Opening towards the World

Abstract

Chapter 6 distinguishes between the benefits of an open economy and the specific risks of opening the economy. A first challenge to transition policy is how to mitigate the shocks on production stemming from getting distorted price relations right after the removal of trade controls and selective protection. The chapter explains why, and how, output declines when opening leads to a massive adjustment of price relations via a higher price level as well as via changing the positive into the negative value added of industries. The chapter further discusses whether, and how, to use the exchange rate of the currency as a non-selective tool for protecting the economy. The chapter also illustrates that the exchange rate tool becomes more or less ineffective when the government lifts capital controls. The exchange rate depends on free capital flows, and undesired capital movements have their own impact on output via the exchange rate and the financial system.

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