However, the increase in real exports has an expansionary impact on real national income. Real imports also increase through the income effect.

Observe that, as the non-traded goods sector shrinks and approaches zero, the marginal propensity to import will subsequently approach unity and, as such, the income effect on imports is exactly equal to the impact on real income. Therefore, in open, oil-based economies, the substitution effect seems negligible and the impact of foreign export price impinges on the domestic real sphere mainly through the income effect. This result is consistent with Cooper (1971), i.e. imports in developing countries depend primarily on income rather than on relative prices. Therefore, consideration of the marginal propensity to spend out of income (absorption)together with price elasticities are indispensable in this case.

The above findings are also intuitively appealing. As the oil-based economies become more open, their economies will be better insulated against external export price shocks. Had these economies been less open, the external price disturbances would have been exacerbated by the substitution effect. The insigificance of non-traded goods eliminates the substitution effect rendering real variations proportional to the income effect.


43

Note that, under the classical full employment case (Ex = En = 0) or internal balance, exports are fully insulated against foreign oil price shocks. Efficient (full) exploitation of the available oil resources would leave the oil-based economies immune against any foreign export price shocks. National income and imports would, however, still rise by the amount of initial exports.

The Impact of Foreign Import Price Shocks on the Oil-based Economies The percentage responses of the real side of the economy to foreign import price shocks are as follows:

= 0 (25)

= (IM0/X0)s2 > 0

= (IM0/X0)EnN0 > 0 (26)

(27)

= -IM0 < 0 (28)

Because of the absence of an import substitution sector on the production side and since domestic consumption of exports is negligible, exports are neutral to fluctuations in foreign import price. However, the demand for domestic substitutes of imports (or non-traded goods) would rise, leading to an increase in their real output by an amount equal to initial imports relative to initial exports (or demand openness relative to supply openness) times the non-traded goods supply response (i.e. IM0/X0 s2). Thus, the impact of import prices on real income is divided into two parts: a positive component (IM0) which is equal to the fall in real imports in response to a rise in their foreign price; and another negative component as a result of the decrease in the demand for home goods in response to an increase in the price of their domestic substitutes (imports) by the amount of (IM0/X0)s2. The real income (employment) net impact is thus ambiguous.

Interestingly, total demand openness (N0 = 0), which may approximate the case of the oil-based economies, can unambiguously lead to an increase in real income by the amount of the fall in real imports. Equation (27) above shows that the less open the economy is, the smaller is the increase in real income. Therefore, the income increase is undermined by the decrease in demand for home goods as a result of their substitution effect with imports. The classical full employment case (En = 0) yields the same type of result. Hence, in the case of foreign import price, demand openness and full employment of resources (or internal balance) are equivalent.


44

Some Empirical Evidence Notwithstanding the general problem of data limitations in the case of developing countries, some empirical analysis may reveal some of our theoretical results. These results suggest the existence of a cross-sectoral interdependence between exports and import substitution on the one hand, and exports and non-traded sectors on the other. The model also predicts no significant impact of oil exports on non-oil sectors. Furthermore, the import-competing sector on the production

. side and export-consumption sector on the demand side are insignificant in the oil-based economies. That is, the non-oil sectors are neutral to changes in export price and output changes on the production side. On the demand side, however, changes in export prices and output impinge on import consumption through the income effect. The absence of strong substitution effects negates any noticeable impact of export prices and output on non-traded sectors.

Likewise, the insignificance of import-competing production implies that export supply is neutral to changes in imports' prices and output. Nevertheless, real non-traded goods are expected to react somewhat to changes in real imports' prices and consumption through the demand-substitution effect.

To test the above hypotheses in both the supply and demand sides, we examined the impact of changes in oil output (exports) on manufactures (import-competing production), imports, and non-traded goods and services. The impact of changes in real foreign imports on non-traded goods was also examined. Recall that this article aims mainly at studying the real effects of external price changes, which depend primarily on the extent of the interrelationships between the different production and consumption sectors. Hence, empirical examinations of the impact of changes in real exports and real imports can provide useful evidence on the real effects of changes in their external prices given by our theoretical results[9]. Regression analysis of distributed-lag models have been employed. Data limitations precluded an extensive empirical investigation of the above issues across several oil-based economies[10]. Therefore, only annual time series data over 1958-1982 from Saudi Arabia were employed in the empirical testing[ll]. It should be noted that Saudi Arabia shares many of its economic and institutional characteristics with several other oil-based economies, particularly the Gulf States. Thus, the empirical results reached in this section for Saudi Arabia are potentially relevant for other oil-based economies as well.

Application of the Chow (1960) test over several alternative breaking dates suggested a structural break in the Saudi data around the year 1969. Therefore, only the latter period (1970-1982) was used in subsequent regressions. In addition, the 1970-1982 period.seems particularly interesting because it contains the two main OPEC price shocks of the 1970s. To achieve stationarity, each variable was expressed in a growth rate format (i.e. first-differences in logarithm). As Granger and Newbold (1974) point out, the first-difference operator can resolve most of the serial correlation problem. This is evident in the scores of the Durbin-Watson statistic across the equations. In view of the limited size of our sample, the contemporaneous and two annual-lagged values were included in all regressions.


45

Table I reports the regression results for the impact of real exports on import-competing production. None of the coefficients on the real export variables is statistically significant even at the weak 10 per cent level. This finding is consistent with our theoretical implication that, on the production side, import-competing output does not respond to changes in real exports. However, on the demand side, results in Table II indicate that real imports do respond significantly to changes in real exports at better than the 10 per cent level. Conversely, Table III reveals no significant contemporaneous or lagged effects of real imports on real exports. Taken together, the results of Tables II and III suggest a unidirectional effect running from real exports to real imports. This finding, too, is consistent with our theoretical model. Real exports impinge on real imports' demand only through the income effect, thus making exports immune to changes in foreign imports.

Turning now to the impact of real exports on real output of non-traded goods and services, Table IV contains the empirical results for six non-traded"goods and services arranged in descending order in terms of sectoral size. As the table

log Mpt = a0+a1log EXt+a2 log EXt_1+a3 log EXt_2+e1t MP = import-competing production (manufactures) EX = real exports t = time (in years) e1 - white-noise error term

Table I. The Impact of Real Exports on Import-

competing Production (Manufacturing) in

Saudi Arabia, Annual Data: 1970-1982

a0 0.054* (1.813)

a1 0.080 (0.573)

a2 -0.301

(-1.200)

a3 0.372

(1.294)

R2

0.34

F

1.04

D.W. 1.96

Notes: * indicates significance at the 10 per cent level. Values in parentheses beneath the coefficient estimates are t-statistics; R2 is the coefficient of multiple determination; and F is an F-value to test the hypothesis that all coefficients on the independent variables, except for the constant term, are jointly zero.

log IMt = b0 + b1 log EXt+b2 log EXt_1 + b3 log EXt_2 + e2t

Table II. The Impact of Real

Exports on Real Imports (IM)

Consumption in Saudi Arabia

b0 0.670

(0.094)

b1 1.322

(1.727)*

b2 -0.739

(-0.605)

b3 1.658

(1.771)*

R2

0.43

F

2.73

D.W.

2.23

See notes to Table I.


46

shows, the only sector that has significantly responded to changes in real exports is the relatively small community services sector. The highly significant constant term in the wholesale and retail sector regression indicates that a large portion of this sector's output changes independently of growth in the export sector.

log EXt = c0 + C1 log IMt+c2 log IMt_1 + c3 log IMt_2 + e3t

Table III. The Impact of Real Imports on Real Exports in Saudi Arabia

c0

5.156 (1.664)*

c1

0.150 (1.415)

c2

0.073 (0.656)

c3

-0.039 (-0.356)

R2

0.24

F

1.13

D.W.

1.85

See notes to Table I.

log yit= d0+d1 log EXt+d2 log EXt_1 + d3 log EXt_2 + e4t yi = real output in the ith non-traded sector, i = l , 2 . . . 6.

Table IV. The Impact of Real Exports on Non-traded Goods and Services in Saudi Arabia

Non-traded goods sector

Construction

Utilities (electricity, gas, water)

Wholesale and retail trade, restaurants and hotels

Transportation, storage and communications

Finance, insurance, real estate and business services

Community, social and personal services

d0

-0.016 (-0.158)

0.190 (1.500)

0.164 (7.346)**

0.333 (0.172)

0.107 (0.020)

0.006 (0.052)

d1

0.114 (0.238)

-0.033 (-0.056)

0.160 (1.540)*

0.255 (0.288)

0.219 (0.448)

0.820 (1.650)*

d2

0.836 (0.962)

-0.773 (-0.689)

-0.090 (-0.479)

-1.000 (-0.623)

0.233 (0.264)

-1.752 (-1.951)**

d3

0.674 (0.677)

0.279 (0.229)

0.143 (0.664)

1.115 (0.606)

0.105 (0.104)

1.883 (1.830)*

R2

0.48

0.24

0.44

0.12

0.22

0.43

F

1.99

5.99

1.60

0.26

0.55

1.51

D.W.

2.03

2.60

1.87

1.97

2.10

3.14

See notes to Table I. "indicates significance at the 5 per cent level.


47

Again, such a finding is compatible with the implications of our theoretical model. The insignificance of non-traded (non-oil) sectors relative to the traded (oil) sector, together with zero price (and output) cross- effects, has insulated non-traded goods and services sectors against changes in real exports.

Finally, Table V reports results pertaining to the effect of real imports on output in six sectors of non-traded goods and services. Contrary to the case of real exports, the results in Table V show that the largest three sectors (construction, utilities, and wholesale and retail trades) have significantly responded to changes in real imports. This indicates strong cross-price and output effects between real imports and the three largest sub-sectors of non-traded goods and services. Real imports have also had some significant effects on the smaller subsectors of transportation and finance, though the effect seems temporary and fades away after the first year. All in all, the results suggest that changes in the prices of foreign imports and the concurrent changes in their demand have had important effects on the demand for non-traded goods and services in the Saudi economy.

log yit = g0+g1 log IMt+g2 log IMt_1+g3 log IMt_2 + e5t

Table V. The Impact of Real

Exports on Non-traded Goods and Services in

Saudi Arabia

Non-traded goods sector

Construction

Electricity, gas water

Wholesale and retail trade, restaurants and hotels

Transportation, storage and communications

Finance, insurance, real estate and business services Community, social and personal services

g0

-0.046 (-0.344)

0.737 (3.355)**

0.285 (6.144)**

0.702 (1.659)*

-0.143 -(0.664)

0.432 (1.301)

g1

0.666 (4.051)**

-0.781 (-2.890)** -0.065

-(1.134)

-0.868 -(1.670)*

0.614 (2.318)**

-0.290 (-0.712)

g2

-0.594 (-3.248)**

-0.135 (-0.449)

-0.201 (-3.162)**

-0.410 (-0.709)

0.195 (0.066)

-0.433 (-0.954)

g3

0.694 (2.917)**

0.775 (1.981)** 0.002

(0.028)

-0.524 (-0.698)

0.314 (0.819)

-0.166 (-0.282)

R2 F D.W.

0.88 13.99 2.14

0.66

0.64

0.35

0.50

0.18

3.87 2.08

3.57 1.75

1.09 1.89

2.06 2.68

0.44 2.82

See notes to Tables I and IV.


48

Concluding Remarks The main purpose of this study is to investigate the real impact of external price shocks on the oil-based developing economies. To that end, an appropriate macroeconomic general equilibrium model is presented and its theoretical implications are derived and assessed. Empirical evidence deduced from a key oil-based economy (Saudi Arabia) appears quite consistent with the model's theoretical implications.

Importantly, we find that real imports are highly insulated against foreign import price shocks, perhaps due to the insignificance of import-substitution and export-consumption sectors. Moreover, due to the small size of non-traded (non-oil) sectors, and the consequent zero cross-price effects between non-traded goods and exports, non-traded goods sectors are found to be highly immune to price changes of foreign exports. In the polar case of total openness (absense of non-traded goods sectors), the substitution effect vanishes and the income effect dominates. In such a case, real changes depend crucially on the export supply response to changes in export prices and on imports demand response to changes in import prices.

Notes 1. The recent decline in oil prices and the failure of the OPEC countries to sustain higher

levels of prices through changes in export quantities indicate that these countries are increasingly acting as price-takers in the world market.

2. According to the literature on "the optimum currency area", the higher the degree of openness, the greater the impact of external shocks on the domestic economy.

3. Both Al-Bashir (1977) and Metwally and Tamasche (1980) support this assumption empirically. For more theoretical and empirical elaborations, see Turnovsky (1976) and Suliman (1984).

4. In Saudi Arabia, for example, import tariffs are being used as an instrument to control local production of manufactures. Hence, they are virtually endogenous. For more on this point, see, The Industrial Studies & Development Centre, A Guide to Industrial Investment in Saudi Arabia, Riyadh (1977), p. 111.

5. The budget constraints of the private and government sectors are: private: PxX + PnN = PmIM + PnNd + + Md

government:

where,

Px =

F =

This implies

= Md - M5 = 0. 6. Evidence for this is indicated, for example, by the recent decline in the OPEC's imports

in response to the continuous decrease in oil prices.


49

7. The model is indifferent to the level of initial exogenous tariffs or subsidies. Hence, for simplicity, we can arbitrarily choose an initial zero-level of restrictions such that initial domestic prices are equal to unity. Note that the initial price of non-traded goods (Pn) has already been assumed to equal unity in equations (13)-(18). Yet, in the equations where it is important to differentiate between absolute and relative prices, we include Pn explicitly for explanatory purposes. Later, the specific solutions of the model will employ directly the assumption of unity for all prices.

8. In a six by six matrix, the latent roots' solution may require some simplifying assumptions about the magnitudes of the different parameters. However, with the assumed positive marginal propensities to import (m3) and to consume non-traded goods (d3); and given that d1 = m1 (since P0m|P0n = 1 = -dN/dIM and both are positive, then the eigenvalues are likely to be positive. For more on dynamic stability, see Takayama (1974, pp. 367-72).

9. The impact of real exports on real income has been empirically examined by Metwally and Tamschke (1980), and Al-Bashir (1977). The implications of our theoretical model on that issue are consistent with their empirical results.

10. Of course, misspecification is always a possibility in any estimation. Thus, the adduced empirical evidence is only meant to be suggestive. One may argue that a system estimation like a VAR approach may be more appropriate, though data limitations prevented such an exercise at this time.

11. The data for real exports have been taken from various issues of the International Financial Statistics (IFS). Real imports have been derived by dividing the total value of imports (FOB) taken from the IFS, by the index of manufactures in industrial countries, the source of most of Saudi Arabia's imports. The data for manufactures and the non-traded goods sectors are based on the United Nations, National Accounts Statistics: Main Aggregates and Detailed Tables. All time series data are available from the authors on request.

References Al-Bashir, F.S. (1977), Saudi Arabian Economy: 1960-1970, John Wiley and Sons, New York. Black, S. (1976), "Exchange Policies for Less-Developed Countries in a World of Floating Rates",

Essays in International Finance, No. 119. Buiter, W.H. and Purvis, D.D. (1983), "Oil, Disinflation and Export Competitiveness: A Model

of the 'Dutch Disease' ", in Bhandari, J. and Putnam, B. (Eds.), The International Transmission of Economic Disturbance under Flexible Exchange Rates, MIT Press, Cambridge, Massachusetts.

Chow, G.C. (1960), "Tests of Equality between Sets of Coefficients in Two Linear Regressions", Econometrica, July, pp. 591-605.

Cooper, R.N. (1971), "Currency Devaluation in Developing Countries", Essays in International Finance, No. 86.

Granger, C.W.J. and Newbold, P. (1974), "Spurious Regressions in Econometrics", Journal of Econometrics, July, pp. 111-20

Metwally, M.M. and Tamschke, H.U. (1980), "Oil Exports and Econometric Growth in the Middle East", Kyklos, pp. 499-522.

Neary, J.P. and Purvis, D.D. (1982), "Sectoral Shocks in a Dependent Economy: Long Run Adjustment and Short Run Accommodation", Scandinavian Journal of Economics, pp. 229-53.

Pesaran, M.H. (1984), "Macroeconomic Policy in an Oil-Exporting Economy with Foreign Exchange Controls", Economica, Vol. 51, pp. 253-70.

Suliman, M.O. (1984), "Appropriate Exchange Regimes and Trade Structure for Small, Open, Developing Economies in the Context of Trade Controls", unpublished PhD Dissertation, Department of Economics, Indiana University.

Takayama, A. (1974) Mathematical Economies, The Dryden Press, Hinsdale, Illinois. Turnovsky, S.J. (1976), "The Relative Stability of Alternative Exchange Rate Systems in the

Presence of Random Disturbances", Journal of Money, Credit and Banking, pp. 29-50.

impact of external price shocks on the oil-based developing economies

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