The Foreign Exchange Constraint Tariffs And Import Substitution

Recent studies have stressed that a foreign exchange constraint can be limiting the rate of output growth in many developing countries. On the basis of a simple constraints model the role of tariffs and related import substitution in relieving a foreign exchange constraint are analyzed. It is first argued that the assumptions necessary for a foreign exchange constraint to be limiting output growth require that the optimal government intervention is through non‐uniform exchange rate adjustment implied by trade controls and multiple exchange rates. But, whereas the optimum government intervention is through the establishment of a structure of optimum tariffs and subsidies, such a policy is not feasible in light of data availability and administrative capacity in developing countries. The costs and benefits of a non‐optimal intervention through controls are then explored and standards of minimum acceptability of developing countries’ trade policies are established against which actual policy can be compared. It is concluded that trade controls can be used to improve growth performance but only if a number of rigid conditions are met.