Edited by John Weiss and David Potts
Chapter 2: Estimating a Shadow Exchange Rate
Elio Londero1 INTRODUCTION This chapter largely avoids theoretical discussion, with formulae presented rather than derived formally. References to the literature where such demonstrations may be consulted are provided throughout. While the most important theoretical considerations are mentioned, emphasis is placed on the issues faced by practitioners when trying to estimate a shadow price of foreign exchange. However, the reader should keep in mind that estimating a shadow price or performing a cost–benefit analysis is an art, the exercise of which requires understanding the principles and assumptions underlying the formulae, procedures and shortcuts used. It is that understanding that allows the applied economist to correctly develop or adapt formulae and recommendations to the particular situations faced in practice. PRINCIPLES AND OPERATIONAL FORMULAE In applied work, the formulae and estimation procedures used are based on a partial equilibrium approach.2 Under such approximation, the shadow price of foreign exchange (SPFE), like any other shadow price, is defined as the change in total economic welfare attributable to a unit change, in this case in the demand or supply of foreign exchange. A change in total economic welfare is conceived as the interpersonal aggregation of individual economic welfare changes. The criterion generally used to obtain an economic measure of a welfare change at the individual level is the compensating variation (Hicks, 1939a, 1939b, 1975; Mishan, 1981; Londero, 1996a, 2003a). It consists of comparing the situation resulting from the action being analysed (the with-project situation) with the situation that would exist if such an action...
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