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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.

31

32

MARCH

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

(1)

I = I ( k , P,)L,

(2)

where

k =K / L

(3)

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 ~

(4)

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.

(4a)

Since trade is permitted, capital accumulation is given by the

following relation :

K P k = I PI, C - D - 6 K P k

(5)

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

2

1975

33

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.

(6)

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.

Therefore,

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.

(8)

Define the rate of change of the price of money to be TT. Thus3

Pm/Pm = R.

(9)

We assume that money demand is proportional to the communitys

wealth but that the proportionality factor depends on k, R and Pr.

Therefore,

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

(10)

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:

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.

e

B

34

MARCH

The above expression can also be derived in another way. Total net

saving is also equal to change in wealth I&. Therefore,

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

economy.

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

level.

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

(12)

= s(cfZpk)--(1-f)(p+T)MPm--6KP,.

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

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

( 10a)

1975

MONETARY EXPANSION, TRADE AND GROWTH

From this we can obtain the following differential equation in

35

?r:

where

KaM

kbk

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

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

growth path, the steady state condition is

s A ( k * , P k ) - ( 1 - ~ ) n b ( k * , O , P k )= n + 8

(19)

where k* stands for the steady state capital intensity. We assume that

36

MARCH

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

+'(/I*)

= s AB* - ( 1 - s ) n b k *

1

(1 - S ) V * b*

< 0.

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

Pk/L.

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 *

-I(k*,

Pk)]Pk.

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.

to

guarantee the existence of at least one solution.

1975

37

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

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

A=-e+Lt+

Y

Y

(pi1P,.

L - I

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

and thus

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

decrease.

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

6

Suggested by a referee.

< 0. Also

38

T H E ECONOMIC RECORD

MARCH

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

aT*

dk*

- - - Pk(n

6 - I k * ) ds > 0

as

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

Pk

-T*

=p-n.

(24)

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

ak*

- ( 1 -s)b,n

-s A k * - ( 1 - s ) n bk*

dp

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.

1975

39

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.

R.

RAMANATHAN

University of California,

Sun Diego

Date of Receipt of Final Typescript: J d y 1974

REFERENCES

[ l J Allen, P. R., Money and Growth in Open Economies, Review of Econotrric

Stirdies, Vol. XXXIX, April 1972, pp. 213-19.

[ 2 ] Fischer, S., and J. A. Frenkel, Investment, the Two-Sector Model and Trade

in Debt and Capital Goods, Journal of International Economics, Vol. 2,

May 1972, pp. 211-33.

[3] Frenkel, J. A., A Theory of Money Trade and Balance of Payments in

a Model of Accumulation, Journal of International Econonrics, Vol. 1, May

1971, pp. 159-87.

[4] Hadjimichalakis, 31. G., Equilibrium and Disequilibrium Growth with

Money-The Tobin Models, R n i n v of Economic Stirdies, Vol. S X X V I I I ,

October 1971, pp. 457-79.

[5] Inada, K., International Trade, Capital Accumulation and Factor Price

Equalization, Ecoirowtic Rccord, Vol. 44, September 1968, pp. 32-41,

[6] Kernp, M. C., The Pitrc Theory of Intrmational Trade and Investment

( Prentice-Hall, Englewood Cliffs, N.J., 1969).

[7] Levhari, D., and D. Patinkin, ,The Role of Money in a Simple Growth

Model, Anzericair Economic Remezu, Vol. LVIII, September 1968, pp. 713-53.

[ 8 ] Oniki, H., and H. Uzawa, Patterns of Trade and Investment in a Dynamic

Model of International Trade, R w i c w of Economic Stidies, Vol. XXXII,

January l?65, pp. 15-38.

[9] Salop, J., The Exchange Rate and the Terms of Trade, manuscript.

[lo] Sate, K., Neo-classical Economic Growth and Saving: An Extension of

I,zawas Model, Econoinic Studies Qiiarterlg, Vol. 14, 1964, pp. 69-75.

[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

Rmiezv, Vol. LX, March 1970, pp, 85-106.

[ 131 Tobin, J., Money and Economic Growth, Econometrica, Vol. 33, October

1965, pp. 671-84.

[14] Uzawa, H., On a Two-Sector Model of Economic Growth: II, Rerrezv

o f Economic Sttrdies, Vol. XXX, June 1963, pp. 105-18.

7

See Sidrauski [ l l ] .