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Monetary Expansion, Balance of Trade

and Economic Growth"

In recent years there have been a number of papers on international
trade, investment and growth (Kemp [6], Sato [lo], Inada [S], Oniki
and Uzawa [8]). Similarly, the literature on one-sector monetary growth
models is also fairly extensive (Tobin [13], Levhari and Patinkin [7],
Sidrauski [ll], Stein [12]). In this paper we attempt to integrate the
two types of models by introducing a monetary asset in a two-sector
economy which allows international trade and in which accumulation
of capital and labour takes place.' The working of the economy is as
follows. At any given instant, the economy has given stocks of capital
and labour and a stock of money supplied by the government as a
transfer payment. The country produces both consumption and capital
goods (i.e., is non-specialized). If at given terms of trade there is an
excess supply of capital (consumption) goods, then, the economy exports
them and imports consumption (capital) goods. The output of the
investment goods sector, plus or minus capital goods traded, goes to
increase the stock of capital. Labour force grows at an exogenously
determined rate. What role does money play in such an economy? When
the stock of money expands, asset holders' wealth increases. On the
one hand, this increases consumption demand and hence will affect the
amount of capital goods imported or exported, if there is no trade in
securities. This in turn afects the productive capacity of the economy
and hence alters its growth path. Second, if money continuously increases and exchange rates are flexible, then the domestic price level
changes. Since this alters the relative yields on capital and money, the
portfolio composition is afFected, thus afecting capital accumulation
and hence the growth path. It is therefore of considerable interest to
examine the long-run behaviour of such an economy. For instance, we
should like to know what effect an increase in the rate of monetary
expansion will have on the long-run per capiru income as well as on the
level of trade. A similar question can be raised with regard to changes
*John Conlisk, Stuart McMenamin, Bill Roberts and a referee made useful
comments but are not responsible for errors.
1Recent papers by Allen [ l ] , Fisher and Frenkel [Z],and Salop [9] also
attempt a similar integration, but our approach and analysis are quite different.
For instance, Allen's is a one-sector (complete specialization) two-country model,
whereas we consider a small country producing both capital and consumption
goods. Fisher and Frenkel have not considered the monetary sector explicitly but
have taken account of trade in securities.





in the world terms of trade, in the presence of a monetary asset that

competes with capital assets.
The paper also briefly discusses the implications of fixed and
flexible exchange rates on the independence of monetary policy. It will
be emphasized that, under pegged exchange rates, the monetary authority
of a small open economy (such as the one we discuss) cannot independently determine the rate of monetary expansion.
1 . The Model
We assume that there are two sectors, a consumption goods sector
(C) and an investment (or capital) goods sector (I). Let K be the
stock of capital, L the stock of labour, and Pk the price of capital goods
in terms of consumption goods. Then it is well known that if production
relations are linearly homogeneous in capital and labour, the output
(or supply) of the two goods can be expressed as follows:
c = C ( k , Pk)L
I = I ( k , P,)L,
k =K / L
is the capital-labour ratio. An increase in the price of capital will raise
the output of the capital goods industry and lower the output of the
consumption goods sector. Thus aC/aP, < 0 and aI/aP, > 0. By
Rybczynskis theorem (Kemp [ 6 ] ) , an increase in k will result in the
expansion of the industry in which capital is used more intensively and
in the contraction of the other industry. Following the rest of the
literature, we shall assume that the consumption sector is more capital
intensive than the investment sector. Under this capital intensity condition, Ck > 0 and I k < o.2
In a closed economy, the output of the investment sector will
simply augment capital stock and hence increase productive capacity.
If, however, we allow international trade, consumption demand need
not equal the output of the consumption goods industry and capital
might flow from or to the rest of the world. Let consumption demand be
D = (1 - s ) Y ~
where Y d is total disposable income. For the time being, we assume
that the saving rate (s) is fixed. This assumption will be relaxed later.
If Id is the investment demand, then the balance of payments
equilibrium is given by
C - D = ( I d - I)Pk.
Since trade is permitted, capital accumulation is given by the
following relation :

K P k = I PI, C - D - 6 K P k
where a dot above a variable denotes its time derivative and 6 is the
constant relative rate of depreciation. If there is an excess supply of

Partial derivatives are denoted by subscripts.




consumption goods, then the economy will export the surplus and import
investment goods, thus augmenting the domestic production of capital
goods. This situation might be typical of a less developed economy that
exports primary goods and imports capital goods. Similarly, an advanced
country might be represented by an excess demand for consumption
goods. Total labour force is given by
L = Lo ent.
We now add a monetary asset. Let M be the nominal stock of
money. It is supplied as a transfer payment by the central bank and is
not a produced commodity. We further assume that money supply
grows at the rate I-I.
M / M =p
is treated alternatively as endogenous and exogenous. Since the consumption good is used as a numeraire, there will be terms of trade
between money and consumption goods. This is denoted by Pm.The
total wealth of the economy (in terms of consumption goods) is
W = K PI, f M Pm.
Define the rate of change of the price of money to be TT. Thus3

Pm/Pm = R.
We assume that money demand is proportional to the communitys
wealth but that the proportionality factor depends on k, R and Pr.
MP,,,=h (k,x,P,)W
O < h < 1.
Using (8) this can be rewritten as follows:
M P, = b ( k , T , P k ) K Pa
where b = A / ( 1 - A).
An increase in k would induce people to hold a greater proportion
of wealth in monetary assets. Therefore h k and bk are positive. An
increase in the price of money in terms of consumption goods will make
the monetary asset more attractive and hence A,, and b, are negative.
If Pk increases, individuals would move in favour of capital and hence
dX/aPk < 0.
The disposable income ( Y d ) of the economy (again in terms of
consumption goods) is given by the following expression:

Disposable income is thus given by the value of domestic output plus

the increase in the value of money (through new transfer payments
and increase in P,) plus the capital gains due to a rise in the price
of capital.
3 Since the numeraire is the consumption good, P , is the reciprocal of what
is usually called the price level in one-sector models. The inflation rate is therefore -T, and an increase in 7 will induce asset holders to hold m o ~ money.




The above expression can also be derived in another way. Total net
saving is also equal to change in wealth I&. Therefore,

From this and (4)we have

Substituting for D from ( 5 ) in the above relation, we obtain (1 1).

For convenience we will refer to P, as the domestic terms of
trade and Pk as the world terms of trade. If, as is common, we assume
that the economy in question is small and that the rest of the world
is in steady state, then we may treat the world terms of trade Pk as
given, in which case P, will be equal to zero for all t . In a two-country
model, Pk would of course be determined endogenously. Later on, we
analyse the effects of changes in Pk on the long-run behaviour of the
Finally we have the exchange rate determination. If P , is the world
price of money, which by the small-country assumption is treated as
given, and P is the exchange rate, we have
P , = p P,.

(1 l a )
Equations ( 1) to ( 1l ) , (4a) and (1 la) uniquely determine the
time paths of the thirteen endogenous variables C, I, k, D, K , L , M ,
P,, Y d ,W , I d , T and p for given values of Pk, P,, R, s, 8 and p . Although
the above formulation treats the exchange rate as flexible and endogenously determined, later we consider the fixed exchange rate case in which
monetary policy is endogenously determined to maintain a stable price

2. Long-run Analysis
The long-run properties of the model may be derived by reducing
the system to two merentid equations. From (4), ( l l ) , and (S),
I(Pk = C f l P k - ( l - S ) Yd-SKPk
= s(cfZpk)--(1-f)(p+T)MPm--6KP,.

Dividing by KPk, substituting for C, I and M P , and noting that

k/k = KIK-n, we obtain the following differential equation in k :

Logarithmically differentiating (10) with respect to t, we get

& ~ / M + T= bkk/b+b,+/b + K / K .

( 10a)

From this we can obtain the following differential equation in




7 = -M a K -- l+T

is the partial elasticity of demand for money with respect to the capital
stock and can be shown to be greater than unity. Equations (13) and
(14) constitute the basic differential equations of the system.
3. Domestic Price Stability
Is it possible to maintain a stable domestic price level; that is,
can x = 0 for all t? The obvious answer is yes, provided the government
pursues an appropriate monetary policy. In this situation, p, will become
an endogenous variable, and the system can be completed by adding
x = 0 as another equation. It is seen from (14) that for x to be zero the
appropriate rate of monetary expansion must be

Therefore, for domestic price stability, the rate of monetary expansion

cannot be set arbitrarily but must equal the natural rate n plus or minus
a correction factor which is the product of the rate of change of the
capital-labour ratio and the partial elasticity of demand for money with
respect to capital. It should be pointed out that equation (16) gives the
appropriate rate of domestic credit expansion that is consistent with a
zero balance of payments. If the exchange rate is pegged, the domestic
money supply will always change at the rate that equals the flow
demand for money. The domestic credit creation will affect this to
maintain balance of payments. Thus, what we call the rate of monetary
expansion is really the rate of credit expansion. In this case, the
system can be reduced to a single differential equation in k . Substitute
for p from ( 16) into ( 13) and solve for k to obtain

where Pk denotes the fixed world terms of trade and

is the average product of capital. Since k = 0 along the balanced

growth path, the steady state condition is
s A ( k * , P k ) - ( 1 - ~ ) n b ( k * , O , P k )= n + 8
where k* stands for the steady state capital intensity. We assume that




at least one solution exist^.^ It was shown earlier that bk is positive, and
hence the second term is a decreasing function of k. By proceeding as in
Uzawa [14], it can be shown that if the consumer goods industry is
more capital intensive than the capital goods industry, then A ( k,PI,) is
a decreasing function of k. Hence, the left-hand side of ( 19) will decrease
when k increases, implying that the steady state k* satisfying (19) is
unique. Will the solution be stable? The necessary and sufficient condition for the stability of this case is that +'(k*) < 0. Differentiating (17)
with respect to k and evaluating at k* (using ( 19) ), we get
= s AB* - ( 1 - s ) n b k *
(1 - S ) V * b*

< 0.

Therefore the steady state is unique and is also stable.

It is possible to give an economic argument for the stability in this
case. Suppose capital stock accumulates faster than labour. Then, as
we saw earlier, the demand for real balances per unit of capital will
increase (because bk > 0 ) . The portfolio composition therefore moves
in favour of monetary assets and away from capital assets. This reduces
investment, and therefore the rate of accumulation of capital falls. This
process will continue as long as the capital stock grows faster than n.
Ultimately, capital accumulation slows to the rate n and balanced
growth is achieved. The mechanism is similar when labour grows faster
than capital,
What will be the level of trade (imports or exports) in the long
run? From ( 5 ) we have the per capita level of trade as

(c - D ) / L = ( k / L - I/L)Pk + 6 K


Since K / K = n in the steady state, the long-run per capita trade level
is (for the flexible exchange rate case)

T* =

(c* - D * ) / L = [(n + 6 ) k *



Since the right-hand side is fixed, the trade level C* - D* will grow
in the long run at the same rate as the labour force. But the ratio of
trade level to total output will remain constant.
We now investigate the sensitivities of the long-run capital intensity
(and hence of other endogenous variables) with respect to changes in
the parameters of the system. It is evident from ( 1 7 ) that an increase
in s will shift the entire + ( k ) curve upwards and thus ak*/as > 0.
Similarly, ak*/an > 0. These results are the same as in most growth
models. Since monetary policy is endogenously determined to maintain
a stable price level, we cannot examine the long-run effects of changes
in the rate of monetary expansion. However, we discuss this issue in the
next section.

4The boundary conditions A ( 0 , Pk) = 03 and A ( m , P k ) = 0 are sufficient

guarantee the existence of at least one solution.




An interesting question that arises in this model is the effect of

changes in the world terms of trade ( P k ) on long-run k* and also on
the equilibrium level of trade.
Differentiate (19) partidly with respect to PI, and solve for
ak*/aPk to obtain

The denominator of the above expression is negative because

A k < 0 and 6 , > 0. An increase in the relative price of capital will
increase the wage-rental ratio because of the capital intensity condition.
The marginal product of capital therefore decreases. This will tend to
induce asset holders to favour the monetary asset more. Thus we should
expect db/dPk to be positive. It can be shown that db/dP, < 0. The
proof5 is as follows. Let Y = C
Z Pk be the aggregate output expressed in consumer goods. Then A = Y / ( K P k ) . Denote by A a
percentage change in a variable (e.g., f = dY/Y). Thus A^ = - k
- pk.Since k^ = 0 for the partial differentiation and

it follows that

c PI

L - I

From the envelope theorem, movement along the transformation schedule

signifies that dC+P,dI = 0, which implies that

and thus

Therefore, a A / 8Pk < 0. It follows from (20) that ak*/aPk is negative.

Thus an increase in the world terms of trade will decrease long-run
capital intensity. In this case, the per capita output (Y/L)* will also
What will be the effect of an increase in PI, on the long-run level
of trade? From the expression for per capita trade level we get

We saw earlier that under the capital intensity condition Zk


Suggested by a referee.

< 0. Also




an increase in the price of capital goods will increase I and hence

dl/aPk > 0. Even under these conditions the sign of aT*/dPk is
ambiguous. However, it is possible to reach more definite conclusions
if T* < 0. We showed earlier that dk*/dPk < 0. It follows from this
and T* < 0 that dT*JdPk* < 0; that is, an increase in the price of
capital will decrease the level of trade if the country imports consumption goods.
What is the effect of an increase in the saving rate (s) on the
extent of trade? We have
- - - Pk(n
6 - I k * ) ds > 0

because I k < 0 and ak*/as > 0. Similarly, aT*/an < 0. Therefore,

an increase in the saving rate increases the long-run trade level whereas
the trade level will decrease when n increases.
4 . Flexible Domestic Price Level
In this section we analyse the more general case in which the
domestic price level (that is, the terms of trade between money and
consumption goods) is flexible which also implies that the exchange
rate is flexible. The monetary authorities are unable or unwilling continuously to adjust the rate of monetary expansion (or contraction)
according to (16) but fix it an an exogenously determined level u.
The domestic price level (P,) will therefore fluctuate to clear the
markets. We retain the assumption that the world terms of trade is
constant (i.e.,
= 0) over time. In the steady state I; = i = 0,
and hence from (14) we have the well-known condition


The steady state capital intensity is determined by
S A (k*,Pk) - (1 -S)&(k*,-p
n, pk) = n 6. ( 2 5 )
It is easy to see, by comparing (19) and (25), that the effect of
changes in PI, is the same and similar sufficient conditions hold. The
question of main interest in this general case is the effect of an increase
in the rate of monetary expansion on the long-run capital intensity and
the balance of trade. Differentiating (25) partially with respect to p,
we get
- ( 1 -s)b,n
-s A k * - ( 1 - s ) n bk*

The denominator is clearly negative. An increase in the price of money

in terms of consumption goods will make the monetary asset more
attractive to wealth holders and hence b > 0. We thus have ak*/apT
> 0, which is the same result obtained in neoclassical onesector
monetary growth
Note also that this result is consistent with Allen [ l ] . She has shown that
if the foreign elasticity of demand for the countrys exports is s f l c i e n t l y large,
then a k * / J p > 0. In our model the elasticity is infinite.




The effect of monetary expansion on the level of trade is given as

because Zk < 0 and d k * / d p > 0. Thus an increase in the rate of

monetary expansion will increase the trade level unambiguously.
Although we have not explicitly carried out the stability analysis,
it is easy to show that, like standard neoclassical models in which
actual rates of inflation are identical with the expected rates of inflation,
this model also has some difficulties with stability. The stability problem
could be solved in various ways. A well known way7 is to introduce
explicitly an adaptive expectation mechanism. Stability is achieved if
the speed of revision of expectation is small. An alternative way is to
introduce a variable saving ratio and impose additional restrictions to
make the system stable. In this variable saving rate case, an increase in
the rate of monetary expansion decreases the long-run capital intensity
as well as the level of trade, a result in strong contrast to the simpler
case of constant saving ratio.



University of California,
Sun Diego
Date of Receipt of Final Typescript: J d y 1974
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Model, Anzericair Economic Remezu, Vol. LVIII, September 1968, pp. 713-53.
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Model of International Trade, R w i c w of Economic Stidies, Vol. XXXII,
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[11 J Sidrauski, hl., Inflation and Economic Growth, Journal of Political Economy, Vol. 75, December 1967, pp. 796-810.
[12] Stein, J. L., Monetary Growth Theory in Perspective, Americon Economic
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See Sidrauski [ l l ] .