p > P > p9
Fig 2 about here.
To analyze the role of DTP in price liberalization, we consider the effects of an
increase in p or a decrease in x (we call each of these reforms ‘transitional policy’)
first on the free market price and then on the CPI.
Proposition 1 In a representative household model, transitional policy reduces
the market price, i.e., dp < 0 < dp.
d d d dp dx
An increase in the plan-track price p cuts the implicit subsidy (p — p)x given to
the household, thereby reducing its full income. Consequently, its demand for X
falls, negatively affecting the market price p. The market equilibrium shifts along
the supply curve. If this has a positive slope the quantity supplied is reduced, so
that the overall fall in p is dampened. A decrease in the plan-track quantity x)
reduces the implicit subsidy, with effects that are qualitatively the same as just
described. Thus, the market equilibrium price falls when the government steadily
shifts the DTP system to a competitive market regime.
According to (6), the direct effect on the CPI, P, of an increase in the plan-
track price p) is positive. However, since dp/dp) <0, there is also a negative indirect
9 In China, a high inflation rate was officially recognized in the late 1980s, when the government
began price liberalisation, starting with an increase of the interest rate. Tight controls were re-
instituted in the austerity programmes of 1986 and 1988, reducing government expenditure and
freezing some long-term capital investments. However, the controls were relaxed later to allow
the growth of the non-state sectors, and regulated prices were raised (Lin 2004). In line with our
analysis, inflation of the average price was partly due to an increase of plan-track price.
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