Annex 2A


 When the exchange rate is fixed, only the prices of non-tradables increase as a result of an
 S increase in demand from A to F. while the domestic prices oftraIdahle are not affected. Due
 to the price increase of non-tradables, the expenditure line rotates through H to the new
 posjiIon-DR. The new point of aggregate demand is F' where n3 non-tradables and t3
 tradables are pjrhased Due to the change of relative prices in favour of non-tradables,
 'production of non-tradables increases from ni before to n3 and is in equilibrium with demand
 for non-tradables. (The tangent of the production possibility curve in point A' has the same
 slope as the new budget line). As to tradables, demand has increased from tj to t3, while
 production has gone down from tl to t4. In the new situation (F'), demand for tradables
 exceeds production by t3-t4 with a corresponding foreign trade/current account deficitL

 (F can only be maintained if the balance of foreign exchange required is made available, for
HM oc// \Kexample, by a depletion of the country's foreign exchange reserves, by substantial capital
 L inflows, e.g foreign aid, foreign investments, remittances from emigrants working abroad, or,
 / \ last but not least, foreign credits. The latter source of financing a trade deficit has been
 common practice but, as experience shows, has only provided short-term relief and led to no
 sustainable solution.

 5. Main conclusions from the model analysis

 The Salter-Swan-model provides evidence on the major factors causing structural imbalances
 and the role of macro-economic policies in either reinforcing or mitigating the dynamic of
 macro-economic disequilibria. The main conclusion from the model analysis for the design
 of economic policies design is clear:

 Reduce policy interventions which impede market processes and encourage market
 forces to establish a state of macro-economic equilibrium. Even if a disequilibrium
 emerges which may be induced by external or internal shocks, any policy intervention should
 be in the direction indicated by market forces (Adam Smith's invisible hand of the market) to
 find a way towards establishing a new macro-economic equilibrium. This is the basic
 philosophy behind IMF and World Bank assisted adjustment programmes.

 However, in spite of the clear and simple conclusions which can be drawn from this analysis.
 critical reservations need to be raised as to the validity of certain assumptions in the model
 and to an unthinking mechanistic application of the messages resulting from use of the model
 in policy formulation:

 This model presents a purely economistic view. It abstracts, for example, from all supply
 and demand factors which are not transmitted through the market and are not expressed in
 market prices. This refers, for example, to all goods and services provided within the
 household economy as well as all those needs which are not expressed as effective monetary
 demand. As to the food economy, all sources of food entitlement bypassing the market
 channels (subsistence production, non-market transfers) as well as food needs of the poor
 who lack the purchasing power to articulate their needs as effective market demand are
 ignored. If such factors are overlooked in policy formulation, this implies a neglect of major
 productive forces and of important aspects of social welfare. It would mean, for example, that


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