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American Economic Association

Comparative Advantage, Trade, and Payments in a Ricardian Model with a Continuum of Goods
Author(s): R. Dornbusch, S. Fischer and P. A. Samuelson
Source: The American Economic Review, Vol. 67, No. 5 (Dec., 1977), pp. 823-839
Published by: American Economic Association
Stable URL: http://www.jstor.org/stable/1828066
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ComparativeAdvantage,Trade, and Payments
in a RicardianModel witha ContinuumofGoods -
By R. DORNBUSCH, S. FISCHER, AND P. A. SAMUELSON*

This paper discussesRicardian trade and I. The Real Model


paymentstheoryin thecase of a continuum
of goods. The analysisthus extendsthe de- In thissection we develop the basic real
velopmentof many-commodity, two-coun- model and determinethe equilibriumrela-
trycomparativeadvantage analysis as pre- tivewage and pricestructurealong withthe
sented,for example, in GottfriedHaberler efficientgeographic pattern of specializa-
(1937), Frank Graham (1923), Paul Samuel- tion. Assumptions about technology are
son (1964), and Frank W. Taussig (1927). specifiedin SectionIA. SectionIB deals with
The literatureis historicallyreviewed by demand. In Section Ic the equilibrium is
JohnChipman(1965). Perhaps surprisingly, constructedand some of its propertiesare
the continuum assumption simplifiesthe explored. Throughoutthis section we as-
analysisneatlyin comparison with the dis- sumezero transportcosts and no otherim-
crete many-commoditycase. The distin- pedimentsto trade.
guishingfeatureof the Ricardian approach
emphasizedin this paper is the determina- A. Technologyand Efficient
tion of the competitivemargin in produc- GeographicSpecialization
tionbetweenimportedand exportedgoods.
The analysisadvances the existingliterature The many-commodityRicardian model
by formallyshowing preciselyhow tariffs assumes constant unit labor requirements
and transportcosts establish a range of (a,,..., a,) and (al*,..., a*) forthe n com-
commoditiesthat are not traded, and how moditiesthatcan be produced in the home
the price-specieflow mechanism does or and foreign countries, respectively.The
does not give rise to movementsin relative commoditiesare convenientlyindexed so
cost and pricelevels. that relative unit labor requirementsare
The formalreal model is introducedin rankedin orderof diminishinghome coun-
Section 1. Its equilibrium determinesthe trycomparativeadvantage,
relativewage and price structureand the
al*1a, > ... > ... > Ol*ai > ... > an*la,
efficientinternationalspecializationpattern.
Section II considers standard comparative wherean asteriskdenotesthe foreigncoun-
staticquestions of growth,demand shifts, try.
technologicalchange,and transfers.Exten- In workingwith a continuumof goods,
sions of the model to nontraded goods, we similarlyindexcommoditieson an inter-
tariffs,and transportcosts are then studied val, say [0, 1], in accordance with diminish-
in Section III. Monetaryconsiderationsare ing home countrycomparative advantage.
introducedin Section IV, which examines A commodityz is associated with each
the price-specie mechanism under stable point on the interval,and for each com-
parities,floatingexchangerate regimes,and moditythereare unitlabor requirementsin
also questions of unemployment under thetwo countries,a(z) and a*(z), withrela-
stickymoneywages. tiveunitlabor requirement givenby

* Massachusetts Institute of Technology. Helpful (1) A(z) - *(z) A


A'(z) < 0
aa (z)
(z)
comments from Ronald W. Jones are gratefully
acknowledged.Financial support was provided by a
Ford Foundationgrantto Dornbusch,NSF GS-41428 The relativeunitlabor requirementfunction
to Fischer,and NSF 75-04053to Samuelson. in (1) is by strongassumptioncontinuous
823

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824 THE AMERICAN ECONOMIC REVIEW DECEMBER 1977

and byconstruction(rankingor indexingof The relativeprice of home produced z in


goods), decreasingin z. The functionA (z) termsof a commodityz" produced abroad
is shownin Figure 1 as the downwardslop- is by contrast
ingschedule. (7) P(z)/P(z") = wa(z)/w*a*(zP")
Consider now the range of commodities
produceddomesticallyand those produced = wa(z)1a*(z'');
abroad, as well as the relativeprice struc- z < z < z"
tureassociated with given wages. For that
purposewe defineas w and w* the domestic In summarizingthe supply part of the
and foreignwages measured in any (com- model we note that any specifiedrelative
mon!) unit. The home country will effi- real wage is associatedwithan efficient geo-
cientlyproduce all those commodities for graphicspecializationpatterncharacterized
which domestic unit labor costs are less by theborderlinecommodityz(w) as well as
than or equal to foreignunit labor costs. by a relativeprice structure.(The patternis
Accordingly,any commodityz will be pro- "efficient"in thesense that the world is out
duced at home if on, and not inside, its production-possibil-
ityfrontier.)
(2) a(z)w < a*(z)w*
B. Demand
Thus
On the demand side, the simplest Mill-
(2') w < A (z) Ricardo analysis imposes a strong homo-
where(3) definesthe parameterw, funda- theticstructurein the formof J. S. Mill or
mentalto Ricardiananalysis, Cobb-Douglas demand functionsthat asso-
ciate with each ith commoditya constant
(3) w/w*
expenditureshare, bi. It furtherassumes
This is the ratio of our real wage to theirs identicaltastesforthe two countriesor uni-
(our "double-factoralterms of trade"). It formhomotheticdemand.
followsthat fora given relativewage w the By analogy with the many-commodity
home countrywill efficiently produce the case, whichinvolvesbudgetshares
rangeof commodities bi*
bi= PiCi/Y bi=
(4) 0 < z < (w) n

where taking(2') withequality definesthe Z bi = I


borderlinecommodityz, forwhich
We thereforeprescribefor the continuum
(5) Z = A-I(w)
case a givenb(z) profile:
A-'( ) being the inversefunctionof A( ). 0
(8) b(z) = P(z)C(z)/Y >
By the same argumentthe foreigncountry
will specialize in the production of com- b(z) = b*(z)
moditiesin therange
fb(z) dz I
(4') (w) < z <
The minimumcost condition determines where Y denotes total income, C demand
thestructureof relativeprices.The relative forand P thepriceof commodityz.
price of a commodityz in terms of any Next we definethe fractionof income
othercommodityz', when both goods are spent(anywhere)on those goods in which
producedin the home country,is equal to thehome countryhas a comparativeadvan-
theratioof home unitlabor costs: tage:
= wa(z)/wa(z')
0
z
(6) P(z)/P(z') b
(9) 0(z) b(z)fdz >
= a(z)/a(z');
z < z, z' < z 0 (z)= b(z) > 0

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VOL. 67 NO. 5 - DORNBUSCH ET AL.: RICARDIAN MODEL 825

whereagain (0, 2) denotesthe rangeof com-


moditiesforwhichthehome countryenjoys B(Z; L*/L)
a comparativeadvantage.Witha fractiont
of each country'sincome, and thereforeof
world income, spent on home produced
goods, it followsthatthefractionof income
spenton foreignproducedcommoditiesis

(9' 1 - 9(z) J b(z) dz

0 < ?<(z) < 1 A(z)

C. EquilibriumRelativeWages 0 . I
and Specialization FIGURE 1

To derivethe equilibriumrelative wage


and price structureand the associated pat- labor (goods) would decline.' A rise in the
tern of efficientgeographic specialization, domesticrelativewage would then be re-
we turn next to the condition of market quired to equate the demand for domestic
equilibrium.Consider the home country's labor to theexistingsupply.
labor market,or equivalentlythe market An alternativeinterpretationof the B( )
for domestically produced commodities. scheduleas the locus of trade balance equi-
With z denotingthe hypotheticaldividing libriauses the factthat(10) can be written
line betweendomesticallyand foreignpro- in thebalance-of-tradeform:
duced commodities,equilibriumin the mar- = 0(2)w*L*
(10") [1 - 0(2)]wL
ket forhome produced goods requiresthat
domestic labor income wL equals world This statesthatequilibriumin thetrade bal-
spendingon domesticallyproducedgoods: ance means importsare equal in value to
exports. On this interpretation,the B( )
(10) wL = 0(2)(wL + w*L*) scheduleis upward sloping because an in-
crease in the range of commoditieshypo-
Equation (10) associateswitheach z a value theticallyproduced at home at constant
ofthe relativewage -w/w*such that market relativewages lowersour importsand raises
equilibriumobtains.This scheduleis drawn our exports.The resultingtrade imbalance
in Figure 1 as theupward slopinglocus and would have to be correctedby an increase
is obtainedfrom(10) by rewritingthe equa- in our relativewage that would raise our
tionin theform: importdemand for goods and reduce our
exports,and thusrestorebalance.
(10') = Il -D(@)( (L*/L) - B(z;L*/L) The nextstep is to combine the demand
side of the economy with the condition of
whereit is apparentfrom(9) thatthe sched- efficientspecialization as represented in
as
ule startsat zero and approaches infinity equation (5), whichspecifiesthecompetitive
z approachesunity. marginas a functionof the relative wage.
To interpretthe B( ) schedule we note Substituting (5) in (10') yieldsas a solution
that it is entirelya representationof the the unique relative wage 5, at which the
demand side; and in that respect it shows specialized, is in bal-
world is efficiently
thatif the range of domesticallyproduced
goods were increased at constant relative 'Throughout this paper we refer to "domestic"
wages,demand for domesticlabor (goods) goods as commoditiesproduced in the home country
would increaseas thedividingline is shifted ratherthan to commoditiesthat are nontraded.The
-at thesame timethat demand forforeign latterwe call "nontraded"goods.

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826 THE AMERICAN ECONOMIC REVIEW DECEMBER 1977

anced trade,and is at fullemploymentwith being of the representativeperson-laborer


all marketsclearing: at home relativeto the well-beingof the
foreignlaborer.
representative
(11) z = A(z) = B(-;L*/L)
The equilibriumrelativewage definedin Statics
II. Comparative
(11) is representedin Figure 1 at the inter-
section of the A( ) and B( ) schedules.2 The unique real equilibriumin Figure 1
Commodityz denotesthe equilibriumbor- is determinedjointly by tastes,technology,
derlineof comparativeadvantage between and relativesize, L*/L. We can now exploit
commoditiesproducedand exportedby the Figure 1 to examine simple comparative
home country(O < z < z), and those com- staticquestions.
moditiesproducedand exportedby the for-
eigncountry(z < z < 1). A. RelativeSize
Amongthe characteristics of the equilib-
riumwe note that the equilibriumrelative Considerfirstthe effectof an increase in
wages and specializationpatternare deter- therelativesize of the restof the world. An
mined by technology,tastes, and relative increase in L*/L by (10) shiftsthe B( )
size (as measured by the relative labor tradebalance equilibriumschedule upward
force).3The relative price structureasso- in proportionto the change in relativesize
ciated with the equilibriumat point E is and must,therefore,raise the equilibrium
definedby equations (6) and (7) once (11) relativewage at home and reduce the range
has defined the relative wage z and the of commoditiesproduced domestically.It
equilibriumspecializationpatternz(Z). is apparentfromFigure2 thatthe domestic
The equilibrium levels of production relativewage increases proportionallyless
Q(z) and Q*(z), and employmentin each thanthedeclinein domesticrelativesize.
industryL(z) and L*(z), can be recovered The risein equilibriumrelativewages due
fromthe demand structureand unit labor to a change in relativesize can be thought
requirementsonce the comparativeadvan- of in the followingmanner. At the initial
tagepatternhas been determined. equilibrium,theincreasein the foreignrela-
We note that with identical homothetic tivelabor forcewould create an excess sup-
tastes across countriesand no distortions, ply of labor abroad and an excess demand
therelativewage Z-is a measureof the well- forlabor at home-or, correspondingly,a
tradesurplusforthe home country.The re-
sultingincrease in domesticrelativewages
2See the Appendix for the relation of the diagram
to previousanalyses. servesto eliminatethe trade surpluswhile
3The constructionof theB( ) schedule reliesheavily
on the Cobb-Douglas demand structure.If, instead,
demand functionswere identicalacross countriesand B(z; L*/L)
homothetic,an analogous schedule could be con- LU\/
structed.In thegeneralhomotheticcase, however,a set
B(z; L*/L)O
of relativepricesis requiredat each z to calculate the
equivalentof the B( ) schedule;the relativeprices are
those that apply on the A (z) schedule for that value
of z. In this case the independenceof the A ( ) and
B( ) schedulesis obviouslylost. In the generalhomo-
theticcase there is still a unique intersectionof the
A ( ) and B( ) schedules.For more generalnonhomo-
theticdemand structures, it is known that an equilib-
rium exists; but even in the case of two Ricardian
goods theremaybe no unique equilibriumeven though
therewill almost always be a finitenumber of equi- I ~~~~A
(z)
libria.See Gerard Debreu and Stephen Smale. Exten-
sions of our analysiswithrespectto the demand struc- Go
0 A
tureand thenumberof countriesare developed in un-
publishedworkby CharlesWilson. FIGURE 2

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VOL. 67 NO. S DORNBUSCH ET AL.: RICARDIAN MODEL 827

at the same timeraisingrelativeunit labor (13) P(z) - P(z") = co- d*(z") > 0
costs at home. The increase in domestic
relativeunit labor costs in turn implies a where a "hat" denotes a proportional
loss of comparativeadvantage in marginal change. Domestic real income increases,as
industriesand thus a needed reduction in does foreignreal income.4 The range of
therangeof commoditiesproduced domes- goods produced domesticallydeclines since
tically. domesticlabor, in efficiency units, is now
The welfareimplicationsof the change in relativelymorescarce.
relativesize take the formof an unambigu- An alternativeformof technicalprogress
ous improvement in thehome country'sreal that can be studied is the international
incomeand (under Cobb-Douglas demand) transferof the least cost technology.Such
a reductionin real incomeper head abroad. transfersreducethediscrepanciesin relative
We observe, too, that from the definition unitlabor requirements-byloweringthem
of the home country'sshare in world in- for each z in the relativelyless efficient
come and (10), we have country-and thereforeflatten the A (z)
(12) =
wL/(wL + w*L*) -() schedulein Figure 1. It can be shown that
such harmonization of technology must
It is apparent,as notedabove, that a reduc- benefitthe innovatinglow-wage country,
tion in domesticrelativesize in raisingthe and that it may reduce real income in the
domestic relative wage (thereby reducing high-wagecountrywhose technologycomes
therange of commoditiesproduced domes- to be adopted. In fact,the high-wagecoun-
tically)must under our Cobb-Douglas de- trymustlose if harmonizationis complete
mandassumptionslowerthe home country's so thatrelativeunitlabor requirementsnow
sharein totalworld income and spending- become identical across countries and all
eventhoughour per capita incomerises. our consumer'ssurplus from international
tradevanishes.5
B. TechnicalProgress

To beginwith,we are concernedwiththe C. DemandShifts


effectsof uniformtechnical progress. By
equation(1), a uniformproportionalreduc- The case witha continuumof commodi-
tionin foreignunit labor requirementsim- tiesrequiresa carefuldefinitionof a demand
plies a reductionin a*(z) and thereforea shift.For our purposes it is sufficientto
proportionaldownward shiftof the A (z) ask: What is theeffectof a shiftfromhighz
schedulein Figure 1. At the initial relative commoditiestoward low z commodities?It
wage a, the loss of our comparativeadvan- is apparentfromFigure 2 that such a shift
tage due to a reductionin foreignunit labor will cause the trade balance equilibrium
costs will imply a loss of some industries scheduleB( ) to shiftup and to the left.It
in the home countryand a corresponding followsthat the equilibriumdomestic rela-
tradedeficit.The resultinginduced decline
in the equilibriumrelativewage serves to 4The purchasingpower of foreignlabor income in
restoretrade balance equilibrium,and to termsof domestically producedgoods is w*L*/wa(z) =
offsetin part our decline in comparative L*/a(z)z and in terms of foreigngoods L*/a*(z).
advantage. The factthat foreigners'real income per head rises is
guaranteedby our Cobb-Douglas demandassumption.
.Thenet effectis thereforea reductionin In the generalhomotheticcase, a balanced reduction
domestic relative wages, which must fall in a* (z) can be immiserizingabroad if the real wage
rproportionally shortof the decline in rela- falls stronglyin terms of all previously imported
tive unit labor requirementsabroad. The goods; however,thebalanced drop in a* (z) in the gen-
home country'stermsof tradethereforeim- eral homotheticcase alwaysincreasesour real wage.
5Complete equilization of unit labor requirements
prove as can be noted by using (7) for any impliesthat the A( ) schedule is horizontal at the
two commodities z and z", respectively, level w = A (z) = 1. In this case geographic specializa-
producedat home and abroad: tionbecomesindeterminate and inessential.

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828 THE AMERICAN ECONOMIC REVIEW DECEMBER 1977

tivewage will rise while the range of com- relativeprice structureand the range of
moditiesproducedbythehome countryde- goods traded.
clines. Domestic labor is allocated to a
narrowerrange of commodities that are A. NontradedGoods
consumedwithhigherdensitywhile foreign
labor is spread more thinlyacross a larger To introduce nontraded goods into the
rangeof goods. analysiswe assume thata fractionk of in-
Welfarechanges cannot be identifiedin come is everywherespenton internationally
thisinstancebecause tastesthemselveshave traded goods, and a fraction (1 - k) is
changed. It is true that domestic relative spent in each countryon nontraded com-
income rises along with the relativewage. modities.With b(z) continuingto denote
Furtherwe note that since Zi rises,the rela- expendituredensitiesfor traded goods, we
tive well-beingof home labor to foreign have accordingly
labor (reckonedat thenew tastes) is greater
than was our laborers' relativewell-being (14) k a b(z) dz < 1
(reckonedat theold tastes).
wherez denotes traded goods.6 As before
D. UnilateralTransfers the fractionof income spent on domesti-
callyexportablecommoditiesis O(z), except
Suppose foreigners make a continualuni- that t now reaches a maximum value of
lateraltransferto us. With uniformhomo- (1)= k.
thetictastes'and no impedimentsto trade, Equation (1) remains valid for traded
neithercurveis shiftedby the transfersince goods, but the trade balance equilibrium
we spend the transferexactly as foreigners conditionin (10 ") mustnow be modifiedto:
would have spentit but forthetransfer. The
new equilibriuminvolves a recurringtrade (15) [1 - 0(z) - (1 - k)]wL
deficitforus, equal to thetransfer,but there = O(Z)W*L*
is no changein thetermsof trade. As Bertil
Ohlin argued against John Maynard sincedomesticspendingon importsis equal
Keynes,here is a case where full equilibra- to income less spendingon all domestically
tion takes place solely as a result of the produced goods includingnontradedcom-
spendingtransfers. When we introducenon- modities.Equation (15) can be rewritten as
traded goods below, Ohlin's presumption
will be found to requiredetailed qualifica- (15') W= k (!) (L*/L)
tions,as it also would if tastesdifferedgeo-
graphically.
wherek is a constant and thereforeinde-
pendentof therelativewage structure.
III. ExtensionsoftheRealModel We note that (15') togetherwith (5) de-
terminesthe equilibriumrelativewage and
Extensionsof the real model taken up in efficientgeographic specialization, (Co,z).
this section concern nontraded goods, Furtherit is apparentthat(15') has exactly
tariffs,and transportcosts. The purpose of the same propertiesas (10') and that ac-
this section is twofold. First we establish cordinglya constructionof equilibriumlike
how the exogenous introductionof non- that in Figure 1 remainsappropriate. The
tradedgoods qualifiesthe precedinganaly- equilibriumrelativewage again depends on
sis. Next we turn to a particularspecifica-
tionoftariffs and transportcoststo establish 6We can thinkof the range of nontradedgoods as
an equilibriumrange of endogenouslyde- another[0, 1] intervalwithcommoditiesdenoted by x
terminednontradedgoods as part of the and expenditurefractionson those goods given by
equilibriumsolution of the model. Trans- c(x). With these definitionswe have f c(x) dx-
fersare thenshownto affecttheequilibrium I - k, a positivefraction.

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VOL. 67 NO. 5 DORNBUSCH ET AL.: RICARDIAN MODEL 829

relativesize, technology,and demand con- tive wage increasesand the range of com-
ditions. In this case demand conditions moditiesproduced domesticallyis reduced.
explicitlyinclude the fraction of income The stepsin achievingthis resultare, first,
spenton tradedgoods: thatat the initialrelativewage only a frac-
tion of the transferis spent on importsin
k-- -= A(z) thehome country,whileforeigndemand for
T-
k (z) L domesticgoods similarlydeclinesonly by a
This nicelygeneralizesour previousequilib- fractionof their reduced income. The re-
riumof (11) to handle exogenouslygiven sultingsurplusforthe home countryhas to
nontradedgoods.7 be eliminatedby, second, an increasein the
Two applications of the extendedmodel domesticrelativewage and a corresponding
highlightthe special aspects newly intro- improvementin the home country'sterms
duced by nontradedgoods. Firstconsidera of trade.8
shiftin demand (in each country)toward The analysisof nontradedgoods there-
nontradedgoods. To determinethe effects fore confirmsin a Ricardian model the
on theequilibriumrelativewage we have to "orthodox" presumptionwithrespectto the
establishwhetherthisshiftis at the expense termsof tradeeffects of transfers.9
of highor low z commodities.In the former
case the home country'srelativewage in- B. TransportCosts: Endogenous
creases while in the lattercase it declines. Equilibrium for NontradedGoods
If the shiftin demand in each countryis
uniformso that b(z) is reducedin the same The notionthat transportcosts give rise
proportionforall z in both countries,then to a range of commoditiesthat are non-
therelativewage remainsunchanged. tradedis establishedin the literatureand is
Consider next a transferreceivedby the particularlywell statedby Haberler (1937).
home countryin the amount T measuredin In contrastwith the previous section we
termsof foreignlabor. As is well known, shall now endogenously determine the
and already shown, with identical homo- rangeof nontradedcommoditiesas part of
thetic tastes and no nontraded goods, a the equilibrium.We assume, followingthe
transferleaves the terms of trade unaf- "iceberg" model of Samuelson (1954), that
fected.In the present case, however, the transportcosts take the form of "shrink-
condition for balanced trade, inclusive of age" in transitso that a fractiong(z) of
transfers, becomes: commodityz shipped actually arrives. We
further imposethe assumptionthatg = g(z)
(16) T= (k - )[wL + T] is identical for all commodities and the
[L - T] same forshipmentsin eitherdirection.
or, in equilibrium, The homecountrywillproduce commod-
ities for which domestic unit labor cost
(16')
fallsshort of foreignunit labor costs ad-
= I
=k (TIL) + k ( ) (L*/L) justed forshrinkage,and we modify(2') ac-
cordingly:
It is apparent from(16') that a transfer
(17) wa(z) < (1/g)w*a*(z)
receipt by the home country causes the
trade balance equilibriumschedule in Fig- or w < A(z)/g
ure 1 to shiftupward at each level of z.
Accordingly,theequilibriumdomesticrela- 8At constant relative wages the current account
worsensby [(1 - k -. tY) + = (1 - k)dT which
0IJdT
is less thanthetransfer,
sinceit is equal to the fraction
7Diagrams much like Figures 1 and 2 again apply: of incomespentonI nontradedgoods.
thedescendingA (z) scheduleis as before;and now the 9The pre-Ohlinorthodoxview of Keynes, Taussig,
new risingschedulelooks muchas before.As before,a Jacob Viner and other writersis discussed in Viner
risein L*/L and a balanced drop in a* (z) will raise Z (1937) and Samuelson (1952, 1954). A recenttreatment
and lowerz. withnontradedgoods is Ronald Jones(1975).

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830 THE AMERICAN ECONOMIC REVIEW DECEMBER 1977

w
(20) X(gw) f b(z)dz X'(gw) < 0
A(z)/g
A(z)g
X*(W/g) j b(z)dz X*'(W/g)> 0

The dependenceof X( ) and X*( ) on the


U~~~~ I variablesspecifiedin (20) and the respective
derivativesfollowfrom(21) below.
The limits of integrationz and z* are
i I \
derived from the conditions for efficient
productionin (17) and (18) by imposing
equalities and so definingthe borderline
exportoblesz nontroded z importobles I
commodities.Thus, in Figure 3, z is the
FIGURE 3 borderline between domestic nontraded
goods and importsfor the home country,
and z* denotes the borderline between
Similarly the foreign country produces foreignnontraded goods and the home
commoditiesfor which foreignunit labor country'sexports:
cost fallsshortof adjusted unit labor costs
of deliveredimports:
(21) z* = A-'(w/g) di*/d(w/g) < 0
z = A-1(gw) df/d(gw) < 0
(18) w*a*(z) < (l/g)wa(z)
or A(z)g < w Of course,equilibriumz and z* are yet to
be determinedby the interactionof tech-
In Figure 3 we show the adjusted relative nologyand demandconditions.
unit labor requirementschedules A (z)/g From (21) an increasein therelativewage
and A (z)g. It is apparentfrom(17) and (18) reducesthe rangeof commoditiesdomesti-
thatfor any given relativewage the home callyproducedand therefore raisesthe frac-
countryproduces and exportscommodities tion of income spent on imports.Abroad
to the left of the A (z)g schedule, both theconverseholds. An increase in the do-
countriesproduceas nontradedgoods com- mesticrelativewage increases the range of
moditiesin the intermediaterange,and the goods produced abroad and thereforere-
foreigncountryproduces and exportscom- duces the fractionof income spent on im-
moditiesin therangeto therightof A (z)/g. ports.It followsthatwe can solve:
To determinethe equilibrium relative
wage we turnto the trade balance equilib- (19') =- 1 - X*(&/g) (L*/L)
riumconditionin (19)-together with (20)
and (21)-which is modifiedto take account 1-X(;L*IL,g) d</d& < O
of the endogenous range of nontraded forthe unique equilibriumrelativewage as
goods: a functionof relative size and transport
costs:
(19) (1 -X)wL = (1 - X*)w*L*
(22) F = Fv(L*/L,g)
The variable X is the fraction of home
countryincome spent on our domestically Because (19')'s right-hand side declinesas X'
(or home) produced goods-exportables rises,a risein L*/L muststillraise 3; a rise
and nontraded-and X* is the share of in g can shiftX in eitherdirection,depend-
foreigners'incomespenton goods theypro- ingon theB(z) and A (z) profiles.
duce. Both X and X* are endogenouslyde- The equilibrium relative wage in (22),
terminedbecause the range of goods pro- taken in conjunctionwith (21), determines
duced in each countrydepends on the rela- theequilibriumgeographicproductionpat-
tivewages. tern,z and z-*.Since the range of nontraded

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VOL. 67 NO. 5 DORNBUSCH ET AL.: RICARDIAN MODEL 831

goods z* < z < z depends in this formula- The implicitrelations(25) can be solved for
tionon the equilibriumrelativewage, it is theequilibriumrelativewage as a function
obvious that shiftsin givenparameterswill structure:
of relativesize and thetariff
shiftthe range of nontraded commodities. Z) = Co(L*/L,t,t*)
(26)
Thus, a transferthat raises the equilibrium
relativewage at home causes previouslyex- From (26) and (23) it is apparent now
portedcommoditiesto become nontraded, thattherangeof nontradedgoods will be a
and previouslynontraded commoditiesto functionof both tariffrates. It is readily
becomeimportables. shown that an increase in the tariffim-
provestheimposingcountry'srelativewage
C. Tariffs and termsof trade. Furthermore,as is well
We considernextthe case of zero trans- known,when all countriesbut one are free
port cost but where each countrylevies a traders,then one countrycan always im-
uniformtariffon importsat respectiverates prove its own welfareby imposinga tariff
t and t*,withproceedsrebatedin lump sum thatis not too large.
form.This case, too, leads to cost barriers A further questionsuggestedby (26) con-
to importing,and to a range of commodi- cerns the effectof a uniformincrease in
tiesthatare not traded,withthe boundaries world tariffs.Startingfromzero, a small
definedby: uniformincreasein tariffs raises the relative
wage of the countrywhose commodities
(23) = A-1 commandthe largershare in world spend-
ing. This result occurs for two reasons.
and - A'(w(1 + t*)) First, at the initial relativewage a larger
shareof spendingout of tariffrebates falls
From (23) it is apparentthatthepresenceof on thegoods of the countrycommandinga
in eitheror both countriesmust give
tariffs largershare in world demand. Second, the
riseto nontradedgoods because-in thiscase tariffinduces new nontraded goods and
thereforeincreases net demand for the
The trade balance equilibriumcondition borderlinecommodityof thecountrywhose
at internationalpricesbecomes, in place of residentshave the largerincome, or equiv-
(19), alently,thelargersharein worldincome.
(24) (1 - X)Y/(1 + t) = If countriesare of equal size as measured
by the share in world income, such a uni-
(1 - X*)Y*/(1 + t*) formtariffincreasehas zero effecton rela-
where Y and Y* denote incomes inclusive tivewages,but of course reduceswell-being
of lump sum tariffrebates. Using the fact in both places. Multilateraltariffincreases,
thatrebatesare equal to thetariffrate times in thiscase, unnecessarilycreatesome non-
thefractionof incomespenton imports,we tradedgoods, and artificially raise the rela-
arriveat the trade balance equilibriumcon- tive price of importablesin terms of do-
ditionin theform:'0 mesticallyproduced commodities in each
countryexactlyin proportionto thetariff.
(25) X(1 -*) 1 + t*x* (L*/L)
Rates
IV. Money,Wages,andExchange
whereX and X* are functionsof (w,t,t*).
In thissectionwe extendthediscussionof
are equal to
rebatesin the homecountry
I0Tariff theRicardian model to deal withmonetary
R = (I - A) Yt/(l + t). With Y = WL + R we there- aspectsof trade.Specificallywe shall be in-
forehave Y = WL(l + t)/(l + At) as.an -expression terestedin the determinationof exchange
forincomeinclusive Fromequations(20)
of transfers.
and (23) we have X = A[w/(1+ t)] and A* =
ratesin a flexibleratesystem,in the process
A*[w(1+ t*)],havingsubstituted insteadof
thetariff of adjustmentto trade imbalance under
transportcostsas theobstacletotrade. fixedrates, and in the role of wage sticki-

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832 THE AMERICAN ECONOMIC REVIEW DECEMBER 1977

ness. The purpose of the extensionis to in- tary changes or velocity changes in one
tegratereal and monetaryaspectsof trade. countrywill be reflectedin equiproportion-
ate changesin pricesin thatcountryand,in
A. FlexibleExchangeRates the exchange rate in the fashion of the
neutral-money QuantityTheory. However,
The barteranalysisof the precedingsec- a real disturbance,as (28) shows, definitely
tions is readily extended to a world of does have repercussionson the nominalex-
flexibleexchange rates and flexiblemoney change rate as well as on the real equilib-
wages.Assume a givennominal quantityof rium.
money in each country,M and M*, re- Using the results of Section II, we see
spectively.Further,in accordance with the thatan increasein the foreignrelativelabor
classical QuantityTheory,assume constant forcecauses, under flexibleexchange rates
expenditurevelocitiesV and V*.ll A flexible and givenM and M*, a depreciationin the
exchangerate, and our stipulatingthe ab- home country'sexchange rate as does uni-
sence of nonmonetaryinternationalasset formtechnicalprogressabroad. A shiftin
flows,will assure trade balance equilibrium real demand toward foreigngoods likewise
and thereforethe equality of income and leads to a depreciationof the exchangerate
spending in each country. The nominal as well as to a reductionin real Z. A rise in
money supplies and velocities determine foreigntariffswill also cause our currency
nominalincomein each country: to depreciate. Each of these real shiftsis
WL = MV W*L* = M* V* assumed to take place while (M, M*) are
(27) and
unchangedand on the simplifyingproviso
where W and W* (now in capital letters) that real income changes leave V and V*
denote domesticand foreignmoneywages unchanged.
in termsof the respectivecurrencies.Fur-
ther,definingthe exchange rate e as the B. Fixed ExchangeRates
domestic currency price of foreign ex-
change,theforeignwage measuredin terms In the fixed exchange rates case we as-
of domesticcurrencyis e W*, and the rela- sume currenciesare fullyconvertibleat a
tivewage therefore is w W/eW*. paritypegged by the monetaryauthorities.
From the determinationof the equilib- In theabsence of capital flowsand steriliza-
riumreal wage ratiocoby our earlier"real" tionpolicy,a tradeimbalance is reflectedin
relations,we can now findan expressionfor monetary flows. In the simplest metal
theequilibriumexchangerates: money model, the world money supply is
redistributedtoward the surpluscountryat
(28) e = (1/&I)(W/W*) = preciselythe rate of the trade surplus. We
assume that the world money supply is
(11F.)(MV/M* V*) (L*/L) givenand equal to G, measuredin termsof
where (27') defines equilibrium money domesticcurrency.The rate of increase of
wages: thedomesticquantityof moneyis therefore
(27') W = MV/L equal to the reductionin foreignmoney,
valued at thefixedexchangeratee:
and
W* = M* V*/L* (29) M=
whereAl dM/dt.
In this simple structureand with wage For a fixed rate world we have to de-
flexibility,we can keep separate the de- terminein addition to the real variables Co
terminants of all equilibriumreal variables and z, thelevelsof moneywages W and W*
fromall monetaryconsiderations.Mone- as well as the equilibriumbalance of pay-
IIThis is a strongassumptionsince it makes spend- mentsassociated with each short-runequi-
ingindependentof incomeand nonliquidassetsevenin librium.In thelong run the balance of pay-
theshortrun. ments will be zero as money ends up

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VOL. 67 NO. 5 DORNBUSCH ET AL.: RICARDIAN MODEL 833

redistributedinternationallyto the point W R'


where income equals spending in each
country.In the shortrun an initialmisallo- G /
cation of money balances implies a dis-
crepancybetweenincomeand spendingand
an associated trade imbalance. To char-
acterizethe preferredrate of adjustmentof
cash balances in thesimplestand mostman-
ageable way, we assume that spending by
each country is proportional to money
//
holdings.'2On the furthersimplifyingas-
sumptionthat velocitiesare equal in each
country,V = V*,13world spendingis equal
to
0 -
(30) VM + eV*M* - VG
FIGURE 4
For thetastesand technologyspecifiedin
Section I, world spendingon domestically
producedgoods is givenby ing from(11) for the equilibriumrelative

(31) VG f b(z)dz t- (w)VG


wage Zi, we can employequations (32) and
(33) to determinemoneywage levels.
The equilibriumdeterminedby equations
z= A-'(w) (32) and (33) can be analyzed in terms of
Figure4. The figureemphasizesthe separa-
In equilibrium, world spending on our tion of real and monetaryaspects of the
goods mustequal the value of our full-em- equilibrium under our assumptions of
ploymentincome WL: tradedgoods only, and no distributionef-
WL = t(w) VG fects.From theratioof (32) and (33) we ob-
(32) tain the equilibriumrelative wage C as a
Equilibriumrequires,too, thatworldspend- functionof tastes and technology solely
ing on foreigngoods equals the value of fromthebartermodel. This equilibriumre-
foreignfull-employment income: lativewage is plottedas the ray OR in Fig-
(33) eW*L* = [1 - (w)]V6 ure4.
The equalityof world income and spend-
Equations (32) and (33) express what ing
would seemto be thejoint determinationof
real and monetaryvariables. But, in fact, (30') WL + eW*L* = VG
we could have taken the shortcutof recog-
nizingthatthe real equilibriumis precisely is shown as the downward sloping straight
thatof thebarteranalysisdeveloped in Sec- line GG, whichis drawn forgiven velocity,
tionI. Dividing (32) by (33) and substitut- world quantityof money,and labor forces.
Point E is the equilibriumwhere relative
pricesand the level of wages and prices are
12Theassumption thatspendingis proportionalto such that all marketsclear. At a level of
cashbalancesis only one of a numberof possible wages and priceshigherthan point E,
specifications.
Conditions forthisexpenditure
function
there
to be optimalare derivedin Dornbuschand Michael would be a world excess supply of goods,
Mussa. In general,expenditure willdependon both and converselyat pointsbelow E.
incomeandcashbalances. Figure 4 immediatelyshows some com-
131nthe long-run equilibrium,higherV than V* parativestatic results.Thus a doubling of
leavesus witha smallershareof the worldmoney
stockthanforeigners, but withnominaland real in- both countries' labor forces, from the
comesharesin thetwo countries thesame as when analysisof the bartermodel, will leave the
V= V*. relative wage unaffectedbut will double

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834 THE AMERICAN ECONOMIC REVIEW DECEMBER 1977

world output. Given unchanged nominal the adjustment process: changes in the
spendingVG,wages and priceswill have to terms of trade, in home and/or foreign
halve. This would be shown by a parallel pricelevels,in relativepricesof traded and
shiftof the GG schedulehalfwaytowardthe nontradedgoods (there being none of the
origin.A shiftin demand towardthe home latter),in double factoral terms of trade;
country'soutput by contrastwould rotate and any discrepanciesin the price of the
the OR ray to a position like OR' since it same commoditybetween countries. The
raisesour relativewage. The ensuingmone- featuresof the adjustmentprocess of this
taryadjustmentis then an increase in our sectionrelyon 1) identical,constantexpen-
moneywage and money income and a de- diturevelocities,2) uniform-homothetic de-
cline in foreignwages, prices, and incomes mand,and 3) the absence of trade impedi-
(point E'). ments. If velocities were constant but
The real and nominal equilibrium at differedbetween countries, the absolute
point E in Figure 4 is independentof the levelsof money wages and prices, though
short- and long-run distributionof the not relativewages or prices,would depend
worldquantityof money.The independence on theworlddistribution of money.Relaxa-
of thereal equilibriumderivesfromthe uni- tion of the uniform-homothetic taste as-
formhomothetictastes. The independence sumptionwould make equilibriumrelative
of the nominal equilibriumis implied by prices a functionof the distributionsof
identical velocities. What does, however, spending. Finally, the presence of non-
depend on the short-rundistributionof tradedgoods would,togetherwithRicardo's
worldmoneyis the transitionperiods' bal- technology,provide valid justificationfor
ance of payments.As in the absorptionap- some of the behavior of relativeprices and
proach of Sidney Alexander (1952), we pricelevelsfrequentlyassertedin the litera-
know this: when goods markets clear, the ture;this behavioris studiedin more detail
trade surplusor balance of paymentsM of in thenextsection.
thehome countryis equal to the excess of
incomeoverspending,or: C. The Price-SpecieFlow Mechanism
underMore GeneralConditions
(34) M= WL- VM
Withthe nominalwage independentof the We now discuss the adjustmentprocess
of world money,equation (34)
distribution to monetary disequilibrium and enquire
thereforeimplies that the trade balance intothepriceeffectsassociatedwitha redis-
monotonicallyconvergesto equilibriumat tributionof the world money supply when
a rateproportionalto the discrepancyfrom thereare nontraded goods. Common ver-
long-runequilibrium:"4 sions of the Hume price-specieflow mech-
anismusually involvethe argumentthat in
(34') M = V(M - M); M = 0 ()G
theadjustmentprocess,pricesdecline along
The assumptionsof this sectionwere de- - withthemoneystock in the deficitcountry,
signedto renderinoperativemostof thetra- whileboth risein thesurpluscountry.There
ditional mechanismsdiscussed as part of is usually,too, an implicationthatthe defi-
cit country'stermsof trade will necessarily
14Suppose V> V* and our share of the world worsenin the adjustmentprocess and in-
moneysupplyis initiallylarger than our equilibrium
share.Then, as we lose M, totalworldnominal income
deed have to do so iftheadjustmentis to be
and nominal GNP falls.Always our share of nominal successful.
world GNP staysthe same under the strongdemand SectionIVB demonstratedthat the redis-
assumptions.Total world real output never changes tributionof money associated with mone-
during the transition; only regional consumption taryimbalance need have no effectson real
shares change. Therefore,both countries' nominal
priceand wage levels fall in the transition,but such variables(production,termsof trade, etc.)
balanced changes have no real effectson either the and on nominal variables other than the
transientor thefinalreal equilibrium. money stock and spending. While this is

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VOL. 67 NO. 5 DORNBUSCH ET AL.: RICARDIAN MODEL 835

clearlya veryspecial case, it does serve as a ing to nontradedgoods, shiftingsome of


benchmark since it establishes that the our resourcesto theirproductionat the ex-
monetaryadjustmentprocess would be ef- penseof our previousexports.We not only
fectiveevenin a one-commodity world. exportfewertypesof goods, but also import
To approach the traditionalview of the more types, and import more of each
adjustmentprocess more clearly and pro- (& risesand z falls).
vide formalsupportforthat view, we con- During the transition, while the real
sideran extensionto the monetaryrealm of transfercorrespondingto our deficitis tak-
our previous model involving nontraded ing place, our terms of trade are more
goods. We returnto the assumptionthat a favorablethan in the long-runstate. The
fraction(1 - k) of spendingin each coun- newgold raises both theirW* and our W,
tryfalls on nontradedgoods, and accord- butin addition,our W is up relativeto their
inglyequations(32)-and (33) become: W*. Thereforethe price level of goods we
(32') WL = 0 (w) VG + (1 - k)yVG; continue to produce is up relativeto the
price level of goods theycontinue to pro-
yMI G duce. This is true both for our nontraded
(33') eW*L* = [k - O(w)]VG goods and for our exportables.The prices
+ (1 - y)(1 - k)VG of goods we produce rise relative to the
pricesof goods theyproduce in proportion
These hold both in finalequilibrium,and in to thechangein relativewages.
transientequilibriumwhere specie is flow- Thus theprice levels in the two countries
ing. Equations (32') and (33') imply that have been changed differentially by the
the equilibriumrelativewage does depend specie flow and implied real transfer.But
on thedistribution of theworld moneysup- that does not mean that any traded good
ply.Solvingtheseequations forthe equilib- eversells fordifferent prices in two places.
riumrelativewage we have: In fact the divergencein weightedaverage
zi5 (consumer)price levels is due to nontraded
(35) z = d > goods. The price level will rise in the gold-
discoveringcountryrelative to the other
An increase in the home country'sinitial countrythe greater is the share of non-
share in the world money supply y raises tradedgoods in expenditure,1 - k. It is a
our relativewage. bit meaningless to say, "What accom-
Using this extendedframework,we can plishedthe adjustmentis the relativemove-
drawon theanalysisof thetransfer problem mentsof pricelevelsfornontradedgoods in
in SectionII to examinetheadjustmentthat thetwo countries,"since we have seen that
follows an initial distributionof world theadjustmentcan and will be made even
moneybetweenthe two countriesthat dif- when thereare no such nontraded goods.
fersfromthe long-runequilibriumdistribu- It is meaningfulto say, "The factthatpeo-
tion. ple wantto directsome of theirexpenditure
Suppose our M is initiallyexcessive,say to nontradedgoods makes it necessaryfor
froma gold discoveryhere. Assume also resourcesto shiftin and out of themas a re-
that the gold discoveryoccurredwhen the sult of a real transfer,and such resource
worldwas in long-runequilibriumwiththe shiftstake place only because the termsof
previousworld moneystock. As a resultof trade(double-factoraland fortradedgoods)
our excess M, we spend more than our do shiftin theindicatedway."
earnings,incurringa balance-of-payments The adjustmentprocess to a monetary
deficitequal to the rate at which our M is disturbanceis stable in the sense that the
flowingout. In effect,the foreigneconomy systemconvergesto a long-runequilibrium
is making us a real transferto offsetour distributionof moneywith balanced trade.
deficit.As seen earlier,we, the deficitcoun- To appreciate that point, we supplement
try,are devotingsome of our excess spend- equations(32') and (33') with(34) thatcon-

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836 THE AMERICAN ECONOMIC REVIEW DECEMBER 1977

tinuesto describethe monetaryadjustment lativeprice,wage, and income movements.


process.We note,however,thatnow W and They are, of course, in no way essential to
W* are endogenous variables whose levels theexistenceof a stable adjustmentprocess,
in the shortrun do depend on the distribu- nor is thereat any time a need for a dis-
tionof the world moneysupply.A redistri- crepancyof prices of the same commodity
butionof moneytowardthe home country across countriesin eithercase. 16
would raise our spendingand demand for A final remarkconcernsthe adjustment
goods, and reduceforeignspendingand de- to real disturbancessuch as demand shifts
mand. As before, spending changes for or technical progress. It is certainlytrue
tradedgoods offseteach other preciselyso that whetherthe exchange rate is fixed or
thatthe net effectis an increasein demand flexible,real adjustmentwill have to take
fornontradedgoods at home and a decline place and cannotbe avoided by choice of an
abroad. As a consequence our wages will exchangerateregime.So long as wages and
rise and foreignwages decline. Therefore, pricesare flexible,it is quite false to think
startingfromfullequilibrium,a redistribu- thatfixedparities"put the whole economy
tionof moneytowardthehomecountrywill throughthe wringerof adjustment" while
createa deficitequal to in floatingrate regimes"only the export
(36) dM/dM= -V(1 6) 0< <1I and importindustrieshave to make the real
adjustment."It is true,however,that once
where 6 is the elasticityof our nominal we depart from flexiblewages and prices
wages withrespectto thequantityof money theremay well be a preferencefor one ex-
and is less than unity.'5 Equation (36) im- changerate regimeover another.The next
plies that the price-specieflow mechanism sectionis devotedto thatquestion.
is stable.
to observein thiscontext
It is interesting D. StickyMoney Wages
thatthepresenceof nontradedgoods in fact
slowsdownthe adjustmentprocess by com- The last question we address in this sec-
parisonwitha world of only traded goods tion concerns the implications of sticky
(contraryto J. Laurence Laughlin's turn.of money wages. For a given world money
thecenturyworries).As we saw before,with supply, downward stickiness of money
all goods freelytradeable,wages are inde- wages implies the possibilityof unemploy-
pendentof the distributionof money,and ment. We assume upward flexibilityin
accordingly6 = 0. Furtherwe observethat wages,once fullemploymentis attained.
thespeed of adjustmentdepends on the re- We start with a fixed exchange rate e.
lativesize of countries.Thus themore equal The relationbetweenwages and the world
countriesare in terms of size, the slower quantityof moneyis broughtout in Figure
tendsto be theadjustmentprocess. 5. Denote employmentlevels in each coun-
In concludingthis section we note that try,as opposed to the labor force, by the
nontraded goods (and/or localized de- newsymbolsL and L*, respectively;denote
mand) are essential to the correctnessof nominalincomesby Y and Y*. The equality
traditionalinsistencethat the adjustment of world income and spending is again
process necessarilyentails absolute and re- shownby the GG schedule,the equation of
whichnow is
I5The value of 6 can be calculated fromequations (37) VG = Y + eY* - WL + W*L*
(32') and (33') to be
16ThecontinuumRicardian technologyis special in
thattherecan be no rangeofgoods both importedand
6 (1Y(- k kY) --
k)y(l ) + E
produced at home. Therefore,the cross elasticityof
supplybetweennontradedgoods and exportsmust be
wheree is the elasticityof the share of our traded greaterthan the zero cross elasticitybetween non-
goods in world spending,e -tYw/lt > 0. The elas- traded goods and imports.Consequently, a transfer
ticity6 is evaluated at the long-runequilibriumwhere mustshiftthetermsof trade(forgoods and factors)in
y t-/k. If A '(z) fallsslowly,e willbe large. thestatedorthodoxway,favorablyforthereceiver.

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VOL. 67 NO. 5 DORNBUSCH ET AL.: RICARDIAN MODEL 837

Y
G / R' plied reductionin our relativewages and
theresultingincreasein our relativeincome
are shown in Figure 5 by the rotationfrom
\/t OR to OR'.
The new equilibriumis at E' where our
E ~~~R moneyincome and employmenthave risen
y~~ while income and employment decline
abroad. Thus an increase in the foreign
wage rate, by moving the terms of trade
against us, shifts comparative advantage
and employmenttowardthe home country.
The extentto whichthehome countrybene-
Y eY* fitsfromthe adversetermsof trade shiftin
0 ET* termsof employmentwill depend on both
FIGURE 5 thesubstitutability in demand and the elas-
ticityof the A (z) schedule in Figure 1. We
observe,too, that the move fromE to E'
where W and W* are the fixed money will bring about a transitorybalance-of-
wages set at too high sticky levels. The paymentssurplus.Given theinitialdistribu-
scheduleis drawnforgivenmoneywages, a tion of money and hence of -spending,the
given world quantity of money, and a foreigndecline in income and the increase
peggedparityfore. The ray OR now is pre- at home impliesthatwe will spend less than
determinedby thegivenstickyrelativewage our income and thereforehave a trade sur-
i = W/eW*. From equations (32) and (33) plus. This surpluspersistsuntilmoneyis re-
theratioof moneyincomes Y/eY* is just a distributedto match the new levels of in-
functionof the relativewage now givenex- come at '.
ogenouslyby rigidmoneywages and the ex- Next we move to flexibleexchange rates.
changerate: Under flexibleratesan increase in the for-
eignmoneywage W*, givenmoneysupplies
(38) Y/eY* - (WeW*) in each country,will similarlyhave real re-
percussioneffects on relativepricesand em-
'(W) < 0 ploymentat home. Now employmentin
each countryis determinedby money sup-
Point E is the nominal equilibriumwhere pliesand prevailingwages:
by assumptiontheworldquantityof money
is insufficient
relativeto wage rates to en- (39') L = VM/ W; L* - VM*/ W*
sure full employment.Although that equi-
libriumis one withunemployedlabor, it is Given the employmentlevels thus deter-
in otherrespects.Specifically,geo-
efficient mined,we know from the analysis of the
graphic specializationfollows comparative earlierbartermodel that thereis a unique
advantageas laid out above, but now labor relativewage at which the trade balance
employedadjuststo stickywage patternsof achievesequilibrium. The higheris M*/ W*,
specialization. the higher will be employmentabroad-
EmploymentlevelsLand L* now are de- and, therefore, the higherwill be our rela-
terminedby(39) tivewage a. It is thus apparent that an in-
crease in the foreignmoneywage, W*, will
(39) L-= Y/W, L* -
reduce employmentabroad. Employment
where Y and Y* are the equilibriumlevels declinesonly in proportionto the increase
of nominalincomedeterminedby equations in wages and thus declines by less than it
(37) and (38) or by pointE in Figure5. would under fixed exchange rates when
Considernow the impact of a foreignin- specieis lost abroad.
creasein moneywages. The effectof the im- We saw in the bartermodel thata reduc-

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838 THE AMERICAN ECONOMIC REVIEW DECEMBER 1977

tion in effectiveforeignlabor causes a de- surpluscauses our exchange rate to appre-


cline in our relative wage, but that the ciate untiltheinitialemploymentlevels and
decline in our relativewage falls propor- therefore trade balance equilibriumare re-
tionatelyshort of the foreignreductionin stored.The demand shiftis fullyabsorbed
labor. Now, at the initialexchangerate,the by a changein thetermsof tradeand a shift
increasein foreignwages reduces our rela- in competitiveadvantage that restoresde-
tivewage and theiremploymentin the same mand forforeigngoods and labor.
proportion.The declinein our relativewage Real and nominalequilibriaare thus seen
is thereforeexcessive.Domestic goods are to be uniquely definablein our continuum
underpricedand the exchange rate appre- model with constant-velocity spending de-
ciatesto partlyoffsetthe gain in cost com- terminants.The differencebetween sticky
petitiveness.The net effectis thereforea and flexiblewage ratesunderfixedexchange
declinein our relativewage and an appre- ratesis understandableas the differencebe-
ciationof our exchangerate (a declinein e) tween(a) havingthe crucial relativewage zi
that falls short of the foreignincrease in be imposedin thestickywage case withem-
wages. Since our termsof trade unambig- ploymentshavingthento adjust; or (b) hav-
uouslydeterioratewithoutany compensat- ingthe fullemploymentsbe imposed and C
inggain in employment, it mustbe truethat having to adjust. Under floatingexchange
welfaredeclinesat home. Abroad, the loss rates,stickynominalwages impose employ-
in employmentis offsetby a gain in the mentlevels in each countryand the crucial
termsof trade,but theretoo thenet effectis relativewage Z then adjusts to those em-
a loss in welfare under our strong Mill- ploymentlevels.
Ricardo assumption.
APPENDIX
The adjustmentto money wage distur-
bances underfixedand flexiblerates differs HistoricalRemark
in several respects.Under fixed rates em-
ployment effects are transmitted,while Figure 1 seems to be new. G. A. Elliot
underflexiblerates theyare bottled up in (1950) gives a somewhatdifferent diagram,
the country initiating the disturbance. one that makes explicit the meaning of
Under fixedrates the termsof trade move Marshall's 1879 "bales" (which,bytheway,
one forone withmoneywage, while under happen to work only in the two-country
flexible rates exchange rate movements constantlabor costs case). In termsof the
partlyoffsetincreasesin the foreignmoney presentnotations,Elliottplots forthe U.S.
wage rate. offercurve the followingsuccessive points
The differencebetweenfixedand flexible tracedout forall w on the range [0, oo]: on
ratesin relationto theadjustmentprocess is theverticalaxis is plottedour total real im-
further broughtout by an example of a real ports valued in foreignlabor units ("our
disturbance.Consider a shiftin world de- demand for bales of their labor," so to
mand toward our goods. Under fixedrates speak), namely,
theresultingincreasein our relativeincome
will, from(38), move us in Figure 5 from
E to E'. Employmentrisesat home and falls
f [P*(z)/w*]C(z)dz = j a*(z)C(z)dz
abroad. Demand shiftsare fullyreflectedin
employmentchanges. Under flexiblerates, and on the horizontal axis, our total real
bycontrast,withgivenwages and money,a exportsvalued in home labor units ("our
demand shifthas no impact on employ- supplyof bales of labor to them"), namely,
ment-as we observefrom(39). At the ini-
tial exchange rate the demand shiftwould rz - C(z)]dz=
giveriseto an excess demand forour goods J[P(z)/w][Q(z)
and to an excess supply abroad. Domestic
incomeand employmentwould tend to rise L - a(z) C(z)dz
while falling abroad. The resultingtrade

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VOL. 67 NO. 5 DORNBUSCH ET AL.: RICARDIAN MODEL 839

It is to be understoodthat2 is a functionof G. A. Elliott,"The Theory of International


w,namelythe inversefunctionA '(w); also Values," J. Polit. Econ., Feb. 1950, 58,
that C(z) are the amounts demanded as a 16-29.
functionof our real income L and of the F. Graham,"The Theory of International
P(z)/ W functiondefinedfor each, namely Balances Re-Examined," Quart.J. Econ.,
min[wa(z), a*(z)]. Because we have a con- Nov. 1923,38, 54-86.
tinuum of goods, we avoid Elliott's GottfriedHaberler, The Theory of Inter-
branches of the offercurve that are seg- nationalTrade,London 1937.
mentsof various rays throughthe origin. R. W. Jones,"Presumptionand the Transfer
The reader will discernby symmetrycon- Problem," J. Int. Econ., Aug. 1975, 5,
siderationshow the' foreignoffercurve is 263-74.
plotted in the same (L, L*) quadrant, by JamesLaurenceLaughlin,Principles of Money,
varyingw to generatethe respectivecoor- New York 1903.
dinates JohnS. Mill,Principlesof Political Economy,
London 1848.
rz DavidRicardo,On the Principlesof Political
a(z)C*(z)dz, Economyand Taxation, 1817; edited by
P. Sraffa,London 1951.
L* a*(z)C*(z)dz P. A. Samuelson,"The TransferProblem and
Transport Costs: The Terms of Trade
When Impedimentsare Absent," Econ.
Our model forces the Elliott-Marshall J., June 1952, 62, 278-304; reprintedin
diagramto generatea uniquesolutionunder Joseph Stiglitz,ed., Collected Scientific
uniform-homothetic demand. Unlike our Papers of Paul A. Samuelson, Vol. 2,
Figure 1, the Elliott diagram can handle Cambridge,Mass., ch. 74.
thegeneralcase of nonhomotheticdemands , "The Transfer Problem and the
in the two countries;but then, as is well TransportCosts, II: Analysis of Effects
known, multiple solutions are possible, of Trade Impediments,"Econ. J., June
some locallystableand some unstable. The 1954, 64, 264-89; reprintedin Joseph
priceone pays forthisgeneralityis that,as Stiglitz,ed., Collected ScientificPapers
Edgeworth observed, the Marshallian of Paul A. Samuelson,Vol. 2, Cambridge,
curvesare the end products of much im- Mass., ch. 75.
plicit theorizing,with much that is inter- , "TheoreticalNotes on Trade Prob-
estinghavingtakenplace offstage. lems," Rev. Econ. Statist.,May 1964,46,
145-54; reprintedin Joseph Stiglitz,ed.,
Collected ScientificPapers of Paul A.
REFERENCES Samuelson, Vol. 2, Cambridge, Mass.,
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S. Alexander, "The Effectsof a Devaluation S. Smale,"StructurallyStable SystemsAre
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Staff Pap., Apr. 1952,2, 263-78. 491-96.
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Trade: Part I: The Classical Theory," York 1927.
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G. Debreu,"Economies witha Finite Set of nationalTrade,New York 1937.
Equilibria," Econometrica,May 1970,38, C. Wilson,"On the General Structureof
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R. Dornbusch and M. Mussa, "Consumption, Goods: Applications to Growth, Tariff
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tion," Int. Econ. Rev., June 1975, 16, lished paper, Univ. Wisconsin-Madison,
415-21. 1977.

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