Annex 2A


 full employment of all production factors,
 the demand for tradables equals production, and imports equal exports, hence the
 exchange rate is in equilibrium,
 the demand for non-tradables equals production,
 all parameters (production, demand, prices, exchange rate) are in a stable position.

 Although, in reality, such an ideal situation can never be found, economic theory assumes
 that an economy tends to develop towards such an equilibrium point, even after having been
 exposed to macro-economic shocks (which may put the economy into a state of
 disequilibrium for a while), if it is not hindered by distorting factors. Major distortions arise
 from demand manipulation and market rigidities resulting from government deficit spending
 and monetary expansion in combination with exchange rate controls. Such factors are
 introduced in the next step of the analysis.

 3. Distortions of the macro-economic equilibrium

 It is assumed that a rise in government expenditures, incurring a budget deficit being financed
 by monetary expansion (printing of money), has pushed demand to point F in Figure 2 (or
any other point outside the production frontier). We get a situation where demand exceeds
 production, in our case of both tradables (t2-t ) and non-tradables (n2-n ). In an ex ante view,
 before the additional money is actually spent and before prices have changed, the new
 expenditure line is given by GH which runs parallel to the income line DE.

 Any combination of demand to the ght ofpoint A means an excess demand for non-
 tradables, any combination above A implies an excessdemand for tradables and a current
 account.deficit. If prices and the exchange rate were not controlled, domestic prices would
 rjjise ino cases. directly due to excess demand in the case of non-tradables, indirectly in the
 case of tradables through the market-price-exchange rate mechanism (see par. 3.1 below,
 world market prices are assumed to be given and fixed). A balance between production and
 demand and a new equilibrium will be re-established by inflation: income and demand will
 increase in nominal terms but remain the same in real terms while the quantity of produHtion
 remains the same throughout. In our graph (which depicts the real values), the expenditure
 curve shifts back to its original position (indicated by the straight arrow).

 If there were a change in the structure of demand for tradables and non-tradables (change of
 the indifference curves) associated with the expansionary fiscal/monetary policy, the relative
 prices (internal terms of trade) would change, as the rates of inflation of tradables and non-
 tradables would be different and induce a relative shift in the production structure towards the
 commodities with relative price increases. In the case of an excess demand for non-tradables.
 the budget line would rotate clockwise in point H to line IH (non-tradables get relatively
 more expensive) with the new equilibrium point at A', where more non-tradables and less
 tradables are produced than at point A. In the case of an excess demand for tradables, the
 budget line would rotate counter clockwise in point G to line JG with the new equilibrium
 point at A", implying a shift in the production pattern from non-tradables to tradables.


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