WF5 tibl
POLICY RESEARCH WORKING PAPER   1967
Agriculture and the                                                   This paper surveys the
literature on the interaction
Macroeconomy                                                          between agriculture and the
macroeconomy in both
industrial and developing
Maurice Schiff
Alberto Valdeis                                                       countnes, identifying what
the authors believe to
represent its most significant
contributions and
shortcomings.
The World Bank
Development Research Group
Trade
and
Rural Development Department                                                   U
August 1998 



POLICY RESEARCH WORKING PAPER 1967
Summary findings
Based on an economywide perspective, this paper begins        Dutch Disease phenomenon and agriculture. The paper
wvith a discussion of the bias against exports and            next examines the influence of interest rates on
agriculture that characterized the economic literature and    incentives in agriculture, arguing that, surprisingly, this
the development strategies in many developing countries       has been a neglected area in the literature.
after World War II. This is followed by an analysis of          The paper explores the effects on agriculture of
how the macroeconomic environment affects agricultural    structural adjustment programs implemented since the
price incentives. Specifically, the paper discusses how       early 1980s in developing countries. The final section
policies concerning industrial protection, exchange rates,    surveys the literature on agriculture and the
and interest rates and other fiscal policies can strongly     macroeconomy in industrial countries, focusing on the
influence the economic incentives for agriculture             impact of the exchange rate on export competitiveness in
compared with other sectors, identifying the most             the United States, the cost of agricultural protection for
relevant literature and alternative approaches used on        the overall economy in Europe and Japan, and the
this issue. It then proceeds to examine how the real          increased importance of fluctuations in money markets
exchange rate can be affected by exogenous shocks, such       for the farm sector and the additional instability they
as the foreign terms of trade, with emphases on the           generate.
This paper - a joint product of Trade, Development Research Group, and the Rural Development Department- will be
published in B. Gardner and G. Rausser, eds., Handbook of Agricultural Economics, North Holland Publishers. Copies of
this paper are available free frorm the World Bank, 1818 H Street NW, Washington, DC 20433. Please contact Alberto
Vald6s, room S8-015, telephone 202-473-5491, fax 202-522-3307, Internet address avaldesCa?worldbank.org. Maurice
Schiff may be contacted at mschiff Aworldbank.org. August 1998. (37 pages)
The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about
development issues. An objective ofthe series is to get the findings oat quickly, eveni ifthe presentations are less than fnuly polished. The
papers carry the names o/the authors and should be cited accordin,,ly. The findings, interpretations, and conclusions expressed in this I
paper are entirely those of the authors. They do 7not necessarily represent the viewv of the World Bank, its Execudtive Directors, or the
coontries they represenlt.
Produced bv the Policy Research Dissemination Center



Elsevier Science
Handbook of Agricultural Economics
Ed. by B. Gardner and G. Rausser
Agriculture and the Macroeconomy
Maurice Schiff and Alberto Valdes
World Bank



Introduction
Until the mid-1980s, most analysts of agricultural policies were preoccupied with
the direct effects of sectoral pricing and trade policies on output, resource use, and income
distribution. Since that time, however, a number of analyses have suggested that the
indirect effects of economy-wide policies on agricultural incentives have been greater than
the impact of policies directed specifically toward agriculture. Conversely, in some cases,
agricultural policies have had significant effects on macroeconomic variables.
This chapter surveys literature on the relationship and interaction between
agriculture and the macroeconomy, in both developing and industrialized countries. It
presents an organized discussion of this literature, identifying what the authors believe to
represent the most significant contributions and shortcomings of the existing scholarship on
agricultural economics. We begin with a discussion of the bias against exports and
agriculture that characterized development economics following the Second World War
and the decolonization of many developing countries. During this time, export pessimism
drove the shift from agriculture toward industry, and the substitution of imported industrial
products with domestically produced goods. This substitution occurred irrespective of
comparative advantage or disadvantage. The effects of import-substituting policies on
agricultural incentives and economic growth were profound. A reorientation towards more
open economies followed, beginning in South America in the mid-1970s, and becoming
more profound in the mid-1980s. The changes were influenced by trade and development
economists who began to investigate the potential contribution that opening the trade
regime could make to overall economic growth.
In an analysis of agricultural incentives from an economy-wide perspective, it was
found that the "indirect" effects of macroeconomic and industrial policies were no less
important to agriculture than the "direct" sector-specific agricultural policies. Two key
relationships were central in this analysis: the relative price of agricultural to non-
agricultural products, and the price of tradable to non-tradable (or "home") goods, i.e. the
real exchange rate. We examined the factors that determine the equilibrium real rate of
exchange, and that shift actual exchange rates toward equilibrium. These factors include
both policy-induced domestic forces (such as changes in technology and productivity), and
exogenous international forces (like changes in a country's foreign terms of trade).
Exogenous factors include the relative prices of a country's imports and exports (its
terms of trade) and the variables that go into determining them. One of the determinants is
an export commodity boom (in some cases resulting in "Dutch disease" phenomenon),
whose effect on other tradables has proven to be profound. Foreign capital flows are also
significant in determining exchange rates, the price of inputs, and the cost of borrowing
money. We discuss below the importance of interest rates to these capital flows, as well as
their effects on agricultural investment itself.
We then explore the effects of structural adjustment programs. These began during
the 1 970s, and gained currency throughout the developing world during the 1 980s, as
countries sought to correct their macroeconomic imbalances, especially overvalued
exchange rates, that resulted from years of industrial protection and budget deficits.



In the final section, we compare and contrast the experience of the industrialized
"North," where agriculture accounts for a far lower proportion of national incomes and
economic growth, to that of the developing "South", where substantially greater levels of
exchange rate misalignment and industrial protection have imposed severe indirect taxation
on agriculture. In stark contrast to the Southern experience, Northern agriculture enjoyed
substantial protection even while industrial protection declined over time. We explore the
macroeconomic implications of agricultural protection in the North for international prices
and agricultural competitiveness, giving special attention to US agricultural tradables and
the European Community's experience under the Common Agricultural Policy.
Development Strategies in the South After World War II: A Historical Perspective
The historical setting in which countries conceived and implemented development
strategies in the decades following World War II is an appropriate place to start. The
central issue of the time was finding and then cultivating a developing economy's "lead"
sector, the sector capable of serving as its "engine of growth". This "engine" would
presumably provide the income necessary to nourish and sustain economic development,
while fostering a self-reliance that would prevent a society from depending upon
international market forces that were outside a small country's capacity to affect.
Economists recalled the collapse of primary commodity markets during the Depression,
and of the disruptions in these markets during the Second World War. Their fear of such
dependency led many development economists to ally themselves with what became
known in economics as the "structuralist school" and "dependency theory."
The sector which seemed capable of providing the "engine", particularly in the
aftermath of the colonial experience, was industry. Agriculture was viewed, by many, as
the station of the colony, the provider of primary products demanded by industrial
countries. Persisting in this peripheral role would be tantamount to a defacto perpetuation
of colonialism, hence the term neo-colonialism. But the nationalistic impulse among
developing countries, many of which were newly independent, was not alone in leading
many in the developing world to spurn agriculture and to discount its potential
contribution to economic growth. Agrarian society by its very nature was regarded as
socially and economically backward, governed by tradition, impervious to market signals,
and devoid of links to other sectors that could bring the benefits of progress in agricultural
production to the economy as a whole.'
Another concern was the perceived secular decline in real agricultural prices which was blamed on
an inelastic demand for agricultural products. The assumption was that the shift in the supply of
agricultural products over time associated with technical progress was larger than the shift in
demand. On the other hand, Martin and Warr (1993) and Gelhar et al. (1994) have argued that
Rybczynski effects associated with the accumulation of capital in the process of growth result in a
shift of resources away from the labor-intensive sector (agriculture) to the capital-intensive one
(industry), which should dampen the negative effects on relative agricultural prices.
2



The academic acceptance of these presumptions without proper empirical evidence,
and the overwhelming pre-eminence that scholars afforded industrial policy as a result,
represented a monumental failure on the part of development economists. The illogic of this
course was characterized succinctly by Theodore W. Schultz at the beginning of
Transforming Traditional Agriculture (1964), when he wrote that "economists who have
been studying growth have, with few exceptions, put agriculture aside in order to
concentrate on industry, despite the fact that every country has an agriculture sector and in
low-income countries it is generally the largest sector." Schultz' work set into motion an
academic reexamination of the anti-export, anti-agricultural prejudice of dependency
doctrine that would ultimately provide many of the theoretical underpinnings of the policy
realignments of the 1980s.
The preoccupation with the limits of traditional and subsistence agriculture that
was so characteristic of structuralists and dependency literature led to a neglect of
agriculture in general. The fear of depending on agricultural exports led to a neglect of the
potential contributions export revenues might deliver to growing, capital-starved
economies. And yet, one of the outstanding attributes shared by nearly all developing
countries was that their exports were overwhelmingly agricultural.
Another attribute shared by most developing countries was that their imports were,
in large measure, industrial products. The unfortunate alternative to pursuing productivity
gains in exportables was to replace imports with products made domestically. The
prescription of import-substituting industrialization followed from the structural and
dependency doctrines' assumptions about agriculture. The reasoning was that if industry
lacked competitive advantage, it must be fostered artificially. The industry must be
shielded from powerful foreign competitors by import barriers until it became capable of
competing, regardless of whether or not this was a realistic expectation. Whatever costs
had to be incurred by other sectors, including agriculture, to pay for this protection were
justified on these grounds. The costs of this protection were felt widely across entire
economies, with disastrous effects on growth.
One theory that had a significant impact on economic policy was that of "balanced
growth," articulated by Rosenstein-Rodan (1943) and Ragner Nurkse (1952). They
predicted that rapid growth in developing economies would not be achieved through
increased exports of primary commodities, and argued that development strategies should
place greater emphasis on industrialization. Recognizing the limits imposed by the small
size of domestic markets, balanced growth theory prescribed the simultaneous promotion
of a variety of different industries in a way that would foster complementary demand
among those industries for one another's products. A central premise in Rosenstein-Rodan
and Nurkse's work (as well as that of Ranis-Fei, A. Lewis, and others), was the
assumption that a large surplus of labor was employed at zero marginal product in rural
areas. This surplus would prevent labor bottlenecks from occurring that might otherwise
constrain balanced growth. Underlying the concept of a balanced growth path was the
perception that resources for investment were severely limited. This, coupled with the
3



belief that a certain minimum level of investment was required to capture the external
economies of sectoral growth and move a country to a higher growth path, was the "big
push" advocated by Rosenstein-Rodan (1943, 1957). And it was here that the debate over
where resources should be concentrated came to a choice between agriculture and
industry.
The "structuralist school," embodied in the works of Prebisch (1950), Singer
(1950), and Myrdal (1957), drew similar conclusions, strongly emphasizing the forces
which limited demand for primary products. The structuralist view, prevalent at the time,
was that agriculture in general, and the traditional agriculture that was characteristic of
developing economies in particular, was slow and weak in its response to market signals,
owing to such constraints as imperfect factor mobility.2
Pessimism about the potential of agricultural exports to "lead" economic
development was based on a number of factors (Valdes, 1991). Agricultural exports
tended to consist of a small number of commodities, more reliant on natural resources as
inputs than other commodities. For this reason, the agricultural sector was perceived as
having few or weak linkages with the rest of the economy, and thus unable to serve as an
"engine of growth." Demand for many of these primary commodities was presumed to be
inelastic, both with respect to their prices and to income. It was argued that dependence on
a few export commodities implied that import capacity would be determined by the prices
of these commodities on the international market, making income subject to boom-bust
cycles which governments could do little or nothing about. There were those who felt that
the lack of control over foreign exchange earnings made outward-oriented development
strategies seem irresponsible.
Given that many countries were indeed experiencing declining demand for their
primary agricultural products (Meier, 1989), it is perhaps not surprising that these ideas
camne to profoundly influence the formulation of development strategies in many
developing countries. In the 1 950s, these countries began pursuing higher economic
growth through policies of import-substituting industrialization. High import tariffs and
concessional credit lines favored industry, while low import tariffs and relatively high
export taxes on agricultural products revealed the extent to which the prevailing export
pessimism was embraced by Third World policy-makers. Resources had to be
purposefully channeled to the non-farm sectors which were thought capable of
contributing to and sustaining faster growth within the overall economy. Agriculture in
this view was there to serve simply as a resource base.
2 The belief that agricultural output was not responsive to changes in price was also
propounded in industrialized countries. This arose from the experiences of the US during the
Depression (1919-22 and 1929-33), as articulated by Galbraith (1938). However, D.G. Johnson
(1950) disputed the validity of this hypothesis as applied to the Depression, and also disputed
its applicability during times of full employment.
4



As understandable as the popularity of the structuralist school was, their emphasis
on factors that would limit the demand for primary products led them to discount the
possible benefits that opening new markets for new primary products might have.
Moreover, the assumption that agriculture had few and weak linkages to the rest of the
economy caused structuralists to disregard these linkages in their strategy. In fact, little
empirical evidence was produced regarding the strength or extent of the interrelationship
between agriculture and the larger economy (Valdes, 1991).
Beginning in the early 1960s, the structuralist and dependency-theory schools
faced increasing criticism. Schultz's Transforming Traditional Agriculture, and
pioneering cross-country studies on trade policy and development by Little, Scitovsky,
and Scott (1970), Anne Krueger and Jagdish Bhagwati (1978), and Bela Balassa (1982),
argued that in terms of both growth performance and employment generation, export-
oriented development strategies had performed better than import-substituting ones during
the post-World War II period.
By the mid- 1 980s, developing countries had grown increasingly disillusioned with
import-substituting strategies, and a major reorientation has been taking place ever since.
The new approach involves a more open economy, and recognizes the active role that
agriculture can play as a major tradable sector in most developing countries.
The Macroeconomic Environment and Agricultural Price Incentives
Governments affect agriculture directly through sector-specific measures including
tariffs, input and credit subsidies, price controls, quantitative restrictions (QRs), and
government expenditures and taxes. Indirectly, government policies often have
unintended effects on agriculture. Policies concerning industrial protection, exchange
rates and interest rates, and other fiscal and monetary policies can strongly influence the
incentives for agriculture vis-a-vis other sectors. For example, border protection has often
been used to protect domestic manufacturing, and restrictive trade policies, accompanied
by fiscal deficits, often result in exchange rate misalignment. Agriculture is also affected
indirectly by exogenous changes in the world prices of non-agricultural commodities,
such as oil and minerals, and by foreign capital flows. Because sectoral growth is affected
by resource flows between sectors, and because these flows adjust to the relative
opportunities offered by different sectors over time, an economy-wide view of returns is
necessary for understanding the dynamics of agricultural growth and employment.
Traditionally, agricultural economics has defined the effect of economic policies
on incentives in terms of the nominal tariff, or sometimes the tariff equivalent (incltiding
QRs), faced by agriculture, or what we referred to above as "direct" price interventions.
Alternatively, in a general equilibrium framework, agricultural incentives could be
defined in terms of the relative price of agricultural to non-agricultural products. The
difference between the two concepts lies in the definition and the measurement of price
5



interventions. Most studies have taken the price of the non-agricultural sector as given,
and have restricted their analysis to the effects of sectoral or direct policie, on agricultural
prices. Some studies did adjust for exchange rate misalignment, generally employing
nominal exchange rates (we will argue below that the real exchange rate is more
appropriate). For examples of the nominal exchange rate adjustment approach, see Valdes
(1973). Taylor and Phillips (1991), Byerlee and Sain (1986), and Lattimore and Schuh,
(1979).
Agriculture's ability to compete for resources domestically and globally is directly
affected by economy-wide policies. These policies have important effects on relative
agricultural prices through the real exchange rate and the price of non-agricultural tradable
activities. We proceed below with a discussion of nominal and real exchange rates,
followed by a description of the evolution of our understanding of how macroeconomic
policies affect agricultural incentives. The remainder of the section discusses, in turn,
exogenous effects (in particular export-commodity booms), interest rates, and structural
adjustment programs.
The Real Exchange Rate
There are two major concepts of the exchange rate, namely the nominal and the
real rates. The nominal rate is an undeflated conversion factor between one currency and
another. It corresponds to the exchange rate a government can announce or fix. The
nominal equilibrium rate is the rate at which the demand and supply of foreign exchange
(to finance both current account and autonomous capital account transactions) are equal
for a given set of trade taxes. The purchasing power parity (PPP) relates the purchasing
power of one currency to that of another, by adjusting the nominal rate for relative
inflation. Neither the PPP nor the nominal equilibrium rate necessarily imply an optimum
exchange rate, nor do they correspond to the shadow price of foreign exchange used in
social project evaluation. The PPP is considered to be misaligned when its value differs
from the base period value. The concept of effective exchange rate, a commodity-specific
rate that expresses the price of foreign exchange including all import or export taxes, is
useful in analyzing individual activities.
In contrast, the real exchange rate (RER) is a relative price that reflects the
competitiveness of the tradable sector (import substitutes and exportables). The RER
varies according to the definition used (e.g., with respect to the deflator). Following Salter
(1959), Swan (1960), Dornbusch (1974), and others, the RER introduces the concept of a
home goods (or non-tradable) sector. A key factor on which the distinction between
tradables and non-tradables is based is their price-formation mechanism. Both prices and
quantities of home goods are determined by domestic supply and demand. In contrast, for
small open economies, the domestic prices of tradables are determined by world markets
together with the nominal exchange rate, trade taxes, and subsidies.
6



The various definitions of the RER that are used in agricultural economics
literature have resulted in some confusion.3 One version is the purchasing power parity
index mentioned above. Most early studies that attempted to measure the impact of the
RER on agricultural incentives used the PPP approach (for example, Valdes, 1973;
Binswanger and Scandizzo, 1983, and more recently Byerlee and Sain, 1986). There are at
least three problems with the PPP concept of the RER. The first is the possibility that the
base period RER may be misaligned as a result of macroeconomic disequilibrium.
Secondly, even if the RER is in equilibrium in the base period, there is no reason to
assume that this equilibrium will remain unchanged over time, owing to such factors as
changes in the terms of trade and international interest rates. Thirdly, the base period PPP
is obtained under given trade policy distortion, while we are interested in the equilibrium
RER that would prevail in the absence of trade policy distortions. This requires a model of
RER determination not found in the PPP adjustment.
A now widely accepted definition of the real exchange rate is the ratio of the price
of tradables to non-tradables:
(1) RER = P7
PNY
in which PT is the price of tradables and PNT is the price of non-tradables. The RER can
serve as a proxy for a country's international competitiveness (Edwards, 1988). An
increase in the RER (a depreciation) represents an improvement in the country's
international competitiveness given relative prices in the rest of the world. Conversely, a
decrease in the RER (an appreciation) indicates a decline in the country's international
competitiveness. Changes in the RER can occur as a result of policy-induced effects that
reflect a misalignment in the RER, and as a result of exogenous factors that reflect a
change in the equilibrium value of the RER.
In empirical estimation, the RER is often proxied as
(2)    RER = E
where Eo is the nominal exchange rate, expressed as local currency per unit of foreign
currency, P* is the foreign price index for tradables (often approximated by the wholesale
price index), and P is the domestic price index, presumably heavily weighted by the home
goods sector (as with the consumer price index).
It is important to clarify the concept of equilibrium RER (ERER). Several
conceptual and empirical definitions of the ERER are used in the literature, including the
PPP. Edwards (1988) defined the ERER as that level of RER at which the economy is
3 See Hinkle and Nsengumiva (1995) for a detailed discussion on the various definitions of the
real exchange rate.
7



accumulating or decumulating foreign assets at the "desired rate," and at which the
demand for domestic goods equals supply. This definition can be refined to consider an
ERER for a given trade policy regime, such as the ERER that would prevail under free
trade. An important feature of this definition is its treatment of the ERER as a general
equilibrium concept.
Edwards' calculation was based on the idea of "macroeconomic fundamentals",
and provides a useful framework for the discussion at hand. The "macroeconomic
fundamentals" that determine the RER can be divided into external and internal factors.
The internal factors can be divided into those influenced by policy decisions, and those
that are exogenous to policy. Domestic policy variables include import tariffs and export
taxes, quantitative restrictions on imports and exports, exchange and capital controls,
other taxes and subsidies, and the level and composition of government expenditure.4
Domestic effects that are exogenous to domestic policies include productivity changes and
teclmological progress, among others. External factors include international prices,
international transfers (such as private capital flows and foreign aid), and world real
interest rates.
Changes in any of the variables will have an impact on the level of the RER, and
most will affect the level of the ERER. For example, an increase in the world price of
importables relative to exportables (i.e. a deterioration of the terms of trade) reduces the
quantity of importables demanded, and induces a change in the level of the ERER (the
direction of the change is ambiguous due to the negative income effect). An increase in
import tariffs will have a similar effect on the domestic relative price of importables,
reducing the quantity of importables demanded, anid resulting in demand switching to
non-tradables and exportables. This in turn exerts upward pressure on the price of non-
tradables, causing the ERER to shift downwards (i.e. to appreciate), given the existing
trade policy regime and other determinants. Sustainable, or permanent, increases in
government expenditure can also cause the ERER to decrease, owing to the increase in
aggregate demand. Even if increases in government spending are financed through taxes,
the ERER may appreciate due to the public sector's higher propensity to spend on non-
tradables (such as labor).
The ERER is, therefore, not a constant, but follows a discernible trend, a fact of
critical importance when considering the effects of policy decisions. Elbadawi (1994), for
instance, found India's ERER from 1967 to 1981 not only close to the actual RER, but
that the ERER depreciated along with the actual RER. This does not imply that the rupee
4 Williamson (1994) pointed out that the evidence for the relevance of the composition of
government expenditure was weak. Both Edwards (1994) and Elbadawi (1994) included it as a
variable in estimating ERERs. In Williamson's view, the size of government expenditure was
the important factor, not its composition.
8



was not overvalued, but simply that the actual depreciation was just sufficient to offset the
reduction in protection, leaving the margin of overvaluation almost unaffected.
Conversely, changes in the RER do not necessarily reflect disequilibrium. For
example, technological progress in the production of importables (which will result in an
improvement in the foreign terms of trade), or increased capital inflows, will both result in
an appreciation of the RER. Insofar as the changes in these factors are permanent, the
ERER will also appreciate.
While the ERER is determined by real variables, the actual RER responds to both
real and monetary variables. Typically, the RER is misaligned when the monetary and
fiscal policies in place are inconsistent with the chosen nominal exchange rate regime.
When the nominal exchange rate is fixed, any increase in domestic credit that exceeds
growth in the domestic demand for money (i.e. expansive monetary policy) will result in
excess demand for both tradables and non-tradables. Excess demand for tradables
translates into higher trade deficits, loss of international reserves, and/or higher net foreign
borrowing, none of which affect domestic prices. Excess demand for non-tradables results
in higher prices, and thus appreciation of the RER. If this appreciation is not the result of
equilibrium changes in the macroeconomic variables, it implies a deviation of the actual
RER from its equilibrium value.
It is also possible to construct another estimate of misalignment by comparing the
ERER under the conditions of free trade to the actual RER. This construction was used by
Schiff and Valdes (1992) in computing the indirect effect of trade and macroeconomic
policies on agricultural incentives.
Policy-Induced Effects
In order to examine the impact of policy on agricultural incentives, we examine
the impact on the value added among agricultural goods relative to that among non-
agricultural goods. Both types of goods can be divided into tradables and home goods, i.e.
VA   A /VAA, + (1  )VAA,,
VANA    a VA1,, + (1-a) VA,,,
where VA A is value added in the agricultural sector, VA NA is valued added in the non-
agricultural sector, and VA, is value added in the non-agricultural tradable (or industrial)
sector. The subscripts T and H refer to tradable and home (non-tradable) goods;
respectively. Since most agricultural goods are tradable, the value of D is usually taken to
be very close to one. The expression simplifies to the following form,
9



(4) VAA            VAA             a
VANA   a VA1 + (I - a) VAH
This can be re-written as:
(5) VAA          VAA/VAH            a < 1.
VANA   a VAI / VAH + ( - a)
Many studies use relative prices instead of value added, in which case the
expression becomes:
(6) PA         PA/PH             a<I
PNA   aPI/PH + (1-a)
The relative price (or value added) of agricultural goods to non-agricultural goods
can- change as a result of changes in the price (or value added) of agricultural, industrial,
or home goods. Protection of industry will affect agricultural relative prices in three ways.
The first is through the real exchange rate, i.e. the price of tradables relative to non-
tradables. Appreciation of the RER lowers both PA/PH and PI/PH, thus lowering PA/PNA.
Secondly, industrial protection raises the domestic prices of industrial goods (PI),
therefore lowering the relative price of agricultural goods. Thirdly, it lowers agriculture's
value added by raising the cost of agricultural inputs.
Protectionist policies could theoretically result in higher PH, higher PI, lower
VAA, or any permutation of the three, depending on what macroeconomic policies are
followed. An increase in the price of non-agricultural goods, resulting from industrial
protection using tariffs or other restrictions, will lower the relative price of agricultural
products. Industrial protection may also result in higher prices of agricultural inputs such
as fertilizer, which will reduce the value added of agriculture (Schiff and Valdes, 1992).
Finally, an increase in the relative price of home goods (i.e. an appreciation of the real
exchange rate) will adversely affect the relative price of agriculture to non-agriculture
(since the value of a is usually significantly less than 1), thus reducing the value of the
numerator more than the value of the denominator in equations (5) and (6).
Early discussions of the bias against agriculture as a result of industrialization
policies pursued by developing countries is found in Diaz-Alejandro's (1970) study of
Argentina, and Little, Scitovsky, and Scott's (1970) study of seven developing economies
in the 1 950s and 1 960s. Diaz-Alejandro used relative prices to examine the impact of
protectionist policies on agriculture, while Little, Scitovsky, and Scott examined effective
protection through an analysis of value added. In the early 1980s, influenced by the work
of Sjaastad (1980), the Trade Policy Program at the International Food Policy Research
Institute (IFPRI) adapted and extended the "true protection" approach to analyze the issue
10



of how industrial policies affected the price of agricultural tradables relative to non-
tradable goods (for a synthesis of this research, see Valdes, 1986). Later, Krueger, Schiff,
and Valdes (1988) and Schiff and Valdes (1992) adapted the "elasticities" approach to
exchange rate determination in conjunction with an explicit treatment of non-agricultural
prices (PNA). These works explored the combined effect of direct (sector-specific) and
indirect (economy-wide) policies on agriculture in a sample of eighteen developing
countries. A sketch of these various approaches is presented below.
The Diaz-Alejandro Approach
Diaz-Alejandro (1970) examined the case of Argentina from 1930 to 1964,
studying the impact of policy on the relative prices of final goods. He focused exclusively
on one ratio, PA/PI, finding that exports (virtually all of which were agricultural
commodities) and the rural sector in general were effectively discriminated against by
Argentine macroeconomic policies. Diaz-Alejandro's hypothesized bias against exports
and agriculture was supported empirically by both data on the evolution of the external
and internal terms of trade, and crop-specific data.
Diaz-Alejandro focused on the relative prices between agricultural and industrial
commodities. He used a proxy that he called the "external terms of trade", or the ratio of
export prices to import prices. The second proxy he used was the "internal terms of trade",
or the ratio of wholesale prices of rural products to those of non-rural goods. He then
calculated an index of the ratio of internal to external terms of trade as a summary
measure of the net effect of government policies on relative prices.
Table 1.    Argentina: Agricultural Domestic and External Terms of Trade
(1935-39 = 100)
Years               Internal TOT         External TOT         Ratio Int/Ext
1925-29             132                  111                  119
1930-34             87                   79                   110
1935-39             100                  100                  100
1940-44             62                   89                   70
1945-46             74                   120                  62
1947-49             80                   169                  47
1950-52             68                   124                  55
1953-55             68                   114                  60
11



1956-58              78                   93                    84
1959-61              85                   91                    93
1962-64              93                   89                    104
Source: Diaz-Alejandro (1970)
Between 1925 and 1949, when the overwhelming majority of Argentina' s exports
were agricultural products, the internal terms of trade of agricultural goods deteriorated
relative to Argentina's external terms of trade as a result of domestic policies. In the
period from 1930 to 1939, Diaz-Alejandro calculated the average index value as 105.5 The
second period, from 1945 to 1955, covered the Peron years, during which policies were
severely biased against agriculture. This period was characterized by extensive import-
substituting industrialization, and the index average dropped to 55. During the final
period, from 1955 to 1964, the index averaged 94, as the bias against rural goods
diminished.
The Effective Protection Approach
The concept of effective protection, developed by Corden (1966) and Balassa
(1965), was used in cross-country studies of the manufacturing sector by Balassa (1965),
and by Little, Scitovsky, and Scott (1970). In their analysis of seven developing countries
in the 1950s and 1960s, Little et al. (1970) compared domestic value added to value
added at world prices. They found extremely high levels of protection for manufacturing
in several of the countries, as high as 313 percent in India in 1961 (the lowest being 27
percent in Mexico in 1960). In four of the seven cases, nominal protection exceeded 100
percent, far higher than could be justified by those who argued in favor of protection of
infant industries.
The protection of manufacturing worked against agriculture by reducing both the
relative incentive (or demand) to invest in the production of agricultural goods, and the
resources available (supply) for this investment. This was especially true of agricultural
tradables, since protection (through quotas, tariffs, and other controls) enabled overvalued
currencies to persist. Little et. al. found nominal protection for agricultural exports
ranging from -10 percent to zero in their sample. Considering that the domestic prices of
manufactured agricultural inputs exceeded world prices in general, effective protection of
agriculture was even lower, and lower still when compared with the high levels of
protection afforded manufacturing.
The "True Protection" Approach
5 Diaz-Alejandro excluded the World War II period, 1940-44.
12



On the premise that an import tariff is an implicit tax on exports (the Lerner
Symmetry Theorem), Sjaastad (1980) derived an incidence parameter, co, using a three-
sector model of a small open economy. The incidence parameter, co, measures the effect
of an increase in import prices (such as would result from an increase in tariffs) on the
domestic price of non-tradables. The term (I -co) measures the change in the price of
importables to non-tradables, something Sjaastad referred to as the "true tariff'. The
application of this approach to agriculture by IFPRI's Trade Program during the 1 980s
focused on the impact of changes in P1/P H (true industrial protection) on agricultural
prices relative to the prices of non-tradables (PA/PH). When a policy of industrial
protection such as an import tariff is put into place, the domestic price of imports rises,
attracting resources to protected sectors, and shifts consumer demand away from them,
resulting in excess demand in the other sectors. This in turn leads to a rise in the price of
non-tradables, and a reduction in the relative price of unprotected tradables (including
agricultural exportables), in effect acting as a tax on them. This effect is reinforced by
wage pressures generated by the higher cost of living due to the rise in the price of
imports.
The incidence parameter, o), reveals the extent to which the burden of the change
in relative prices is divided among different sectors. If importables and home goods are
close substitutes, either in consumption or production, the most notable effect of higher
tariffs is to reduce the price of exportables relative to the price of home goods. The
equation that Sjaastad used in his empirical estimation was:
(7) ln(ph / P) = a + c ln(p, / Pj)
where co, the incidence parameter, reflects proportional changes in the price of home
goods relative to exportables as a function of proportional changes in the price of
importables relative to exportables, Ph is the price of home goods, Px the price of
exportables, Pm the price of importables, and a is a constant.
Table 2.     Estimates of the Incidence Parameter (co) as it Affects Agriculture
Country                     Author                       Value of co
Argentina                   Sjaastad*                    0.4 to 0.5
Chile                       Sjaastad*                    0.5 to 0.6
Colombia                    Garcia                       about 0.9
Nigeria                     Oyejide                      0.6 to 0.9
Peru                        Valdes                       about 0.7
Philippines                 Bautista                     about 0.8
Zaire                       Tshibaka                     about 0.8
13



* Sjaastad's studies of Argentina and Chile analyzed the entire tradable sector, while the others
analyzed agriculture only.
Source: Vald6s (1986)
Table 2 presents the estimated incidence parameters of seven country studies, five
of which focused specifically on the agriculture sector. These studies found a fairly high
level of substitution between home goods and importables, implying a strong negative
impact on the relative price of exportables to home goods. For example, Bautista (1987)
found a persistent and significant bias in relative price incentives against agricultural
exports in the Philippines during the period from 1950 to 1980. The bias was not
surprising considering the Philippine's strategy of import-substituting industrialization
through the 1950s and 1960s. The surprise was that this bias persisted through the 1970s,
when the government was supposedly committed to export promotion. Bautista's study
also found that a 1O percent increase in the domestic price of importables was associated
with an 8 percent decline in the domestic price of agricultural exports relative to home
goods. This was essentially a significant tax on agricultural exportables. In Peru, Valdes
(1985) found that raising the uniform tariff of manufactured goods by 10 percent imposed
an implicit 5.6 percent tax (with respect to home goods) on the production of importables
(e.g. rice), and an implicit 6.7 percent tax on the production of exportables (e.g. cotton and
sugar).
The Mundlak general equilibrium econometric approach
The previous studies examined the impact of policy on incentives, but did not
examine the impact of policy on supply response. Most studies of agriculture's aggregate
supply response have used a partial equilibrium approach, and thus have failed to take into
account the effects of relative price changes on intersectoral resource flows over time.
More specifically, they have failed to take into account relative price changes associated
with economy-wide macroeconomic policies. An important contribution to correcting this
inadequacy was pioneered by Mundlak and his colleagues. Employing a general
equilibrium approach, Mundlak, Cavallo, and Domench (1989) analyzed the experience of
Argentina from 1913 to 1984. Argentina grew faster than many countries (including
Brazil, Canada, and the US) until 1930, at which point it began to lag behind. Mundlak
et.al. found that Argentine agriculture was heavily taxed post-World War II, directly
through export taxes, and indirectly through trade restrictions and protection of non-
agricultural goods (note that these findings are consistent with those of Diaz-Alejandro's
study of Argentina). Simulations in a general equilibrium framework suggested that
Argentina would have achieved a much higher rate of economic growth if it had crafted
policies that permitted it to benefit from its comparative advantage in agricultural exports.
Such policies would have ensured that incentives reflected true terms of trade, without
distortions.
14



In their study on Chile, Coeymans and Mundlak (1993) applied a five-sector
econometric model to the period 1962-82, and found that economy-wide policies were far
more important than sector-specific policies in influencing the sectoral allocation of labor,
capital, and overall growth. Changes in the RER affected sectoral prices according to the
sector's tradability. In the case of Chile, mining and agriculture had the largest tradable
components, suggesting that their product prices would be the most responsive to changes
in the RER. In their simulations, Coeymans and Mundlak found that mining and
agriculture did indeed respond strongly to changes in the RER. Chile's long-run aggregate
supply elasticity for agriculture was estimated to be 1.4, while Argentina's was estimated
at 1.8.
The Krueger, Schiff and Taldes approach
The taxation of agriculture through sector-specific price interventions, and through
trade, exchange rate, and other macroeconomic policies was examined for a wider sample
of developing countries in Krueger, Schiff, and Valdes (1988) and in Schiff and Valdes
(1 992-a,b). They examined direct protection as the difference between relative producer
prices and border prices (PA'PNA) at the official exchange rate. They also measured both
the effect of exchange rate overvaluation, using the elasticities approach, and the effect of
industrial protection on agriculture's relative price.
As derived in Schiff and Valdes (Chapter 2, 1992), the measures of intervention
were calculated as follows. The direct nominal protection rate is estimated as
Pi   P',
(8) NPRD = PNA  PNVS        I
___i    p, i
PNA
where NPRD measures the effect of price controls, export taxes or quotas, and other
sectoral policies on the domestic producer price, P, of tradable agricultural product i (Pi);
P'i is the border price (PiB) converted into local currency at the official nominal exchange
rate Eo and adjusted for transport, storage and other costs, and quality differences, so that
P'i = PiBEO; P*i is the border price of product i at the equilibrium nominal exchange rate E
and adjusted as before so that P*i = Pi BE = P'1 E*/ Eo; PNA is the nonagricultural sector
price index, which consists of a tradable share a with a price PNAT and of a nontradable
share 1 - a with a price PNAH, so that PNA = aPNAT + (1-a) PNAH; and P NA is the
nonagricultural sector price index, where the price index of the tradable part is evaluated
at E* and in the absence of trade interventions (tNA) affecting nonagricultural tradables, so
that P*NA= UPNAT [E*/ (1+ tNA) EJ] + (l-a) PNAH
The indirect nominal protection rate would be
15



P'i  P*i    P'i
(9) NPRi  PNA  P * NA   PNA-
(9)N=P *  P*i
P*NA      P*NA
P'i
=   PNA       P*NAEO
E* P,       PNAE*
Eo P*NA
It measures the effect of the difference between the nominal exchange rate, Eo,
and the equilibrium exchange rate, E , and of the effect of trade policy on PNAT. NPRI is
the same for all tradable products since Pi does not appear in equation (9).
The total nominal protection rate is
Pi   P*i    Pi
PNA  P * NA   PNA
(IO) NPRI. =    P*              I *-
P*i       P*i
P * NA    P* NA
Because the denominator of equation (8) differs from that of equations (9) and
(10), NPRD + NPR1 � NPRT. To make the three measures comparable, we define another
direct protection rate,
Pi P', i
(11) npro- =PNA  PNA
P*NA
* NA
which measures the impact of direct policies (Pi/PNA - P /PNA) as a percentage of the
relative price that would prevail in the absence of all interventions (P i/P NA), the same
denominator used in equations (9) and (10). Then, nprD + NPRI - NPRT.
Schiff and Valdes found that indirect taxation, NPRI , generally exceeded direct
taxation, nprD (see Table 3 below). Taxation of agriculture as a result of direct price
intervention averaged 8 percent, while indirect taxation (the product of macroeconomic
policies and industrial protection) taxed agriculture in excess of 22 percent, for a total
taxation of 30 percent. Industrial protection policies in most of the countries examined
had a more adverse impact on agriculture than did exchange rate overvaluation.
As shown in Table 3, sub-Saharan African countries had both the highest direct
and highest indirect taxation of agriculture, with a total tax on agriculture higher than 50
percent. The group of ten representative taxers had an average total rate of taxation of 36
percent. Of the 18 developing countries in the sample, only Korea and Portugal appeared
to be net protectors of agriculture.
In a nutshell, the most striking findings of Schiff and Valdes were:
D The indirect tax on agriculture from industrial protection and macroeconomic
policies was about 22 percent on average for the eighteen countries during
16



1960-85, nearly three times the direct tax from agricultural pricing policies
(which was about 8 percent). The total (direct plus indirect) was thus 30
percent.
*  Industrial protection policies taxed agriculture more than did real overvaluation
of the exchange rate.
*  High taxation of agriculture was associated with low growth in agriculture, and
low growth in the economy.
*  Surprisingly, most countries protected importables. On average, the direct
protection of importables was about 18 percent, and the direct taxation of
exportables about 16 percent, for an average impact (on the relative price of
importables to exportables) of about 40 percent. These distortions within
agriculture increased between the early 1960s and the mid-i 980s.
Direct price policies stabilized domestic agricultural prices relative to world
prices, with an average reduction in variability of 25 percent, and even more
when world prices were highly volatile. Indirect policies contributed little, if
anything, to price stability.
* Public investment in agriculture did not compensate for adverse price policies.
*  The effect of removing agricultural price interventions was not regressive. In
most countries, removing direct (or total) interventions changed the real
incomes of the poorer urban and rural groups by less than 5 percent (up or
down). More often than not, the rural poor gained from removing the
interventions.
*  The contribution of agriculture to fiscal revenues has fallen over time, and is,
on average, small.
Using a similar approach, Dorosh and Valdes (1990) found a strong import-
substituting, anti-export bias in Pakistan during the period 1960 to 1987. Import quotas,
rather than tariffs, were used as the primary instrument of protection. However, implicit
import tariffs on principal importables ranged between 130 and 220 percent in the 1960s,
declining to still-high levels of between 40 and 55 percent from the mid-1970s onward.
Direct taxation of agricultural exportables averaged 15 percent from 1972 to 1987. The
cost of this taxation was compounded by indirect taxation of 38 percent through a
combination of trade and exchange rate policies. Transfers out of agriculture, resulting
from both direct and indirect policies, averaged about 36 percent of agricultural value
added. Simulations revealed that in the absence of all interventions, farm income from
Pakistan's five leading crops would have been 40 percent higher between 1983 and 1987.
Table 3. Direct and Indirect Rates of Nominal Protection, 1960-84
(period averages in percentages)
17



Country                 Period       Indirect        Tax due to           Direct         Total
Protection      industrial          Protection      Protection
protection
Extreme taxers                                                                           -51.6
Cote d'Ivoire            1960-82     -23.3           -23.2                -25.7          -49.0
Ghana                    1958-76     -32.6           -32.4               -26.6           -59.5
Zambia                   1966-84     -29.9           -21.4                -16.4          -46.3
-36.4
Representative taxers
Argentina                1960-84     -21.3           -39.5               -17.8           -39.1
Colombia                 1960-83     -25.2           -37.8               -4.8            -30.0
Dominican Republic      1966-85      -21.3           -20.8                -18.6          -39.9
Egypt                   1964-84      -19.6           -27.5               -24.8           -44.4
Morocco                  1963-84     -17.4           -13.4                -15.0          -32.4
Pakistan                 1960-86     -33.1           -44.9               -6.4            -39.5
Philippines              1960-86     -23.3           -33.0               -4.1            -27.4
Sri Lanka                1960-85     -31.1           -40.1               -9.0            -40.1
Thailand                 1962-84     -15.0           -13.9               -25.1           -40.1
Turkey                   1961-83     -37.1           -57.4                5.3             -31.8
-15.8
Mild taxers
Brazil                   1969-83     -18.4           -21.4                10.1           - 8.3
Chile                    1960-83     -20.4           -37.4               -1.2            -21.6
Malaysia                1960-83      -8.2            -9.9                -9.4            -17.6
10.4
Protectors
Korea, Republic of      1960-83      -25.8           -26.7                39.0           13.2
Portugal                 1960-84     -1.3            -1.0                 9.0            7.7
Sample Average          1960-84      -22.5           -27.9               -7.9            -30.3
Notes: The tax on agriculture resulting from industrial protection, tna, is given by [11(1 + tna)]-1. Direct
protecti  n is measured as the difference between relative producer and border prices at the official exchange
rate, aft r adjusting for transportation, storage, and other relevant margins, and divided by the relative price
hi the absence of all intervenitions. Sample average is a simple unweighted cross-country average.
Source: Schiff and Vald6s (1 992-a).
Using measures of direct and indirect taxation similar to those applied by Schiff
and Valdes, Amin (1996) considered the case of Cameroon. As a member of the
Communaute Financiere Africaine (CFA), Cameroon has fixed its currency, in nominal
terms, to the French franc. During the period 1963 to 1992, the CFA franc became
18



increasingly overvalued. owing to both the mounting strength of the French franc. and to a
number of adverse shocks to the country s terms of trade. the most important of which
related directly to Cameroon's two major agricultural exports. coffee and cocoa. The
study ended before the devaluation of the CFA franc that took place in January 1994.
Amin estimated that the level of over-valuation peaked at 77 percent in ( hen). The
agricultural sector was taxed directly, with coffee and cocoa producers typically receiving
less than one-half of the f.o.b. price. The results Amin obtained for Cameroon are in line
with those obtained by Schiff and Valdes in their sample. although it should be qualified
that under the nominal exchange rate arrangements of the CFA. Cameroon's policy
flexibility to accommodate adverse exogenous shocks was severely limited.
Agriculture was similarly taxed elsewhere in sub-Saharan Africa, owing to the
widespread perception among developing countries that industrialization was the key to
economic growth. Import substitution and tight trade controls conspired to transfer
resources out of agriculture and into industry. In his study on Nigeria, Oyejide (1993)
found that all crops suffered negative nominal (direct) protection from 1969 to 1983. This
taxation declined from -0.27 in 1969-71 to -0.01 by 1981-83, mainly as a result of
increased protection of cereals, but export crops remained heavily taxed. Indirect taxation
increased throughout the entire period, compounding the effect of direct taxation on
exportables, and more than offsetting any direct protection to agricultural importables.
Macroeconomic and industrial policy have come under increasing scrutiny by
economists seeking to explain the poor economic performance of agriculture in many sub-
Saharan African countries during the past two decades. Ghurra and Grennes (1993)
confirmed a negative relationship between RER misalignment and economic performance,
using pooled data, for the years 1972 to 1987, for thirty-three sub-Saharan African
countries. They tested this relationship with three different measurements of RER
misalignment. These included one measure based on purchasing power parity, one derived
from an Edwards-type model in which the ERER was estimated as a function of
macroeconomic variables, and one that used the black-market premium of the exchange
rate.
Ghurra and Grennes found that the RER had been substantially overvalued in most
of the countries in their sample. regardless of which measure of RER misalignment was
used. Botswana, the country with the least misalignment, had experienced the highest rate
of growth. The poorest economic performers, such as Ghana and Uganda, also had the
most misaligned real exchange rates. Estimates of the RER, irrespective of which measure
was used, revealed an unambiguously negative relationship between misalignment of the
RER and export growth. Their results also suggest that export growth was adversely
affected by macroeconomic instability.
Exogenous Effects including Dutch Disease
19



Having examined the impact of industrial and macroeconomic policies on the real
exchange rate, we can proceed to understanding how the RER can be affected by
exogenous factors such as changes to an economy's terms of trade. Such changes may
result from the boom or bust of an important commodity, from technological change, from
changes in productivity, or from medium- or long-term changes in foreign capital flows.
The effects these have on the equilibrium RER will, in the absence of intervention, affect
the RER. A change in the RER will, in turn, have an impact on all tradables, not confining
itself to the sector experiencing the boom, bust, technological change, or change in
productivity.
Such phenomena have been popularly referred to as the Dutch disease. Dutch
disease has been associated with significant temporary (medium-term) increases in export
revenues from oil, gas, coffee, or more recently from the increased foreign capital inflows
that tend to follow structural adjustment and trade liberalization. It is characterized by the
simultaneous co-existence of advancing and declining subsectors within the traded-goods
sector, during which time declining RERs profoundly inhibit the ability of non-booming
subsectors to export or compete with imports. In developing countries, the agricultural
sector has usually been the traded goods subsector that suffers most from this decline.
Examples of Dutch disease associated with commodity booms include the natural gas
boom in the Netherlands, oil export booms in the UK, Nigeria, Mexico, and Venezuela,
and coffee booms in Colombia and other countries.
A widely accepted theoretical model of the Dutch disease phenomenon was
developed by Corden and Neary (1982), and is summarized here. We then examine
several country-specific applications of this model. Corden and Neary developed a variant
of the Salter "dependent economy" model to analyze the impact of a booming export
subsector on the RER and on the economy as a whole. They were interested in both the
short- and long-term impacts of the boom on production, employment, wages, and
profitability. They distinguished between two effects, the resource movement effect, and
the spending effect.
The spending effect occurs through the higher real income resulting from the
commodity boom. As long as neither traded goods nor non-traded goods are inferior, the
increase in income will raise demand for both types of goods. The short-term effects of
this increased demand will include higher prices for non-traded goods, and an increase in
imports. The higher price of non-traded goods relative to traded goods implies an
appreciation of the RER, and a loss of competitiveness among non-booming exports.
The higher price of home goods and boom-sector activity attracts factors of
production, at the expense of traditional exports, which are usually agricultural in
developing countries. This is part of the resource movement effect. Simple models of
Dutch disease assume that labor is the only mobile factor, though Corden and Neary also
examined cases in which capital is mobile across sectors. For purposes of illustration, we
restrict our discussion to cases in which labor is assumed to be the only factor that is
20



mobile across sectors, keeping in mind that some of these outcomes may be reversed
when capital is also mobile across sectors (as demonstrated by Corden and Neary, 1982).
With labor the only factor that is mobile across sectors, the impact will remain
confined to the wage rate. A commodity boom causes wages to increase in the booming
subsector, thereby inducing labor to move out of both the home-goods sector and the non-
booming traded-goods sector. The spending effect will tend to raise the price of non-
traded goods, placing upward pressure on wages in these sectors as well, also inducing
labor to move out of the non-booming traded goods sector. This last sector is squeezed the
most, and employment and production in the sector will fall further than in the others.
To the extent that it is the equilibrium RER that changes, policy prescriptions are
neither obvious nor unambiguous. One issue is whether it is advisable to pursue a policy
that prevents the RER from appreciating fully, by depreciating the nominal exchange rate.
In addition, the model assumes that the increase in income is spent by factors, when in
reality a significant share of this increase is likely to be collected by the government as
taxes. The level and composition of government spending of this revenue increase will
therefore influence the subsequent magnitude and direction of the spending effect.
In his analysis of the coffee boom in Colombia, Edwards (1985) found that higher
coffee prices resulted in an accumulation of international reserves, and a higher rate of
growth of the money supply. The resultant higher rate of inflation, for a given rate of
change of the nominal exchange rate, results in an appreciation of the RER, which leads to
a loss of competitiveness in the non-coffee tradable goods sectors. The RER will
appreciate even more if the fiscal deficit increases, and is financed, even if only partially,
by money creation. If, as was the case in Colombia, the rate of devaluation of the nominal
exchange rate is decreased, the RER appreciation will be correspondingly greater, as will
be the squeeze on the non-coffee tradable goods sector.
Oyejide (1993) found that the structural changes that occurred in Nigeria between
1960 and 1984, particularly during the oil boom of the 1970s, reflected a similar story.
Agriculture accounted for almost 60 percent of Nigeria's export revenue prior to the oil
boom, when it then dropped to 25 percent. During the same period, agriculture's share of
non-oil GDP fell from an average of 60 percent during 1960-65, to about 30 percent
between 1978 and 1981. Agriculture's share in employment likewise fell, from 75 percent
in 1970 to 59 percent in 1982. The fact that agriculture's share of non-oil GDP fell by
50%O, but agricultural employment fell by only about 20%, reflected the low degree of
labor mobility in this sector. The two non-oil tradable sectors, agriculture and
manufacturing, were both losers relative to oil in the structural changes that occurred in
the wake of the oil boom. Oil revenues accrued mainly to the government, and public
spending rose rapidly between 1970 and 1980. In spite of increased revenues, fiscal
deficits grew between 1975 and 1983, and the current account remained in deficit, as
Nigeria accumulated both internal and external debt.
21



The oil boom did yield one favorable effect on agriculture, as increased revenues
from oil reduced the government's reliance on taxation of agricultural exports. Poor
agricultural performance during the 1 970s led the government to focus more attention on
the sector, as evidenced by reforms of Nigeria's agricultural marketing boards, the
institution of generous input subsidies, increased direct protection to importables, and
lower taxation of exportables. None of these policy changes were sufficient, however, to
compensate the agricultural sector for the effects of inflation and appreciation of the RER,
as real producer crop prices fell, or, at best, remained constant.
The oil boom of the 1 970s led to a similar situation in Venezuela. But the case of
Indonesia, another oil-exporting developing country, provides a marked contrast to the
experiences of Nigeria and Venezuela, and an instructive counterexample to the Dutch
disease phenomenon. Following a more prudent macroeconomic management of their oil-
boom windfall, Indonesia's RER did not appreciate to any significant degree, and exports
remained diversified. Clearly, how a government manages a commodity boom is
important in determining its ultimate effect on the economy and on economic growth.
For Chile and New Zealand, structural reform triggered changes in the equilibrium
RER (Vald6s, 1994). Prior to these reforms, both countries were inward looking and
highly regulated. Each had high rates of protection, extensive government intervention in
both product and factor markets, and low rates of agricultural and economic growth.
Chile undertook reform in two stages. In the first stage, from 1973 to 1983, the
Government focused on general economic reforms, in response to an urgent need to
correct fundamental macroeconomic imbalances. Sweeping trade liberalization took place,
as tariffs were cut drastically, quantitative restrictions were removed, and most price
controls and all multiple exchange rates were eliminated. Interest rate ceilings were also
gradually withdrawn, and input subsidies eliminated.
Although trade liberalization initially resulted in depreciation of the RER, a
turnaround occurred, and the RER began appreciating between 1979 and 1982 as a result
of capital inflows and wage indexation. Following a deep recession in 1983 that led to a
devaluation and a real depreciation, agriculture began to recover. Around 1990, following
capital inflows, the RER began to appreciate, leading once more to a slowdown in
agricultural growth.
The stabilization program initiated by New Zealand in 1984 led to high interest
rates, an inflow of foreign capital, and the appreciation of their RER. On the trade front,
the Government liberalized agriculture and removed farm subsidies, even though
industrial protection remained high. Sandrey and Scobie (1994) estimated that by 1992,
agriculture in New Zealand faced an II percent implicit tax as a result of industrial
protection. Argentina and a number of other countries in Latin America have recently
experienced similar circumstances to those of New Zealand, as capital inflows increased
22



in the wake of structural reforms. Similar evidence is emerging in Russia, Estonia, and
Poland.
So far we have stressed the importance of the relationship of capital inflows to
competitiveness of agriculture. Long-term capital inflows are essential for development,
even though the comparative advantage of some sectors may be affected. Capital inflows
do, however, entail some risk, by generating inflationary pressures and appreciation of the
RER. These risks are higher with short-term inflows, particularly if international interest
rates are expected to rise, and when investors sense financial fragility, as we have seen in
relation to the 1994 "Tequila" crisis in Mexico, and the 1997 "Asian flu" crisis in East and
South East Asia. The result can be abrupt capital outflows which, although less likely to
occur in foreign direct investment, remain difficult to anticipate. The recent experience of
middle-income countries has demonstrated the difficulty of judging ex ante whether a
particular inflow is likely to be permanent or transitory. Countries like Chile, Colombia,
and India have attempted to restrict short-term capital inflows by imposing high taxes on
them, a temporary solution at best. The issue will become increasingly important as a
growing number of countries choose to liberalize their economies. It is far from obvious
what, if any, policy action is optimal. An obvious one is to first reform the domestic
financial sector.
Interest Rates
In spite of the substantial body of literature on rural financial markets in less-
developed countries, there is very little applied research on the interface between domestic
capital markets and agriculture. This omission is the more surprising in light of economic
reforms in Latin America and eastern and central Europe, where dramatic increases in real
interest rates have occurred. By raising the cost of capital, higher domestic interest rates
have the largest adverse effect on capital-intensive industries. Research presented by
Mundlak (1997) on a large sample of developing countries shows that because agriculture
is capital intensive, it is more sensitive than non-agriculture to changes in interest rates
and less sensitive to changes in the cost of labor. The capital/labor ratio in agriculture
increases over time and, Mundlak concluded, "...policies that cause a rise in interest rates
are more damaging to agriculture and to agricultural investment in particular."
Changes in the interest rates have macroeconomic consequences well beyond their
direct effect on investment and production decisions. An important article by Snape
(1989) elucidated the interactions between real exchange rates, interest rates and
agriculture, using Salter's "dependent economy" model. Snape considered four scenarios
of the interaction between real exchange rates and real interest rates. Two were policy-
induced (fiscal and monetary expansion), and two were induced by exogenous changes (in
the savings rate and in world interest rates).
23



In considering the case of fiscal expansion, in which the government would
finance its increased budget deficit by borrowing from the private sector, ",nape made two
assumptions. He assumed that the economy was at full employment, and that an increase
in public expenditure would not be offset by an increase in private savings. This meant
that no private savings were put aside to pay future taxes that would be necessary to meet
payments on interest and principal on the new public borrowing. In the absence of
international capital flows, increased public borrowing would result in higher real interest
rates, and private investment would be crowded out. Foreign capital inflows would
finance increased public borrowing, and real interest rates would remain constant (unless
the country risk premium rises with the level of external borrowing). The additional
foreign exchange would result in an appreciation of the real exchange rate.
In a floating exchange rate regime, this would occur through an appreciation of the
nominal exchange rate. If the nominal exchange rate was fixed, the capital inflow would
result in a balance of payments surplus, and an accumulation of foreign exchange
reserves. If this increase in international reserves was not sterilized, the rate of inflation
would increase, and the real exchange rate would appreciate. Sterilization of foreign
exchange reserves (by selling Treasury bills in the open market) could delay appreciation
of the RER, but fiscal expansion would result in a higher interest rate, which, in turn
would continue to attract capital inflows, resulting in further appreciation of the RER. A
once-and-for-all fiscal expansion would result in higher interest rates in the absence of
capital flows or in an appreciation of the RER in the presence of capital flows, regardless
of the nominal exchange rate regime in place. Thus, under both scenarios, agriculture
would be harmed by fiscal expansion.
We have already seen that an increase in world real interest rates would raise the
cost of borrowing and servicing public debt, resulting in a reduction in real absorption and
a depreciation of RER. Thus, while the production of tradables would be positively
affected by the depreciation of the RER, it would be negatively affected by an increase in
world interest rates.
Prior to economic reforms in the mid-1980s, much of global agriculture benefited
from subsidized credit lines. When these subsidies were removed, the farm and
agroprocessing sectors faced high market interest rates. The experience of early reformers
such as Chile and New Zealand, and later Argentina and Mexico, along with others,
showed that in spite of the opening of the capital account, domestic real interest rates
remained much higher than international interest rates for a period of several years.
Interest rates were higher primarily because the cost of intermediation in the domestic
capital market remained high. Costs were high due to a relatively uncompetitive capital
market in an obsolete regulatory framework. Rodriguez (1994, cited in Brock, 1996),
calculated the spread between local currency lending rates and the US Treasury bill rate,
adjusted for exchange rate depreciation, at 23 percentage points in Argentina in 1993, and
59 points in Uruguay in 1992. There is ample evidence, therefore, of the critical
24



importance of including the financial sector early on in the process of overall economic
reform.
Structural Adjustment
A growing number of developing countries have implemented structural adjustment
programs, with the support of the World Bank, aimed at reducing fiscal imbalances,
redefining the role of the public sector, and accelerating growth (Goldin and Winters, 1992
). Structural adjustment programs affect agriculture in a number of ways. Redressing fiscal
imbalances typically involves reductions in both agricultural and non-agricultural subsidies.
The impact of these reductions on agriculture's relative value added is ambiguous a priori,
and depends on the initial distribution of subsidies across sectors. We see in equation (5)
that a reduction in subsidies to intermediate inputs would cause value added in all affected
sectors to fall, with an ambiguous relative impact on agriculture.
As seen in equations (5) and (6), a reduction in government expenditures results in a
depreciation of the RER, which in turn increases agriculture's relative prices and value
added. The relative price changes affect relative factor rewards, the distribution of income,
and ultimately rural-urban migration patterns over time.
Trade liberalization, another major component of structural adjustment programs,
improves agricultural incentives in two ways, through lower industrial prices, and through
the depreciation in the RER.
In view of the potential benefits of structural adjustment, how can it best be carried
out? Three issues emerge in response to this question. The first is the sequence of reforms
(Edwards, 1991), which reduces to the question of whether trade liberalization should
precede capital account liberalization or vice versa. The second issue centers on the
"small-country assumption". In the countries that influence world prices, increased
exports can theoretically result in lower revenues, but this is, generally, not supported by
evidence, with the exception of a few cases such as coffee in Brazil and cocoa in Cote
d'Ivoire (Panagariya and Schiff, 1991).
Thirdly, we should be interested in the effects of structural adjustment on public
spending. Public expenditure cuts are an inescapable component of structural adjustment,
and will undoubtedly include cuts in spending on agriculture. Van Blarcom, Knudsen, and
Nash (1993) analyzed a sample of 32 countries in which public spending on agriculture had
been cut some time after 1970. They concluded that much of the public spending on
agriculture in these countries had been directed toward relatively unproductive purposes. In
Mexico, for instance, 85 percent of public spending on agriculture in 1989 went to
untargeted food and input subsidies administered primarily through state agencies.
According to the authors' calculations, if spending on untargeted subsidies was cut in half,
spending on irrigation, research, and extension could be doubled at the same time as overall
sectoral spending was reduced by 28 percent. As a result, public investment in agriculture
25



declined, as fiscal pressures created by funding these subsidies escalated. The point is, that
a reduction in public spending on agriculture need not have a negative impact on
agricultural output as long as the allocation of public spending is targeted to public goods.
Van Blarcom et.al. developed a set of guidelines for structural adjustment in
agriculture. These included: (i) reduce industrial protection and remove the misalignment of
the RER; (ii) reduce subsidies and effectively target the remaining subsidies to services that
foster growth; (iii) increase the public goods component of public spending on agriculture
(such as research and extension); (iv) privatize state-owned enterprises in conjunction with
price liberalization in order to end the drain on fiscal resources; and (v) build greater
transparency into the public sector's budget process so that public funds are allocated in a
context of clearly defined sector strategies and explicitly stated goals.
Support services that can be transferred to the private sector should be transferred.
Recurrent costs should be adequately funded, particularly operations and maintenance costs
of public infrastructure. Indeed, the World Development Report 1994 (World Bank, 1994)
identified these recurrent costs as generating some of the highest social returns of any type
of public spending. One way of ensuring adequate funding for recurrent costs is through
cost recovery measures. The user charges for water, power, and fertilizer often account for a
small fraction of their actual cost in many countries, and should be increased to reflect the
cost of providing them.
The North
Agricultural policies in industrialized countries (the North) have taken
fundamentally different forms than those in developing countries (the South), and the
contrasts are instructive. Agricultural sectors in the North generally comprise a small
proportion of the economy relative to the urban-industrial sectors. Northern agriculture has
remained highly protected, while Northern industry is afforded generally low rates of
protection. Furthermore, low industrial protection, coupled with lower levels of exchange
rate misalignment, has resulted in a substantially lower level of indirect taxation of
agriculture than in developing countries.
The United States
The nature of the relationship between the macroeconomy and relative prices in
agriculture for the US was detailed in several pioneering studies by Schuh (1974, 1989).
Schuh's (1974) analysis for the US began with the 1950s. The US dollar was considered
overvalued, but under the Bretton Woods agreement, the US agreed to a fixed nominal
exchange rate relative to gold. The exchange rate overvaluation adversely affected the
competitiveness of US agriculture, particularly for exportables, at a time of burgeoning
levels of grain stocks. The US resorted to providing massive food aid, in essence as an
implicit export subsidy, and by the end of the 1 960s, had added explicit export subsidies as
26



well. But these efforts did not succeed in lowering the level of stocks sufficiently, given the
level of exports at the prevailing exchange rate. By _ , as real price supports were
reduced or eliminated, about 60 million acres of land were taken out of production.
In his 1989 article, Schuh argued that the combined effect of an overvalued dollar
and the commodity programs in place induced an income transfer to consumers, while the
land set-aside program made land more scarce, and induced the adoption of land-
substituting inputs. The Bretton Woods system was abandoned when the US devalued its
currency in 1972, and the dollar depreciated roughly 25%. The depreciation, combined with
an unstable monetary policy that resulted in negative real interest rates and varying inflation
rates, contributed to an agricultural boom that was sustained through the 1970s. The boom
came to an end with the OPEC oil price increase of 1979. In the 1980s, taxes were cut, but
public expenditures were not. The result was a growing fiscal deficit at a time when the
Federal Reserve chose to maintain tight monetary policies. Real interest rates climbed, and
capital inflows increased, leading to an appreciation of the real exchange rate.
The increase in interest rates ended the land market boom, at the same time that the
US imposed a grain embargo on the Soviet Union. US agriculture faced three simultaneous
shocks: declining domestic prices due to the appreciation in the RER, the collapse of the
land market, and the loss of the Soviet grain market. Asset values and farm income also
collapsed. US agriculture began to recover only after significant agricultural acreage was
retired, and the Government has only partially scaled back from the relatively high implicit
and explicit subsidies it continues to provide for key commodities.
A number of lessons can be learned from the US experience. First, as with the
developing countries, changes in the real exchange rate are important to agriculture.
Second, changes in macroeconomic conditions are likely to inspire changes in direct
interventions, such as agricultural commodity-support programs. Through their effects on
the structure of incentives and on commodity programs, macroeconomic events indirectly
influence productivity change as well as the distribution of benefits between producers and
consumers.
Another lesson relates to short-term price instability. Traditionally, prior to the
early 1 970s price instability in agricultural markets was explained largely by the inelastic
nature of food demand, and on the supply side, by weather patterns, rapid technological
change, and asset fixity. In an important contribution on the US experience,Rausser,
Chalfant and Stamoulis (1985) examine the increased importance of money markets on the
farm sector and the additional source of instability that it generates. Because agricultural
markets behave as "flex price" while other markets behave as "fixed price" (e.g. stickiness
of non-food prices) in the short run, overshooting in agricultural commodity markets will
occur, even if expectations are formed rationally. This amount to either a tax (in the case of
deflation) or a subsidy (in the case of inflation) to agriculture through relative price
changes. For example, anticipated money growth, according to their econometric estimates,
causes a much greater response in food prices (the flex-prices) than for non-agricultural
27



goods. Under negative shocks, the implicit taxes resulting from overshooting imposed on
US agriculture were limited by the price support policy, which introduced a downward
price inflexibility for the supported commodities, but which in turn cause the incidence of
the macroeconomic policy tax on agriculture to shift towards the cost of mantaining stocks.
The implications of these findings for other economies needs to be examined. One
would expect that, unlike the US, most LDCs are price takers in grain markets and so (at a
given nominal exchange rate), domestic farm prices would change relatively less than those
of home goods after a monetary shock, which would not induce overshooting. This is
likely to apply to most Latin American countries but not necessarily to other ones. For
instance, state trading in agricultural commodities is still pervasive in India. In that case or
in the case of non-tariff barriers, the domestic price may be unrelated to the world price and
overshooting may occur as well.
The EU and their Common Agricultural Policy
The fiscal burden of the Common Agricultural Program (CAP) has inspired
substantial analyses of the impact of agricultural protection on macroeconomic variables in
studies such as Gylfason (1995), and Stoeckel, Vincent, and Cuthbertson (1989). Gylfason
argued that although partial equilibrium analysis found that deadweight losses resulting
from farm policies represented about 1 percent of GDP, long-term general equilibrium
considerations were shown to raise the loss estimates to about 3 percent of GDP. The CAP
has been responsible for higher consumer food prices and an increased tax burden. Total per
capita agricultural transfers per full-time farmer equivalent6 averaged $17,700 in the EU,
compared with a median labor income of $12,000 in 1992.
Based on general equilibrium models described in the volume edited by Stoeckel
et.al., various authors quantified the impact of agricultural protection on relative prices to
manufacturing, manufacturing output, and employment. The studies found that industrial
countries would benefit from removing agricultural protection because manufacturing
output and exports would increase, as would employment.
Stoeckel and Breckling (1989) examined the effects of removing both the CAP and
national agricultural protection in the four largest EU countries, namely Germany, France,
Italy, and the United Kingdom. They found that the elimination of both measures of
protection could generate an increase in aggregate output of over 1 percent, create 3 million
new jobs, and lead to a 5 percent increase in manufacturing exports to the rest of the world.
Dicke, Donges, Gerken, and Kirkpatrick (1989) focused on the case of West
Germany, the largest economy in the EU and the largest contributor to the CAP. They also
found that Germany would experience gains from liberalization similar to those estimated
GFull-time farmer equivalent is defined as 2200 hours of work in agriculture annually.
28



by Stoeckel and Breckling. Total public subsidies to German agriculture are, at present,
equal to about 70 percent of the sector's gross value added at domestic prices. Assuming an
increase of 10 percent in world agricultural prices and constant wages, agricultural
liberalization would result in a reduction in the rate of unemployment from 9 to 5 percent,
along with a 3 percent gain in real GDP, and a 5 percent increase in foreign trade. Their
results on employment support Stoeckel, Vincent, and Cuthbertson's (1989) estimate that
continued support of agriculture could result in an increase in unemployment of up to 3
million workers in the EU. Given the small share of agriculture in the economy of the EU
and Germany, the effects found in the above studies seem rather large.
Japan and New Zealand
A similar study by Vincent (1989) on Japan's agricultural economy also appears in
the Stoeckel et.al. volume. Japan, which has the highest agricultural protection levels in the
OECD, would enjoy benefits from liberalization similar to those of the EU. Vincent found
that agricultural liberalization in Japan could result in a 3 percent increase in revenues from
manufactured exports in the short run, and an increase in average real wages of about 2.5
percent.
In New Zealand, extensive reforms have resulted in the virtual elimination of
agricultural protection.7 The reform program began in earnest in 1984, and during its initial
phases had severe adverse effects on agriculture (Sandrey and Scobie, 1994). Subsidies
were removed early in the reforms, at the same time as the real exchange rate experienced a
substantial appreciation, aggravating the problems faced by the agriculture sector. Since
that time however, public sector deficits have been eliminated, and compensatory
microeconomic reforms have been implemented. As a result, New Zealand's agriculture
sector has become increasingly competitive in international markets.
Concluding Comments
A basic concept underlying the analysis presented in this paper is that of
'neutrality'. By that, we mean 'intersectoral neutrality' or the equal treatment of all sectors.
In other words, we considered the case of intersectorally neutral policies as the
counterfactual or 'anti-monde' to which the actual policies were compared. Neutrality was
selected as the 'anti-monde' based on efficiency considerations. In the absence of power
on the world market and externalities, the Pareto efficient solution is to treat all sectors
equally.
.
7Australia and New Zealand were the only two industrial countries that taxed agriculture by
providing relatively higher protection to manufacturing.
29



We submit this as a paradigm, i.e., from the viewpoint of efficiency, agriculture
should not be taxed relative to other sectors and neither should it be favored. Nevertheless,
developing countries have traditionally taxed the agricultural sector while developed
countries have protected it, and both have incurred efficiency losses.
Based on Schiff and Valdes (1992), it was shown that the taxation of agriculture in
developing countries resulted in a slowdown in agricultural growth and in overall economic
growth, and that the slowdown was caused essentially by indirect taxation policies rather
than by the direct ones. A number of LDCs have undertaken structural adjustment reforms
in the last fifteen years, including trade policy reform and stabilization efforts, and this has
reduced the level of indirect taxation. One reason often given for direct taxation of
agriculture is to keep food prices low for urban consumers and to obtain export tax revenue.
The benefits from food subsidies were captured mainly by urban households. However, the
majority of the poor are often located in the rural areas rather than in the cities, and it is the
rural poor who gain most from the removal of price interventions. As for export tax
revenues, their contribution to fiscal revenues has fallen over time, and is, on average,
small. For LDCs who depend heavily on them will have to look for alternative sources of
revenue by implementing a tax reform and/or will have to raise the efficiency of the public
sector and/or reduce its size.
In the developed countries, protection of agriculture has had adverse general
equilibrium effects by raising costs and reducing production and employment in the
manufacturing sector. A number of studies have found the cost in terms of higher
unemployment to be significant. Moreover, a GATT study found that the policy had a
negative impact on poor consumers.
Since the Uruguay Round, agriculture has been integrated into the trade rules of the
WTO, and most LDCs have joined the WTO. This gives us hope that future multilateral
negotiations will continue to lower the bias against agriculture in LDCs, and in favor of
agriculture in developed countries.
30



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Policy Research Working Paper Series
Contact
T5tle                            Author                  Date              for paper
WPS1952 Enterprise Isolation Programs in   Simeon Djankov          August 1998        R. Vo
Transition Economies                                                        33722
WPS1953 Trade Policies and incentives in   Garry Purseil           August 1998        L. Tabada
Indian Agriculture: Methodology,                                            36896
Background Statistics and Protection,
and Incentive Indicators, 1965-95-
Background Paper 1, Sugar and
Sugarcane
WPS1954 Politicians and Firms in Seven     Stijn Claessens         August 1998        R. Vo
Central and Eastern European     Simeon Djankov                             33722
Countries
WPS1955 Appraising Workfare Programs       Martin Ravallion        August 1998        P. Sader
33902
WPS1956 Benefit Incidence and the Timing   Peter Lanjouw           August 1998        P. Sader
of Program Capture               Martin Ravallion                           33902
WPS1957 Bidding for Concessions            Michael Klein           August 41998       J. Dytang
37161
WPS1958 Total Strangers or Soul Mates?     J. Luis Guash           August 1998        J. Troncoso
Antidumping and Competition      Sarath Rajapatirana                        37826
Policies in Latin America and the
Caribbean
WPS1959 Is There a Credit Crunch in       Wei Ding                 August 1998        F. Fernandes
East Asia?                      ilker Domag                                 80453
Giovanni Ferri
WPS1960 Calm After the Storms: Income      Francisco H. G. Ferreira   August 1998     C. Ilogon
Distribution in Chile, 1987-94   Julie A. Litchfield                        33732
WPS196'I Protecting the Environment and the  Gunnar S. Eskeland    August 1998        C. Bernardo
Poor: A Public Goods Framework    Chingying Kong                            31148
Applied to Indonesia
WPS1962 The Political Economy of           George R. C. Clarke     August 1998        P. Sintim-Aboagye
Privatization: An Empirical Analysis  Robert Cull                           38526
of Bank Privatization in Argentina
WPS1963 Commodity Risk Management and   Donald F. Larson           August 1998        P. Kokila
Development                      Panos Varangis                             33716
Nanae Yabuki
WP51964 Public Investment and Economic     Ulrich Lachler          August 1998        C. Lazcano
Growth in Mexico                 David Alan Aschauer                        37776



Policy Research Working Paper Series
Contact
Titlie                           Author                   Date              for paper
WPS1965ManufactUring Firms in Developing   James Tybout            August 1998        L. Tabada
Countries: How Well Do They Oo.                                              36869
and Why
WPS1966 Sulfur Dioxide Control by Electric    Curtis Carlson       August 1998         T. Tourougui
Utilities: What Are the Gains from  Dallas Burtraw                           87431
Trade?                           Maureen Cropper
Karen L. Palmer