Effects of macroeconomic policies on sectoral prices

/4azfl THE WORLD BANK ECONOMIC REVIEW, VOL. 4, NO. 1: 55-79 FILE CO!PY ""/J Effects of Macroeconomic Policies on Sectoral Prices Yair Mundlak, Domingo Cavallo, and Roberto Domenech The effect of macroeconomic policies on the relative prices of internationally traded and domestic goods has beetn the subject of extensive study. Analysis of the way in which these policies then affect prices at the sectoral level is complicated by the heterogeneity of sectoral production: even the prices of single products usually are determined by both domestic and traded components. We present a framework which first traces the influence of macropolicy on the relative prices of exports, imports, and home goods. It then accounts for each sector's degree of "tradability," which is based on the importance of trade in sectoral income, and the influence of macroeconomic policy on sectoral prices. To illustrate the use of this approach, it is applied to a simulation of trade liberalization in Argentina. Our results suggest that economywide policies had substantial negative effects on both the real exchange rate and the incentives to agricultural exports. In an open economy, the prices of tradable products are determined by world prices, nominal exchange rates, and taxes. The prices of products which are not tradable are determined by domestic supply and demand, which are them- selves influenced by the actions and policies of the government. Some very important economic decisions depend on the price of tradables relative to that of nontradables-the real exchange rate. We examine here the way in which broader government policies affect the real exchange rate, and through it, prices at the sectoral level. Analyses of the real exchange rate generally aggregate all production into two sectors, tradables and nontradables. This aggregation simplifies the discus- sion and helps illuminate some important issues, but it has limited empirical relevance: there are no products which can be classified as purely tradables or nontradables. To illustrate, a television set is a tradable product, but the price of a television set quoted in a department store in the Ginza district of Tokyo reflects inputs, such as location, which are not tradable. Thus, if we are to Yair Mundlak is a professor at the University of Chicago and a research fellow at the International Food Policy Research Institute. Domingo Cavallo and Roberto Domenech are economists at Instituto de Estudios Economicos sobre la Realidad Argentina y Latinoamericana, Fundacion Mediteranea. In revising the paper, the authors benefited from comments by Maurice Schiff and the referees.