Tunisia - Country economic memorandum : the road to an outward oriented economy (Vol. 4 of 5) : Annex 3

Report No. 8044-TUN Republic of Tunisia Country Economic Memorandum: The Road to an Outward-Oriented Economy (In Five Volumes) Volume IV: Annex 3-A Macroeconomic Framework for Tunisia and Its Application to an Analysis of Medium-Term Economic Prospects March 1990 Country Operations Division Country Department 11 Europe, Middle East and North Africa Region FOR OFFICIAL USE ONLY Document of the World Bank This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  FOR OFFICIALL USE ONLY REPUBLIC OF TUNISIA A MACROECONOMIC FRAMEWORK FOR TUNISIA AND ITS APPLICATION TO AN ANALYSIS OF MEDIUM-TERN ECONOMIC PROSPECTS This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwi-o be disclosed without World Bank authorization.  REPUBLIC OF TUNISIA A MACROECONOMIC FRAMEWORK FOR TUNISIA AND ITS APPLICATION TO AN ANALYSIS OF MEDIUM-TERM ECONOMIC PROSPECTS I TABLE OF CONTENTS Page No. I. INTRODUCTION .1................... . 1 II. THE MACROECONOMIC IFRAEWORK . . . . . . . . . . . . . . 1 A. Similarities and Differences with Earlier Models . . . . . . . . . . . . . . . . . 2 B. The Structure of the Tunisian Macroframework. 4 C. The Flow of Funds. 4 D. Functioning of the Framework . . . . . . . . . . 8 E. Functioning of the Markets . . . . . . . . . . . 10 III. TUNISIA's MEDIUM-TERM PROSPECTS: AN APPLICATION OF THE MACROFRAMEWORK . . . . . . . . . . . 20 IV. TECHNICAL APPENDICES .33 Appendix A: Economic Classification of the Central Government Budget and Financial System Tables Appendix B: Detailed Ministry of Planning and Finance Projections of the Central Government Budget Deficit Appendix C: Historical Flow of Funds Appendix D: Equations of the Tunisian Two-Sector Macroframework  A XACROECONOMIC FRAMEWORK FOR TUNISIA AND ITS APPLICATION TO AN ANALYSIS OF XEDIUM TERX ECONOMIC PROSPECTS I. INTRODUCTION 1. This annex describes the macroeconomic framework developed for Tunisia by the EM2CO staff and discusses the medium-term prospects for the Tunisian economy in the context of this framework. The annex consists of three parts. Part II is devoted to the description of the macroframework. It includes (i) a brief re-view of the origins of the framework and the reasons for developing an analytical tool, (ii) a detailed explanation of its general and institutional structure, and (iii) a description of its functioning and the particular closure chosen for the medium-term projections carried out in this report. Part III presents the medium-term projections for the Turvsian economy and reviews the medium-term prospects for the Tunisian ecnn-my with particular emphasis on the government's budget deficit, private investment and growth. Part IV consists of technical notes defining the equations of the model and the accounting identities of Tunisia's flow of funds. II. THE MACROECONOMIC FRAMEWORK 2. The macroeconomic framework described in the following three sections is spec_.fically designed to serve as an analytical tool in addressing economic policy questions in the context of the Tunisian economy. In addition, the macroframework also provides consistent projections, in the economic as well as the accounting sense, for real as well as financial variables. Its most distinguishing feature is the complete integration of the real and financial sectors, allowing for a full analysis of the interactions between the monetary and real sectors oi the economy. 3. The Tunisian macroframework is the outcome of the recent modelling work of the EM2CO staff which builds on the general and Tunisia-specific models previously developed as part of the economic and operational work of the division. Its general structure follows very closely that of the general macroeconomic framework described in Grey, Parks, and Ziller.Y It is an extension of the one-sector Tunisia application of the general macroframework, Grey, Parks, Ziller (1989), "A Macroeconomic Framework for an Open Economy", EMENA Staff Working Papers.  - 2 - described in Parks.V The Tunisian macroframework presented here also borrows heavily from the institutional structure of the earlier model of de Melo, Leduc and Razmara for Tunisia,W although some significant differences exist both in structure and concept. These differences and similarities are briefly reviewed in the next section. A. SIMILARITIES AND DIFFERENCES WITH EARLIER MODELS 4. The General Macroframework and the Tunisia Framework: The major focus of recent modelling efforts in EM2CO has been on integrating real with financial sectors. Towards this end the general macroframework of Gray, et. al. was developed with the range of Mahgreb countries in mind. No single country was selected out. This approach allowed development of the general framework to concentrate on the main issues involved in integrating financial and real sectors without having to address the specific details of a particular country. Nonetheless, the general framework was designed to easily incorporate such details at a later, country-specific implementation phase such as that described here for Tunisia. 5. The differences between the general macroeconomic framework of Gray, et. al. and the Tunisian implementation fall into two categories: changes in functional form and changes in the flow of funds. 6. There are two main changes in functional form. The first is a conversion of production functions from the Cobb-Douglas specification to the more flexible Constant Elasticity of Substitution (CES) specification. This conversion involves changes to the within-period labor demand equations, the production equations, and the private investment demand equations. 7. Thte second major change in functional form involves the portfolio balance function. The portfolio balance function of the general macroframework (as well as the preceding work of Lance Taylor) is criticized on three major shortcomings.! First, the utility-maximizing derivation of asset demands is based on the introduction of nominal quantities (asset stocks) into the household utility function, thereby contradicting economic theory. Second, the a Parks, J. (1988), "A One-Sector Tunisian Macroeconomic Framework", World Bank Mimeo. de Melo, Leduc, and Razmara (1989), " A Policy Model for Tunisia with Real and Financial Flows", PPR Working Paper No. 157. See Annex B of Gray, Parks, and Ziller (1988), "A Macroeconomic Framework an Open Economy", EMENA Staff Working Paper No. 27, for reference.  - 3 - maximization of weaVth allocation is based on flows (returns to assets) rather than stocks (future value of assets). Third, no provision is made for the transactions demand for money, i.e. the portfolio balance depends only on total wealth and relative returns on assets; it does not depend explicitly on the level of economic activity or income. 8. These three shortcomings are addressed in the Tunisian implementation of the macroframework described here. Real asset values replace nominal ones in the household utility function. This requires the use of real asset returns in place of nominal ones. In addition, utility maximization is based on the expected future value of assets rather than their expected future return. In the utility function, this involves replacing the expected real rate of return (r,) of each asset k with one plus the expected real rate (l+rk). Finally, the transactions demand for money is introduced by adding a real growth rate of GDP term to the calculation of the real return on money (eqn 35). The resulting shadow return on money is used in the utility function. These revisions to the portfolio balance function affect the framework through the asset demand equations (eqns 37-40). 9. Changes in the flow of funds involve the division of firms into public and private enterprise. In addition, the accounts of the individual agents are revised and expanded to better reflect the real-world of Tunisia. 10. The de Melo Model and the Tunisia Framewok: As noted earlier, there are some important differences between the Tunisian macroframework and the deMelo model. On the real side, the Tunisian macroframework has two sectors, distinguishing between public and private enterprise. Separating public from private enterprise allows one to model the differences between public and private investment as well as to model the complementarities between them. The de Melo model follows a different approach, breaking production down along traditional sectorial lines.Y 11. On the financial side, the de Melo model operates on an LM curve. The introduction of an explicit portfolio balance function, as in this Tunisian macroframework, allows the modelling of more than two financial markets. Furthermore, the Tunisian macroframework's incorporation of a dynamic private investment function allows one to explore the dependence of private investment on macroeconomic conditions - whether in a rationed or free credit context. In addition, the framework described here breaks down the non-governmental sector into private firms and households, giving insights into the important interactions between these two agents. Finally, the Tunisian macroframework, by accommodating equity investment, creates a more detailed flow of funds I, The version of the de Melo model with a fully integrated flow of funds has one real sector. The three-sector (agriculture, energy, and others) version used for preparation of the Tunisian SAL President's Report, has a recursive flow of funds. See: "Tunisian SAL President's Report", World Bank, 1988.  - 4 - accounting. The result is a complete breakdown between capital and current accounts for all macroeconomic agents. B. THE STRUCTURE OF THE TUNISIAN MACROFRAMEWORK 12. Conceptually, the macroframework consists of two components, the flow of funds and the model. The flow of funds provides the accounting framework which describes the markets, the agents involved in each market and their interactions, while the model specifies the technological and behavioral equations which determine the rules of action for each agent. The flow of funds incorporates the principal characteristics of the institutional structure of the Tunisian economy and the functional forms are selected, to the extent possible, to reflect the way the agents behave in this environment. Both of these components are described below in greater detail. 13. The relative autonomy of the two components, i.e., the flow of funds and the model, from each other allows for a great degree of flexibility in the utilization of the framework. Without altering the flow of funds and the institutional structure, the model's equations can easily be substituted by others, i.e., calibrated equations by econometrically estimated ones. ,imilarly, the closure of the model can easily be changed by redefining what is exogenous and what is endogenous, thereby greatly expanding the number of policy experiments that can be done. It also allows the user to check the viability of certain macro targets by setting the value of that variable at target levels and solving for other variables. C. THE FLOW OF FUNDS 14. Integration of a flow of funds into the macroframework has the advantage of ensuring the internal consistency of projections. The Tunisian flow of funds module comprises eight economic agents, i.e., the Central Bank, the central government, the local administration, financial institutions, public enterprises, private enterprises, households and the rest of the world. The central government account of the flow of funds is complemented by a detailed budget breakdown module which decomposes the macro projections of budgetary revenues and expenditures obtained from the flow of funds into its line items. This decomposition is compatible with the Tunisian Ministry of Planning budget projections to facilitate comparisons. 15. Appendix C contains a complete listing of the flow of funds module used for calibrating the framework. These accounts are designed to follow closely Tunisian institutional realities. Despite their seeming complexity, therefore, all accounts can be updated easily from standard Tunisian sources, i.e., regularly published government documents. The budget breakdown produced by the government budget module is also given in Appendix A. The following section  gives a description of each of the flow of fund accounts, and explains some of the important institutional characteristics of the Tunisian economy which are integrated into the flow of funds. 16. Description of the Flow of Fund Accounts: The "sources and uses of funds", i.e. the flow of funds, accounting framework used for Tunisia consists of nine accounts.V These accounts are linked together and are composed of four basic economic management accounts--those for the Central Government budget, the Central Bank, the 3alance of Payments and the Financial ..nstitutions--plus five complementary accounts, the National Accounts, Public Enterprises, Private Enterprises, Households and Other Administration Accounts. 17. The monetary system is desegregated into Central Bank and Financial Institutions to capture the flows between the two, and to be able to analyze the effects of monetary policy. The Financial Institutions Accounts is the aggregation of: Deposit banks, Development Banks, CENT (Centre d'Epargne National Tunisien) and CCP (Centre de Cheques Postaux). 18. The flow of funds accounts for each of the nine agents mentioned above consists of a current account and a capital account and each account satisfies a budget constraint "Sources - Uses of Funds" equation for each agent. In addition, the accounts show the variable that are included in the model. A characteristic of the flow of funds accounts is a double entry accounting system in the sense that each variables appears twice in the identities (as a source of resources for one account and as a use of resources by another account). The savings variables are exceptions, because they are in both current and capital accounts and therefore they appear four times rather than twice in the identities. The accounts are generated in nominal terms, but constant price national accounts are subsequently derived. An essential property of the Sources and Uses of Funds approach is that the intersectoral flow variables appear as "Sources" in one account and as "Uses" in another, thereby ensuring the internal consistency of the data. 19. A sources and Uses of Funds projection such as that illustrated for Tunisia is particularly useful for medium-term financial programming since it puts the basic "economic management accounts" (such as budget, BOP, and monetary accounts) into a consistent accounting framework which also includes the national accounts, public and private enterprises and households. This accounting framework also helps to see the implications of the assumed targets and exogenous circumstances. 1. National Accounts: Usually the "origin and use of resources" table of National Accounts data is a tabular presentation of the equation [GDP+M-X-C+I] and there is a consolidation of the current and capital accounts; However in the Tunisian flow of funds, the lTational Accounts have been broken down between the current and capital See de Melo, 1989, op.cit., for a more aggregate flow of funds presentation.  - 6 - accounts in order to show in more detail savings and investmerts by different agents. 2. Other Public Administration Budget: Given that the Central Government budget does not include Social Security avid Local Administration budget, the 'Other Public Administration" account is used in order to mutch government investment, consumption and value added to that of the national accounts. 3. Central Government Budget: This account is based on the economic classification of the Central Government budget from the Tunisian Ministry of Planning. However the budget is deaegregated in more detailed identities based on : (i) direct taxes received from private and public enterprises, financial institutions and households; (ii) indirect taxes on trade and local production; (iii) profits received from the Central Bank. Additionally, on the current expenditure side interest payments on borrowing for financing the budgetary deficit is broken down between foreign and domestic interest payments. The latter is desegregated into interest payments on national borrowing from households, on borrowing from financial institutions and other borrowing from other public administration. Budgetary savings, which is the difference between current revenues and current expenditures, is obtained from the economic classification of the Central Government budget. On the capital account side, the budgetary deficit can be financed through: (i) foreign borrowing; (ii) government bonds which are sold to the general public, (iii) borrowing from domestic financial institutions; and (iv) credit from Central Bank which can be financed by the local currency counttsrpart to a drawdown in net foreign assets or by an increase in money base. In Tunisia, however, given the large size of external debt, the government sets the targets for foreign borrowing consistent with the desired external debt to GDP ratio to reduce the burden and the cost of foreign borrowing. Although, as mentioned above, the channel for central bank credit to Government exists in the flow of funds, a direct monetization of the deficit through "Central Bank advances to the Government" is not analyzed further because this option has not been used in Tunisia in recent years as a policy instrument. Instead, the Central Bank generally uses the option of expanding credit to financial institutions. The portion of Tunisian budget deficit financed by domestic borrowing, is largely through government development bonds (Bons d'equipement) placed with financial institutions and other public administration, and the "National Borrowing" from households (emprunt national), which increased substantially in 1988. Despite the absence of direct Central Bank monetization of the deficit, in the Tunisian institutional setting there is still one other channel open for the Central Bank to increase the resources of the government budget, that is, Central Bank profits. At the end  of the calendar year, Central Bank profits, including the revaluation of net foreign assets of the Central Bank due to a depreciation of the Tunisian Dinar, are transferred to the government by crediting the "Compte Courant du Tr6sor". These appear in the current revenues of the Central Government Account as the Treasury draws from this account against its expenditures. It should also be noted that Central Bank profits increase government revenues and reduce the size of the deficit rather than work as means of financing a given level of deficit. 4. Central Bank Account: rThe Central Bank is identified as a separate account because of its important role in holding international reserves and creating money base. The Central Bank of Tunisia is assumed to have full control over monetary policy. The capital sources of Central Bank are composed of money base and net government transfers. All financial interactinns between the Treasury and the rest of the Tunisian economy take place through the "Compte Courant du Tresor" of the Treasury at the Central Bank. Given that there is only one Compte Courant du Tresor at Central Bank, transactions budgeted for different years get mixed normally into the same account. Therefore, there is always a discrepancy between net Central Bank credits to the government as measured by the Central Bank statistics and Central Bank advances which appear in the budget. 5. Financial Institutions: This account, which is the aggregation of total banking system in Tunisia, as mentioned above, includes Deposit Banks, Development Banks, CENT and CCP. (Tunisian Leasing Companies are not included according to the new classification of the Central Bank statistics). Therefore, investment banks and specialized savings institutions are aggregated with deposit money banks in order to create a single comprehensive account for the total Financial Institutions Account. The total deposits from households held by Financial Institutions include time as well as demand deposits. There is no reserve requirement in Tunisia for banks.Z/ 6. Public and Private Enternrises Accounts: The productive sector is broken down in a consistent way between Public and Private enterprises in order to distinguish the composition of investment, value-added, wages, saving and profits in the Tunisian economy. As noted earlier, this distinction permits a separate analysis of the private sector investment behavior. Consequently, private investment is defined as a function of the expected rate of return and the relative cost of borrowing while savings are derived as residual. V For a more detailed description of each bank account please see the technical note prepared by EM2O.  - 8 - 7. Households Account: This account is defined residually in order to balance other sectors. 8. Rest of the World Account (Balance of Payments): In the current account scurces and capital account uses the interest payments on foreign debt and the net foreign borrowing have been disaggregated between Central Government, Public and Private Enterprises, and Financial Institutions, based on information provided by the World Bank Debt Reporting System. In the Balance of Payments, flows include Public and Publicly Guaranteed debt, net short-term capital flows, net Non-Guaranteed MLT and net credit from the IMF (which is part of Net Foreign Assets). The capital account projections, meaning the financial requirements needed in order to finance the current account deficit, is based on RMSM debt module. Since the RMSM debt module calculates the foreign borrowing required for the desired change in net foreign assets of the Central Bank (including net credit from IMF), consistency in the Balance of Payments as shown in the Rest of the World Account is already ensured. D. FUNCTIONING OF THE FRAMEWORK 20. Data Flow of the Macroframework: The flow of funds module runs in Javelin and is directly connected to the EM2CO Tunisian database. The module contains additional spreadsheets used to perform regression analysis and automatically communicate the calibration data to the macroframework. The framework itself runs under the General Algebraic Modelling System (GAMS) developed at the World Bank. The projections of the framework are read automatically back into Javelin and presented in a flow of funds format exactly comparable to that for the historical series. The historical and projected series are then comabined in Javelin. Standard tables are then automatically produced from the combined results. The debt routine for Tunisia is used for feeding the necessary debt indicators into the flow of funds and the model for projections. The data flow described above is depicted in Chart 1.Y As noted in Chart 1, at this point some of the data connections have yet to be automated.  - 9 - CHAT I. Databse Debt Routine |. Exogeno s Variable Li~~~~~~~~~~Ft Ftow of FuonfdudsFo f ud . _(D ^ Das _ Projet=onsa ProJect. TABLES DATA FLOW FOR MARK I Data connection automated ........ . OData connection not yet automated  - 10 . 21. The flow of funds is complemented by a detailed breakdown by economic classification of the government's budget for historical years. This breakdown is based on the Tunisian Ministry of Planning's (MOP) economic budget classification and as mentioned earlier, it is fully compatible with the budget breakdown used for projections. This economic classification, which can be considered as part of the Tunisian database, serves as a source of input data for the budget section of the flow of funds. In addition, the flow of funds' financial institution section is constructed from a set of tables containing detailed information for each of the four types of institutions which make up the financial system; deposit banks, development banks, the Centre d'Epargne National Tunisien (CENT), and the Centre des Cheques Postaux (CCP). Like the economic classification of the budget, this set of financial system tables forms an integral part of the database.Y E. FUNCTIONING OF THE MARKETS 22. All equations are calibrated on 1986-1988 financial and real sector data with the exception of stock balances in the flow of funds which cover the years 1985 to 1988. This section describes the functioning of the agents and markets in the model to give a sense of how main macro variables are determined. It should be kept in mind, however, that the macroframework permits the closures to change and variables can be made exogenous or endogenous as needed. 23. Production by Private and Public Enterprises: As noted earlier, the model depicts two productive sectors, private and public enterprises. Each sector produces the same output.2 Production equations of both sectors are specified as CES functions. Private enterprise production is a function of the private capital stock which remains fixed within the current period, and labor demand which in turn depends on the real wage rate. Public capital is also included as a third factor to allow for complementarity between private and public investment. Similarly, private capital enters the public enterprise production function as a third factor reflecting a symmetry in complementarity. Employment in the public enterprise sector is exogenous and consequently public sector profitability is endogenous. In the base line World Bank scenario described here, wage dynamics are specified to keep the real private sector wage A copy of the financial system tables and the economic classification of the budget for the years 1980-1988 are included in appendix B. i-O/ Depending on the country context it may be that public enterprises produce non-tradeable goods whereas private enterprises produce tradeable goods, and therefore, it may be preferable to have different production functions for public and private enterprises in the model. In the case of Tunisia however, a tradeable/non-tradeable distinction is not a relevant one since oil and phosphates, both tradeables, constitute an important part of public enterprise production.  - 11 - constant within the period through adjustments in the nominal wage. Given firm employment and the fixed within-period capital stock of firms, domestic output is determined independently of any within-period price movements. Investment is a function of expected profitability of future investments. More specifically it depends on the expected real wage, expected real interest rate and the rate of depreciation. Investment leads to an increase in the next year's capital stock. Assuming that the real wage remains fixed, this results in increased real output. The investment/growth relationship is depicted in Diagram I, and the determination of real return on equity is given by Diagram II.  - 12 - DIAGRAMS I i I. DETERMINATIQ OF. REAL GDP GROWT:i delta - Productivity > Increases Old Govt. Capital Stock Old Pub. Ent. - Capital Stock Old Pvt. Ent. -> Capital Stock Ig -> Ipub -> Ipvt > II. DETERMINATION OF REAL RETURN ON DOMESTIC EOUITY (reah) Initial Pvt.Ent.-> Capital Stock > i- Pvt. Ent. -> * -> Capital Gains Pi -> Pvt. Ent. -> Profits -> reqh delta -> (Real Return FI Profits -> on Domestic O- > Equity) Old stock of - > Domestic Equity Pi -> Pi D Domestic Inflation Rate Ig * Government Investment Ipub * Public Ent. Investment Ipvt - Private Ent. Investment g - Real GDP Growth Rate o - Nominal Exchange Rate ;o - Lagged Nominal Exchange Rate P - Domestic Price Level P * Lagged Domestic Price Level delta - Capital Depreciation Rate p* Foreign Price Level WR a Net Worker's Remittances 82078  - 13 - 24. Households: Household income derives from labor income, transfers and interest income on deposits and financial investments. Household savings (and consumption) are determined as a fixed share of income. Savings, together with capital gains on investment, makes up the change in total wealth. As specified in the portfolio balance equation, the new wealth stock (net of required direct holdings of government debt) is allocated to money, deposits and equity (i.e., direct investment), depending on the real expected relative rates of return on these three assets.WU All price expectations are modelled as static expectations. Determination of the household portfolio balance is described in Diagram III. 25. Government: The central government collects direct and indirect taxes, receives oil revenues, central bank profits, and dividends from public enterprise. It consumes goods and services, provides transfer payments, and invests. Its deficit is financed through foreign and domestic credit as well as central bank advances. Local government is defined as the difference between central government and public administration as given by the national accounts. 26. External Sector: Workers' remittances, other net foreign payments, the existing stock of foreign debt and the resulting foreign interest payments, as well as world prices (and world inflation) are taken as exogenous. Both imports and exports are functions of GDP and the real exchange rate.!1 Depending on the closure chosen, the real exchange rate can be set to a desired value to solve for the trade balance, or, given the trade balance, the real exchange rate consistent with it can be derived. The nominal exchange rate, together with the foreign inflation rate, determines the domestic rate of inflation. If the nominal rate of devaluation is set exogenously as a target, as in the scenarios presented here, the domestic inflation rate will also be determined. On the other hand, if the inflation rate is derived from the money market equilibrium the nominal rate of devaluation has to become endogenous. The external sector is depicted in Diagram IV. -U The portfolio balance equation is based on a geometric mean approach which assures that the sum of asset demands adds up to the new wealth stock. See L. Taylor and J. Rosenweig (1984). Li/ Armington assumption: See K. Dervis, J. de Melo and S. Robinson.  -14 - DIAGRAM III III. HOUSEHOLD PORTFOLIO BALANCE Old Wealth - Stock Savings - - > New Wealth ->I Capital - Stock - Adjusted New - Gains Wealth Stock Now Govt. - - New Deposit Capital Direct Borrowing -> rC -> Stock Subsidies -> from Govt. I _.pie -pi ,- >reqh- - -r> New Domestic ro - Equity Stock plo e - reqh -> reqh - New Money - Future Price -> Asset 4toc; > New Base Expectations go - New FI Money Stock Reserve - (demand) Stock reqhe - Lagged Expected Return on omestic Equity g - Real GDP Growth 9O -Lagged GDP Growth reqh * Real Return on Domestic Equity reqhe * Expected Real Return on Domestic Equity re * Expected Real Interest Rate re * Lagged Expected Real Interest Rate Pio e * Lagged Expected Domestic Inflation Pie * Expected Domestic Inflation 8207B  - 15 - DIAGRAM IV IV. DETERMINATION OF EXTERNAL SECTOR Foreign Debt to - > GDP Capital - Resource - -> Account -> GAP -> P 9 W \R e - Po->I- Interest-> P - Other - Net Payments New CB NFA -> Pi - Domestic Inflation Rate Ig - Government Investment Ipub - Public Ent. Investmnt lpvt a Private Ent. Investment g * Real GOP Growth Rate e * Nominal Exchange Rate - Lagged Nominal Exchange Rate P * omestic Price Level PO * Lagged Domestic Price Level delta * Capital Depreciation Rate p* * Foreign Price Level WR * Net Worker's Remittances  - 16 - 27. Money Market: Base money issued by the Central Bank is held by two agents, households and banks. The demand for money is a function of household wealth, bank reserve requirements and the real shadow return on money.'3 The stock of base money supplied by the Central Bank must remain equal to the stock of base money demanded by banks and households. Therefore, the inflation rate adjusts to maintain the equilibrium in the money market. The change in the central bank's supply of base money is determined by the change in the net foreign assets of the central bank as well as the new credit issued to financial institutions, public enterprises and the government, and changes in central bank capital. More specifically, the difference between the Central Bank capital and the total change in the asset side of the balance sheet gives the amount of new base money issued by the Central Bank. As pointed out above, if the government chooses a target nominal devaluation rate exogenously, the Central Bank has to adjust its money supply accordingly. The relationship between the Central Bank capital balances, money supply and domestic inflation shown in Diagram V. 28. The Equity Market: The equity market is quite straightforward. This is a direct investment market, not a stock market. Therefore, the price of equity is equal to the price of capital. Firms are assumed to be willing to hold all the equity that households wish to invest. Given the amount of new equity that households want to invest this period, as well as new foreign equity in private firms and new private foreign borrowing (both determined exogenously), firms attempt to meet their remaining investment needs in the domestic credit market. 29. Financial Institutions: Functioning of the domestic credit market is given in diagram VI. Financial institutions make the domestic credit market. On the liability side, they accept deposits from households. They borrow loanable funds from the central bank and foreign sources. They also receive loanable resources from the government and from households. On the asset side, financial institutions lend to the government, and to private and public firms. In addition, financial institutions hold domestic reserves and net foreign assets. In the credit market, government and public enterprise borrowing requirements are assumed to be met first. Private investment, therefore, must adjust to the residual credit supply. If there is excess demand in the credit market, real interest rates will rise to reduce private credit demand. Rising real interest rates also increase credit supply as households shift their portfolios in favor of deposits. 30. Closure of the Model: As mentioned earlier the framework is flexible and permits having various different closures by redefining what is exogenous In the model, the real shadow return on money has two components: a financial return, given by the inflation rate (-); and a transactions (or convenience) return modelled as a function of the GDP growth rate. Here, the growth rate captures liquidity preference created by changes in the level of economic activity. Liquidity demand created by the level of activity itself is captured indirectly through the implicit relation between GDP level and household wealth.  - 17 - and what is endogenous. The closure chosen in preparing the baseline scenario for this report is described in Part III of this Annex.  -18 - DIAGRAM V V. CENTRAL BANK CAPITAL BALANCE (Domestic Money Market) New CO - > NFA - Total Change -> in CB NFA Valuation Effct on- New CB - Old CO NFA Credit to Fl Stock - New CB -> New CB Assets Credit to - - New Base -.> Pub. Ent. New CO -> Money New Base Capital -> Money Stock - Now CB Old Base - > (Supply) Credit to - Money Stock > Pi Government New Base Money Stock - (Demand) 8207B  -19 - DIAGRA VI VI. DOMESTIC CREDIT MARKET New Deposit -> Stock - Now Deposits -)> Old Deposit - Stock -> New Credit