Introduction

This chapter describes how to specify, solve, and draw policy lessons from small, two-sector, general equilibrium models of open, developing economies. In the last two decades, changes in the external environment and economic policies have been instrumental in determining the performance of these economies. The relationship between external shocks and policy responses is complex; this chapter provides a starting point for its analysis.

Two-sector models provide a good starting point because of the nature of the external shocks faced by these countries and the policy responses they elicit. These models capture the essential mechanisms by which external shocks and economic policies ripple through the economy. By and large, the shocks have involved the external sector: terms-of-trade shocks, such as the fourfold increase in the price of oil in 1973–74 or the decline in primary commodity prices in the mid-1980s; or cutbacks in foreign capital inflows. The policy responses most commonly proposed (usually by international agencies) have also been targeted at the external sector: (1) depreciating the real exchange rate to adjust to an adverse terms-of-trade shock or to a cutback in foreign borrowing and (2) reducing distortionary taxes (some of which are trade taxes) to enhance economic efficiency and make the economy more competitive in world markets.

A “minimalist” model that captures the shocks and policies mentioned should therefore emphasize the external sector of the economy. Moreover, many of the problems – and solutions – are related to the relationship between the external sector and the rest of the economy.