Multiple constraint relaxation and the shadow price of foreign exchange

We argue that in the presence of multiple constraints (such as a trade constraint and a government budget constraint), the shadow price of foreign exchange is no longer well defined. A dollar of foreign exchange received directly by the private sector will relax only the trade constraint, while a dollar of foreign exchange received by the government can relax both the trade and government budget constraints. With distorting taxes, the marginal cost of public funds will come into play if the government budget constraint is also relaxed with the foreign trade constraint as extra foreign exchange accrues, potentially sharply raising the social value of additional foreign exchange. Our numerical simulation results based on Indian and Canadian data suggest that significant differences are involved between single and multiple constraint cases, reflecting current large literature estimates of the marginal cost of public funds. (C) 1999 Elsevier Science B.V. All rights reserved.