Journal Issue

Price and Output Effects of Monetary and Fiscal Policy Under Flexible Exchange Rates: Comment on Argy and Salop

International Monetary Fund. Research Dept.
Published Date:
January 1988
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In a well-known contribution to this journal, Argy and Salop (1979) analyzed the effects of monetary and fiscal policy on the price level and real output when exchange rates are flexible, paying particular attention to the consequences of real wage rigidity. This comment concerns one of their conclusions in particular: that if the consumption real wage is completely rigid, the balanced-budget multiplier is negative. Moreover, in their model the overall price level (the consumer price index) moves in a direction opposite to that of real output for given money supply, so that a balanced-budget reduction in government spending would actually raise output and lower the price level. Balanced-budget reductions in government expenditure therefore seem to be an attractive policy option.

This result, however, may not be robust because it depends on the assumption that absorption (measured in units of domestic output) decreases as the terms of trade improve—the Laursen-Metzler effect (Laursen and Metzler (1950)). Recent work on this effect (for example. Obstfeld (1982) and Svensson and Razin (1983)) implies that, on the contrary, absorption in units of domestic output may rise with the terms of trade. I show below that if there is no Laursen-Metzler effect, the balanced-budget multiplier can take either sign; this conclusion is reinforced if the Laursen-Metzler effect has the unconventional sign suggested by Obstfeld.

I. The Argy-Salop Model Under Wage Rigidity

Equations (2)–(6) of Argy and Salop can be substituted into their equation (1) to define an aggregate demand curve, and their equation (9) can be substituted into equation (8) to define an aggregate supply curve. If there is no money illusion in the labor market, the two resultant equations can be solved simultaneously for output, Y, and the terms of trade, T; Argy and Salop’s equation (7) then determines the overall price level. In differential form, these two equations (after imposing the balanced-budget condition dG=tdY+Ydt,

ignoring subsidies, setting equal to unity, and recognizing that dT=dPdde
because initially Pd = P = Pf = e = 1) are

where g’ is the marginal product of labor.

Note that the coefficient of dT in equation (1) comprises two terms: X’M1 + M is the Marshall-Lerner condition, whereas f2[A – (1 – M2) C’(l – t)Y] the Laursen-Metzler effect. It can be shown that if AP/Pd (absorption measured in units of domestic output) were made a function of Y(l – t) (income in units of domestic output) instead of Y(l – t)Pd/P (income in units of the consumption basket), the term f2[A – (1 –M2)C’(1 – t)Y] would disappear.

Argy and Salop’s result may be demonstrated in this framework in the following way. If taxes are raised by an amount dt, the after-tax consumption real wage would be unaffected, provided that the terms of trade improved sufficiently. From equation (2), the exact improvement in the terms of trade that is required is

But if the terms of trade do improve by this amount, then equation (1) becomes

The coefficient of dY is positive; the Marshall-Lerner term, –(X'M1 + M)/f2(1 – t), is negative. The term in double brackets on the right-hand side comprises two parts: the first, Y(1 – C’)(l – M2) dt, which gives the direct effect of the balanced-budget increase in government spending, is positive; the second, Y{A/[Y(1t)]C(1M2)}dt,

gives the (Laursen-Metzler) effect of an improvement in the terms of trade by an amount [1/f2(1 – t)]dt on demand for domestic output and is negative. The term [[. . .]] simplifies, however, to

which is negative, provided that Y(= A + XM) does not exceed A by “too great” an amount.1 In other words, the Laursen-Metzler effect outweighs the direct effect of government spending, so that the right-hand side of equation (1a) is negative.

Thus, an improvement in the terms of trade that is just sufficient to maintain aggregate supply in the face of a balanced-budget increase in government expenditure causes overall aggregate demand to fall, despite the increase in government spending. To preserve goods-market equilibrium, output must therefore fall below its original level, as Argy and Salop conclude; and the terms of trade will improve, but by less than [1/f2(1 – t)]dt.

If there were no Laursen-Metzler effect, the term [[. . .]] on the right-hand side of equation (1a) would reduce to (1 – C’)(l – M2)Ydt, which is positive. The sign of the right-hand side of equation (la) would then depend on whether the direct effect of the increase in government expenditure, (1 – C’)(l – M2)Ydt, exceeded the conventional Marshall-Lerner effect on demand for domestic goods of a terms of trade improvement in the amount [1/f2(1 – t)]dt; that is, [(X’M1 + M)/f2(l – t)]dt. For sufficiently small elasticities of demand for exports and imports, the right-hand side of equation (1a) could then be positive, so that a balanced-budget increase in government spending would create excess demand at the original output level. To restore equilibrium, output would therefore rise and, from Argy and Salop’s equation (7), the price level would fall.

II. Further Evidence from Recent Studies of the Laursen-Metzler Effect

Similar conclusions would hold if the sign of the Laursen-Metzler effect were to be reversed, as Obstfeld (1982) has suggested in a framework of intertemporal utility maximization. By assuming that the rate of time preference increases with the instantaneous utility level and by imposing a steady-state condition, he has argued that steady-state utility and steady-state saving are uniquely determined. An improvement in the terms of trade that raises utility levels will therefore cause individuals to reduce saving (increase spending) to restore utility to its steady-state level. Although Svensson and Razin (1983) obtained somewhat different results, the possibility remains that an improvement in the terms of trade will raise private spending.

These conclusions cannot be straightforwardly carried over to the earlier analysis of Argy and Salop because their analysis did not incorporate an intertemporal utility-maximizing framework. But the results ob-tained by Obstfeld and Svensson and Razin do suggest that it is entirely possible that a balanced-budget expansion in government spending would raise output and lower the price level-—even if there were com-plete real wage rigidity and if the Laursen-Metzler effect were accounted for. Therefore, the recommendation that governments should imple-ment balanced-budget expenditure reductions to combat stagflation does not appear to be justified.


    ArgyVictor and JoanneSalop“Price and Output Effects of Monetary and Fiscal Policy Under Flexible Exchange Rates,”Staff PapersInternational Monetary Fund (Washington) Vol. 26 (June1979) pp. 22456.

    LaursenSvend and LloydMetzler“Flexible Exchange Rates and the Theory of Employment,”Review of Economics and Statistics (Cambridge, Massachusetts) Vol. 32 (November1950) pp. 25199.

    ObstfeldMaurice“Aggregate Spending and the Terms of Trade: Is There a Laursen-Metzler Effect?,”Quarterly Journal of Economics (Cambridge, Massachusetts) Vol. 97 (May1982) pp. 25170.

    SvenssonLars E.O. and AssafRazin“The Terms of Trade and the Current Account: The Harberger-Laursen-Metzler Effect,”Journal of Political Economy (Chicago) Vol. 91 (February1983) pp. 97125.

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Published jointly by The Economics Department of the University of Pennsylvania and the Osaka University Institute of Social and Economic Research Association

Editors: W. J. Ethier, H. Oniki

Volume 29May 1988Number 2
A Generalization of the Second Theorem of Welfare Economics for Nonconvex EconomiesDonald E. Campbell
Optimal Financial Structure in Exchange EconomiesJoseph G. Haubrich
Financial Structure and International TradeHarold Cole
Domestic Industrial Structure and Export QualityShih-Chen Chiang and Robert T. Masson
Staggered Employment Contracts under Asymmetric InformationArthur J. Hosios
Regulating without Cost Information: the Incremental Surplus Subsidy SchemeDavid E. M. Sappington and David S. Sibley
Appropriation of Common Access Natural Resources through Exploration: the Relevance of the Open-Loop ConceptErnst Mohr
The Corporate Income Tax in an Intertemporal Equilibrium Model with Imperfectly Mobile CapitalA. Lans Bovenberg
Fixed Capital within a Von Neumann-Morishima Model of Growth and DistributionNeri Salvadori
Fertility, Choice, Land, and the Malthusian HypothesisZvi Eckstein, Steven Stern, and Kenneth I. Wolpin
A Family of Aggregative Compromise Inequality MeasuresUdo Ebert
Bayesian and Non-Bayesian Tests of Independence in Seemingly Unrelated RegressionsTsunemasa Shiba and Hiroki Tsurami

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Mr. Phelps is Lecturer in Economics at University College, Cardiff, United Kingdom, and holds degrees from Oxford University.

Argy and Salop dealt with this problem by incorporating the (XM) component into their modified Marshall-Lerner expression: [X’M1 + f2X + f1M]. See Argy and Salop (1979, footnote 19, pp. 234–35, and p. 249).

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