Adjustment of Trade Balances: Some Experiments with a Model of Trade Among Many Countries

ANALYSIS of how trade balances could adjust so as to reach given targets would seem to be a fitting task for a model of international trade. The peculiar strength of a trade model is its capacity to reflect the simultaneous interaction among countries’ trade positions as well as the interaction of underlying variables, such as the levels of prices, income, and spending. A model could show, for example, how the forces leading to a specified improvement in one country’s trade balance are at the same time bringing about a corresponding deterioration in the collective position of other countries, and how various types of defensive or cooperative action by these other countries might affect the outcome for the first country.

Abstract

ANALYSIS of how trade balances could adjust so as to reach given targets would seem to be a fitting task for a model of international trade. The peculiar strength of a trade model is its capacity to reflect the simultaneous interaction among countries’ trade positions as well as the interaction of underlying variables, such as the levels of prices, income, and spending. A model could show, for example, how the forces leading to a specified improvement in one country’s trade balance are at the same time bringing about a corresponding deterioration in the collective position of other countries, and how various types of defensive or cooperative action by these other countries might affect the outcome for the first country.

I. Overview 1

ANALYSIS of how trade balances could adjust so as to reach given targets would seem to be a fitting task for a model of international trade. The peculiar strength of a trade model is its capacity to reflect the simultaneous interaction among countries’ trade positions as well as the interaction of underlying variables, such as the levels of prices, income, and spending. A model could show, for example, how the forces leading to a specified improvement in one country’s trade balance are at the same time bringing about a corresponding deterioration in the collective position of other countries, and how various types of defensive or cooperative action by these other countries might affect the outcome for the first country.

Assume that country A wishes to improve its trade balance by a given amount and that, given a system of fixed exchange rates, demand management is taken to be the instrument of adjustment.2 The model should provide some link between A’s total demand and its demand for imports, and between total imports and imports from particular countries. The geographical structure of A’s import trade would be an important factor determining the relative impact on other countries’ exports of a drop in A’s total demand.

Reductions in exports from other countries—say, B and C—to country A would in the first instance reduce incomes in those countries by respective amounts, unless their policies shift in an expansionary direction to offset the drop in foreign demand. Reflecting these income declines, imports into B and C will fall, leading to, inter alia, a decline in A’s exports. Country A will then have to cut its imports by an additional amount in order to achieve the stipulated improvement in its trade balance, and this second-round cut in A’s imports will send additional ripples throughout the system. The process is complicated further by the fact that first-round reductions in incomes of B and C (reflecting reductions in their exports to A) would tend to induce reductions in their spending on domestically produced merchandise and services, as well as on imports, and hence lead to further reductions in incomes and imports.

Prices, as well as spending, may play a role in helping a country to improve the trade balance through demand management. Country A’s demand restraint would tend to improve the international competitiveness of its output, leading to an increase in its share of foreign markets and also, possibly, to a reduction in the share of imports in the domestic market. Such adjustments in export and import shares would tend to supplement the gains directly attributable to the restraint on the size of the domestic market; the larger these adjustments, the less will total spending have to be restrained to reach the given target.

The improvements in A’s trade balance caused by a gain in its competitiveness must be matched, of course, by a deterioration in the collective balance of all other countries, reflecting the decline in their competitiveness vis-à-vis A. How A’s gain affects foreign countries individually is a complex matter, and the outcome for, say, country B may be very different from that for country C. The results given below show that the more dependent B is on country A as an export market (and the more dependent B is on third markets that in turn depend on A), the greater the tendency for B’s price level to move downward in line with A’s, and the smaller the deterioration in B’s balance owing to price movements.3

Such causal links form a web of simultaneous interaction that can be studied effectively only with the aid of a system of equations. The author has presented elsewhere a model that exhibits all the kinds of links that have been mentioned above.4 The exact forms of the linkages found in this model are admittedly simple and are based on restrictive assumptions,5 but the benefit obtained thereby is that any number of countries or areas can be handled systematically at once. This means not only that the effects of country A’s adjustment can be obtained for a world of many countries but also that targets for the trade balances of any number of countries can be reached simultaneously.6

The purpose of this paper is to provide a general understanding of how the model operates by discussing sample solutions, and beyond that to shed some new light on how the process of adjustment in trade positions might actually operate in given circumstances. Incorporating trade data for the period 1966–68, together with the necessary complement of assumptions regarding elasticities, the model has been used to calculate how trade and other variables would have been affected in that period by policy adjustments designed to reach certain targets. The illustrative solutions include the following:

Solution I

A target-increase of $2,000 million in the trade surplus of the United States, expressed as an annual average for the three-year period 1966–68.7

Solution II

The same target-change for the United States, together with a target-improvement of $1,000 million in the trade balance of the United Kingdom (also expressed as an annual average for the three years 1966–68) plus a requirement that the balances of Canada and the primary producing countries (the latter countries taken together) remain unchanged.8

Solution III

The same target-changes as in Solution II plus the requirement that industrial countries other than the United States, the United Kingdom, and Canada cooperate in the adjustment process to the extent of preventing their total spending from declining, despite the declines in their exports.

Solution IV

Target-decreases of $1,000 million in the trade balances of Germany, Italy, and Japan plus, for all other countries, the same assumptions used in Solution III. In this Solution, the target-decrease in the collective balance of Germany, Italy, and Japan exactly matches the assumed, collective improvement in the position of the United States and the United Kingdom.

II. Data and Other Numerical Input

Two types of numerical input are required: first, a matrix of trade data showing flows from all countries or areas identified to all those same countries or areas and, second, a list of parameters indicating the strength of the causal linkage between changes in various flows, and between changes in prices and changes in flows. Whereas the data on trade are quite solid, the parameters used here amount to no more than reasonable guesses. At this stage in the research, the interesting features of the model’s solutions are those that reflect most directly the input of data and the way it is used in the calculations.

The input of data on foreign trade is a 15-by-15 matrix of trade in total merchandise in 1966–68; the data are expressed as annual averages, in millions of U.S. dollars. The 15 “countries” comprise 14 industrial countries (Austria, Belgium-Luxembourg, Canada, Denmark, France, Germany, Italy, Japan, the Netherlands, Norway, Sweden, Switzerland, the United Kingdom, and the United States) plus the Rest of the World, treated as a single country. The number of single countries distinguished in the model’s solutions could be increased at will.

The hypothetical adjustments in trade positions take place over the period of time to which the trade data refer. In particular, solutions of the model based on 1966–68 data represent hypothetical adjustments in the values taken by the variables in that period, and the adjustments result from hypothetical alterations in policies applied in that period. The results of the model, like the input data, are expressed as annual averages for the three-year period. The model itself provides no basis for allocating the adjustments by years or by parts of years; additional assumptions regarding such allocations would be required for calculating, say, the adjustments in annual growth of imports and exports consistent with the target-changes imposed.

In practical applications, of course, the targets that would be under consideration would generally be forward looking, and the period of adjustment would commonly begin presently and extend into the medium-term future. In such applications the input of data should represent a forecast for that period of adjustment based on “present policies”—i.e., a forecast of what the trade positions would be in the absence of those policy adjustments whose effects are to be explored in the model. The use of historical data in the illustrations presented below serves to avoid numerous problems of forecasting that do not need to be confronted for purposes of this paper.

In addition to data on foreign trade, the model also uses figures representing internal trade. These figures can be visualized as the diagonal cells of the trade matrix. For example, the diagonal cell for country A, plus A’s imports, can be called A’s total spending on tradable merchandise; similarly, the same diagonal cell, plus A’s exports, can be called A’s total sales or output of tradable merchandise. While the national accounts of the various countries provide some basis for the estimation of internal trade, it is difficult to say how much of domestic production of merchandise should be deemed to be tradable—that is, effectively competing with the output of other countries in both domestic and foreign markets.9 A promising method of resolving this difficulty makes use of an a priori relationship between the effective size of the import-competing sector and the price elasticity of demand for imports.10 The larger the import-competing sector, relative to a given level of imports, the higher is the elasticity of demand for imports, other things being equal.11 In the estimating procedure described in Appendix A, figures for internal trade based on national accounts are scaled down by a factor, uniform for all countries, that satisfies an assumption that a weighted average of price elasticities of demand for imports is 1.5.12 Countries whose domestic production is large in relation to imports, such as the United States, come out with relatively high import elasticities, while the opposite is true of more open economies, such as the Netherlands.13

The elasticity of substitution between the merchandise of each pair of countries competing in a market is assumed to be 2. This assumption is made for each market, foreign and domestic. The elasticity of substitution between a country’s total imports and its import-competing production is, therefore, equal to 2.14 The price elasticity of each country’s demand for tradable merchandise (i.e., imports and import-competing merchandise taken together) is assumed to be 1. These assumptions were taken into account in arriving at the estimates of internal trade, discussed above.15 The elasticity of each country’s supply of tradable merchandise is assumed to be 1.16

Finally, the model requires assumptions linking changes in money incomes to changes in spending on tradable merchandise that would result in the absence of policy intervention. The proportion of any change in a country’s money income that is spent in turn on tradable merchandise is assumed simply to be the ratio of its total spending on tradable merchandise to its gross national expenditure (GNE). A consequence of this assumption is that the proportion of any change in income that is spent on imports (abstracting from the effects of price changes) is given by the ratio of imports to GNE. In effect, the “marginal propensity” to import, conceived in money terms, is assumed to be the same as the “average propensity.” 17

III. An Adjustment to Target in the Trade Balance of a Single Country

With the inclusion of the data and assumptions discussed above, the model has been used to calculate the hypothetical effects of an adjustment toward restraint in policies pursued by the United States over the period 1966–68. The adjustment should be one that would lead to a target-improvement of $2,000 million per annum in the U.S. trade balance over this three-year period. To achieve this improvement, U.S. spending on tradable merchandise declines, and the extent of this decline will take into account any adjustments in market shares that may be induced by the dampening of U.S. demand, as well as any adverse feedback effects on U.S. exports working through the income-spending relations in other countries. The main adjustments in trade flows are analyzed in Table 1, and the underlying adjustments in prices, output, and total spending are shown in Table 2.

Table 1.

Solution I: Effects on Trade of an Adjustment of $2,000 Million in the Trade Balance of the United States

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General note on sources: Tables 1 through 8 of this paper contain results of a trade model whose basic input of data, with their sources, is shown in Table 9. For information on the statistical and methodological basis of these results, see the Appendices.

Less than ±0.05 per cent.

This is computed as a residual from world totals and hence includes the CMEA countries, mainland China, etc., as well as the countries usually classed, for analytical purposes, in the International Monetary Fund’s Annual Report as primary producing.

The world totals automatically “add up,” since, throughout the process of computation, the effects of adjustments in prices and spending are calculated as matrices of changes in trade flows (not as changes in the trade totals at the margins of the matrix). The process of computation is summarized in Appendix B. For the world as a whole, expenditure effects on exports must equal expenditure effects on imports, and the same is true of price effects. The change in the global trade balance must be zero.

Less rounded figures for Japan and primary producing countries are —0.26, while figures for the United Kingdom and Germany are —0.31 and —0.30, respectively. See discussion on page 499.

Table 2.

Solution I: Adjustments in the Price Level, Output, Total Spending, and Trade Balance of Each Country

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This column also shows percentage changes in volume of output of tradable merchandise, inasmuch as the supply elasticities are assumed to be unity in each country (see p. 493).

In Table 1 the change in a country’s trade balance is analyzed as the difference between the changes in its exports and its imports; changes in exports, imports, and balances are in turn divided into expenditure and price effects. These are the effects on demand of the equilibrating adjustments in prices and spending in each country. Table 1 thus demonstrates the compatibility of the demand side of the model with the target-change imposed.18

In Table 2 the change in a country’s balance can be related to the difference between the percentage change in the value of its output and the percentage change in its total spending. The compatibility of the supply side with the target-change imposed is clear from this table. Figures in the second column are twice as large as respective figures in the first column, since all supply elasticities are 2 in value terms, by assumption.

U.S. spending on tradable merchandise shrinks by 5.58 per cent (Table 2), causing imports to drop in the same proportion—by $1,568 million—abstracting from the effects of any price changes (Table 1).19 Moreover, the U.S. price level declines in greater proportion than price levels abroad (Table 2), and the share of imports in the domestic market declines owing to the relative increase in import prices. The effect of this share adjustment on U.S. imports is —$219 million, bringing the total change in U.S. imports to —$1,787 million.20

Reflecting the deflationary (or counterinflationary) impact of the drop in U.S. demand, markets abroad for tradable merchandise also shrink, but by much less, of course, than the U.S. market (Table 2). These percentage declines, taking into account the geographic distribution of U.S. exports, cause a reduction in U.S. exports of $94 million (Table 1). The improvement in the competitive position of the United States, however, means that the average U.S. share in those markets rises; this factor alone increases U.S. exports by $307 million, or by 1 per cent—much more than offsetting the adverse feedback effects working through the income-spending relations.

Expenditure effects on the U.S. trade balance, measured by the difference between the expenditure effects on exports and on imports, account for about 75 per cent of the stipulated improvement in the U.S. balance. Price effects account for the remaining 25 per cent. The data thus indicate that, with substitution elasticities in the neighborhood of 2 and supply elasticities in the neighborhood of 1, price effects make a significant contribution to the adjustment, despite the fact that the instrument of adjustment is demand management. One should anticipate, however, that the 25 per cent figure would be markedly altered as a consequence of changing the assumptions regarding the elasticities.21

What are the implications of the adjustment for U.S. policy? At the present stage in the development of the model, no policy instrument is explicitly represented, nor for that matter is GNE or any other standard measure of aggregate demand.22 Nevertheless, some indication of the extent of policy action required of the United States is provided by the drop in imports attributable to the reduction in the size of the domestic market. In Solution I this drop is -$1,568 million, only 78 per cent of the improvement in the balance actually achieved. The policy implications could be entirely different if other countries simultaneously take defensive action to preserve their trade positions, or if they aim at competing targets of their own. Indeed, the burden of adjustment on the United States (the “policy-induced” reduction in imports) could be far greater than the final adjustment in its trade balance, as will be illustrated in the next section.

For countries other than the United States, changes in balances in Solution I (totaling —$2,000 million) reflect average declines in export markets. In percentage terms, these declines depend mainly on the importance of the U.S. market (and to a lesser extent the Canadian market) in the exports of the various countries. For example, exports from Canada and Japan fall by 3.7 per cent and 1.9 per cent, respectively, as a result of average declines in foreign markets (Table 1), while the corresponding changes for Germany and France are only —0.7 per cent and —0.5 per cent, respectively.

Price changes tend to reduce the exports of these countries, because they lose competitiveness vis-à-vis the United States. An interesting exception is Canada, whose exports rise by $19 million owing to price changes (second column of Table 1). The U.S. deflationary action has a relatively large spillover effect on Canadian output of tradable merchandise (second column of Table 2), resulting in a relatively large reduction in Canada’s price level.23 The improvement in Canada’s competitiveness vis-à-vis countries other than the United States leads to an increase in Canada’s exports to these countries of $28 million (reflecting price effects alone). There is a less-than-offsetting reduction of $9 million in Canada’s exports to the U.S. market, where U.S. sellers are the chief competitors and where the scope for gains against third countries is relatively small. In general, the more dependent a country is on the U.S. market, the more adverse will be the expenditure effects on its exports but the less adverse will be the price effects on its exports.24

Price effects on the imports of countries other than the United States are small and positive, reflecting declines in the levels of import prices relative to home prices. The percentage change in a country’s import price level, in this model, is an average of price changes abroad, weighted, respectively, by the country’s imports from each of the other countries. One might think, therefore, that Canada’s imports would rise substantially owing to price factors, because the big drop in U.S. prices would have a much greater effect on the price level of imports into Canada than into any other country. Just the opposite result obtains. Despite the large, average decline in Canada’s import prices, Canada’s imports are virtually unchanged, owing to the equally large drop in Canada’s own price level. Thus, on both the export and import sides, the country that is most dependent on the U.S. market maintains a relatively strong competitive position.25

International trade of all countries taken together declines by 1.1 per cent in value, reflecting the use of “expenditure-reducing” policy to bring about the adjustment (Table 1). The cost of the adjustment in terms of loss in world trade in volume is 0.4 per cent, as prices drop on average by 0.7 per cent.26 Price effects on global foreign trade are very small (Table 1), reflecting some replacement of imports by domestic supplies.

A result of particular interest, because of its comparative insensitivity to variations in the parameters used, is the relative impact of an adjustment in one country on the trade balances of the other countries. This relative impact, defined in the present example as the change in each country’s trade balance expressed as a percentage of $2,000 million, is shown in the first column of Table 3. These figures, obviously, depend mainly on the size and geographic structure of each country’s trade.

Table 3.

Solution I: Measures of the Relative Impact of the U.S. Adjustment on Other Countries

(In per cent)

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The change in trade balance of each country (except the United States) expressed as a percentage of $2,000 million (based on the fourth column of Table 2).

Each country’s total exports plus total imports expressed as a percentage of the sum of these data for all countries except the United States (based on Table 9).

Each country’s exports to the United States plus imports from the United States expressed as a percentage of the sum of these data for all 14 countries (based on Table 9).

But does it really make much difference, in assessing the effect on other countries of a given adjustment, whether one uses a model or some simpler rule of thumb? For example, one could think of distributing the offset to the U.S. gain on the basis of the relative size of each country’s total exports and imports (“total-trade method”), or on the basis of the relative size of each country’s bilateral trade with the United States (“bilateral-trade method”). These distributions are also shown in Table 3. Differences between them and the distribution based on the model (right-hand columns) provide measures of the refinement to be achieved by using the model.

As might be expected, a method of distribution based on total trade would understate the impact on countries whose trade is closely linked with the United States and overstate the impact on other countries. The errors could be large: for Canada, in the present instance, the understatement would be about $175 million, for Japan, $80 million, etc. The method of distribution based on bilateral trade with the United States yields—except in three instances—smaller errors than the total-trade method. The relative size of countries’ bilateral trade with the United States tends to be correlated with the relative size of countries’ total trade and at the same time reflects the main features of trade structure that should be taken into account.27

Nevertheless, the bilateral-trade method would seem to be far from satisfactory. If applied in the present case, this method would overstate the impact on Canada by almost as much as the total-trade method would understate it. The bilateral-trade method would understate the impact on France and Germany by more than the total-trade method would overstate it. In general, the bilateral-trade method leaves out of account third-market effects that tend to dilute the impact on countries whose bilateral trade with the United States is large, and that intensify the impact on countries whose bilateral trade with the United States is small. The refinement of results that the model makes possible is substantial.

IV. Adjustments to Targets in Several Trade Positions at Once

In realistic situations the process of adjustment may reflect the efforts of several countries, acting more or less simultaneously, to bring their trade positions into line with policy objectives. Still other countries, moreover, may wish to prevent their trade positions from being modified in any substantial way as a consequence of programs being pursued abroad. How can all objectives be accommodated simultaneously? What would be the burden of adjustment on individual countries that are working toward external targets? What would be the effects on the trade positions of the remaining countries? How would world trade be affected? The solutions discussed below indicate how the model would attempt to answer such questions.

In Solution II, the United Kingdom is assumed to achieve an improvement in its trade balance of $1,000 million per annum over the period 1966–68, while the U.S. target-change of $2,000 million per annum is retained.28 In addition, it is assumed that Canada and the primary producing countries (the latter as a group) prevent their positions from deteriorating by cutting back their imports in line with any declines in their exports.29 Of course, the efforts of the United Kingdom and the United States to move their balances simultaneously in the same direction tend to be self-defeating to the extent that they trade with each other. To put it another way, each of the two countries must cut its spending by more than would be necessary if the other country were not doing the same thing. Moreover, the assumed unwillingness of Canada and the primary producing countries to take shares of the $3,000 million offset (shares that would be very large in the absence of defensive action on their part—see Table 3) adds importantly to the burden of adjustment falling on the United Kingdom and the United States. In Solution II the necessary cutback in U.S. spending on tradable merchandise is 9.5 per cent, compared with only 5.6 per cent in Solution I (Table 4). Similarly, whereas in Solution I the reduction in the value of U.S. imports directly attributable to demand restraint (i.e., excluding price effects) is much less than the final improvement in the balance achieved, the opposite is true in Solution II: here, policymakers must aim to overshoot the target, so to speak, in order to hit it.

Table 4.

Main Analytic Results of Four Model Solutions: Changes in Total Spending, Changes in Global Trade, and Changes in Prices1

(In per cent)

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See text for more precise description of the assumptions underlying each solution.

Figures in parentheses indicate changes in value of U.S. imports (in millions of U.S. dollars) owing to expenditure effects (i.e., excluding price effects). Comparing these figures with the increase of $2,000 million in the trade surplus achieved in each solution is one way of assessing the burden of adjustment on the United States in the various solutions.

Value data deflated by the change in the world export price level. The latter is the average of percentage changes in national price levels, weighting by total exports.

These are equivalent to the changes in volume of output of tradable merchandise, inasmuch as the supply elasticities are assumed to be unity in each country (see p. 493).

In Solutions I and II, most countries are assumed to play a strictly passive role: reductions in their exports are allowed to generate reductions in their incomes and imports without policy intervention. If, on the other hand, the policy in these countries is to offset any reduction in foreign demand, so that their spending on tradable merchandise is maintained, one source of adverse feedback effects on the United Kingdom and the United States is cut off. Specifications for Solution III are the same as for II except that total spending is maintained in Japan and in the industrial countries of continental Europe. The effect, of course, is to reduce the burden of adjustment on the United Kingdom and the United States (Table 4).30

The purpose of Solution IV is to illustrate what happens in the model if some countries are assumed to do more than just maintain spending and actually commit demand management to the goal of reducing trade balances. Specifications for Solution IV differ from Solution III only in that Germany, Italy, and Japan each adopt target-changes of —$1,000 million per annum in their respective balances. Germany, for example, undertakes to increase spending to whatever extent proves necessary to reduce its surplus by $3,000 million over the three-year period, taking into account (inter alia) whatever happens to its exports. The latter, of course, will be affected in this situation not only by measures of restraint taken by the United States and the United Kingdom but also by more rapid expansion in Italy and Japan. Not surprisingly, the results of this solution describe a more balanced pattern of adjustment: increases in prices, output, and spending in Germany, Italy, and Japan tend to offset decreases elsewhere; increases in these countries’ imports permit smaller reductions in imports of the United Kingdom, the United States, Canada, and the primary producing countries (Tables 4 and 5).

Table 5.

Changes in Exports and Imports in Solutions II, III, and IV 1

(In per cent)

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Less than ± 0.05.

See text for more precise description of the assumptions underlying each solution.

Despite the fact that target-changes in Solution IV sum to zero (the three countries in hypothetically strong positions are reducing their balances by just as much as the United States and the United Kingdom are increasing theirs), world trade declines in both value and volume (Table 4). This result is intuitively plausible, in view of the structure of trade and the underlying assumptions. The assumed defensive action by Canada and the primary producing countries tends mainly to frustrate the policies of the United Kingdom and the United States; on the other hand, the assumed policy of maintaining spending in France, the Netherlands, etc., tends mainly to forestall induced increases in exports from Germany and Italy, thus assisting the latter countries to reduce their balances. Under such conditions, it is more difficult for the United States and the United Kingdom to improve their collective balance by a given amount than for Germany, Italy, and Japan to reduce theirs by the same amount. This means that the cutbacks in output and spending more than outweigh the advances, and global imports decline (Tables 4 and 6).31

Table 6.

Effects on Trade of Adjustments Required in Solution IV 1

(In millions of U.S. dollars)

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Less than $0.5 million.

In this Solution, the changes in the balances of the first 7 countries shown in the stub have been constrained to take the values appearing in the right-hand column. For all other countries, spending on tradable merchandise has been constrained not to change, as indicated by absence of expenditure effects on their imports.

Of course, the opposite result is obtained if the policy roles are reversed: that is, if Canada and the primary producing countries maintain their spending while France, the Netherlands, etc., expand their imports as necessary to prevent increases in their trade balances. On such assumptions, the same realignment of trade positions of the United States, the United Kingdom, Germany, Italy, and Japan is mildly inflationary, as the value and volume of world trade are raised by 0.5 per cent and 0.3 per cent, respectively. In sum, the fact that target-changes are compatible in the sense that they add to zero is not sufficient to ensure an adjustment free of deflationary or inflationary bias from the global viewpoint. The role of secondary participants in the adjustment process should be considered, taking into account the orientation of their trade with the countries principally involved.

V. Adjustment via Policies Directly Affecting the Price Level

In preceding illustrations of the model the only variable that is influenced directly by policy is a country’s total spending on tradable merchandise. The country’s price level is affected only indirectly, in the process of clearing markets whose equilibria are upset by shifts in demand. In reality, some policy instruments—e.g., incomes policies, wage-price guidelines—can affect a country’s competitiveness more directly. This section describes a solution (Solution V) in which price policy is combined with demand management to reach a target level for the trade balance.

Policy directly reducing the price level is represented in the model as a vertical, percentage shift in the country’s supply function.32 Such a shift, which measures the degree of restraint applied, is generally greater than the actual drop in the country’s price level as it adjusts to a new equilibrium, since the supply shift will be combined with a movement upward along the supply curve. In other words, inasmuch as the force of the policy is to make the country’s output cheaper in world markets, demand will switch to this now-cheaper source and, in so doing, tend to limit the fall in the price level.

A simple illustration can be obtained by recomputing Solution I (based on the single target-change of $2,000 million for the United States) with the additional assumption of a downward shift in the U.S. supply function.33 The size of this shift is assumed to be 4.4 per cent of the 1966–68 price level. On present elasticity assumptions, a drop of 4.4 per cent in the U.S. price level—barring induced price reductions abroad—would be sufficient to reach the given U.S. target without any cut in U.S. spending.34

What happens in the solution, however, is that U.S. output expands, as both foreign and domestic buyers switch to the now-cheaper U.S. merchandise. This expansion would account for a price increase of 1.4 per cent, given the supply elasticity assumed. Thus, instead of falling by 4.4 per cent, the U.S. price level actually declines by only 3.0 per cent. Furthermore, the dampening of demand for output of other countries, which is the counterpart to the switch just mentioned, brings about small reductions in prices and incomes abroad, which in turn have adverse effects on the U.S. position. Thus, after all, U.S. price policy must be supplemented by demand management in order to reach the target.35 However, price effects in Solution V are still important (Table 7). They account for about one half of the U.S. gain, compared with one fourth of the gain in Solution I, where price policy was not employed. Reflecting the reduction in the burden of adjustment that falls on demand management, U.S. imports decline by 3.6 per cent owing to a contraction in spending (Table 7), compared with a decline of 5.6 per cent in Solution I.36

Table 7.

Solution V: Effects on Trade of an Adjustment of $2,000 Million in the Trade Balance of the United States, Achieved Partly Through Direct Action on the Price Level1

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Less than ± $0.5 million.

Less than ± 0.05 per cent.

U.S. policy aimed at restraining prices directly is assumed to account for a downward shift in the U.S. supply function equaling 4.4 per cent of the 1966–68 price level. See text, page 509. Apart from this shift, the assumptions underlying these figures are the same as those in Solution I above (see Table 1).

The use of price policy alters the relative impact of the U.S. adjustment on the other countries. Relatively more of the $2,000 million offset is absorbed by countries that are important competitors of the United States in third markets, and relatively less of the offset falls on the principal suppliers of the U.S. market. Thus, Canada and Japan are affected less than in Solution I, while European countries are affected more.

The value of world trade falls less in Solution V than in Solution I, reflecting use of an expenditure-switching policy instead of total reliance on an expenditure-reducing policy. More striking is the fact that the entire reduction in the value of world trade in this situation is due to price reductions; indeed, the volume of world trade rises a little, reflecting mainly the increase in the volume of U.S. output. The difference between the two solutions, in what may be called the global cost of adjustment in real terms, is about 0.5 per cent.37

VI. Next Step in the Research

The model as presently used deals with only one class of item. In the illustrations given above, this class was taken to be tradable merchandise, and the constituent elements were the merchandise produced by each of the 15 countries. The model would work in much the same way if the input of data referred to, say, manufactures or chemicals.38 But the model could not deal simultaneously with trade in chemicals and other manufactures. In the theoretical work that gave rise to the model, it was envisaged that several classes of items would be distinguished.39

A multiclass system would permit the inclusion of all production comprised in gross national product (GNP); specifically, it could handle nontradable merchandise and services as well as tradables. Such comprehensiveness itself would bring two important advantages.

First, a comprehensive system could ensure that computed changes in international trade reflect any changes that may be induced in the domestic economy. For example, changes in policy such as those envisaged in the illustrations above could be expected to affect the whole economy, not just the foreign sector; but the present model does not show how possible changes in output and earnings in other sectors may in turn affect international trade.40

Second, a comprehensive system could include variables pertinent to a better assessment of the policy implications of a given adjustment in external positions. Policy implications would have to be assessed in the light of the outcome of a model solution for real GNP or other familiar aggregates in the income and expenditure accounts. The changes in output, spending, and prices generated by the present, one-class model are relatively uninformative because they relate to only one sector—a sector, moreover, that cannot be rigorously defined (see Appendix A). Linking markets for tradables to aggregate demand in the whole economy would be a step toward obtaining more meaningful results.

A multiclass system would also permit a disaggregation of tradables. Such disaggregation—at a minimum, separating manufactures from the rest—would be certain to increase the reliability of the model’s results for changes in total trade. Because the present model involves no commodity breakdown at all, it cannot make effective use of the econometric evidence presently or potentially available. A multiclass framework would better serve to incorporate some of the results of empirical studies of income and price elasticities.

APPENDICES

A. Estimation of Internal Trade and of the Parameter Linking Spending to Income

Internal trade

This appendix describes how figures for internal trade were obtained (see also pp. 492–93). First, exports were subtracted from twice the value of gross domestic product (GDP) originating in agriculture, mining, and manufacturing (assumed to be the “tradable-merchandise” sectors) to obtain a preliminary measure of internal trade for each country. Taking twice the value of GDP represents a crude allowance for the fact that the GDP data show value added in the respective sectors, whereas exports refer to gross values. The relative sizes of these preliminary figures for internal trade were preserved in later steps, but the absolute sizes were reduced by a common factor, reflecting the idea that not all the apparent domestic output really competes internationally in any meaningful sense.

In obtaining the reduction factor just mentioned, use was made of the following formula, derived in an earlier paper:

ηm = (1 — Sm) σ + Smη,

where ηm is the elasticity of a country’s demand for imports, Sm is the share of imports in the domestic market, σ is the elasticity of substitution between imports and import-competing products, and η is the elasticity of demand for imports and import-competing products taken together.41 In the illustrations given in the text, σ=2 and η = 1 for each importing country. Given these assumptions, any assumption about the elasticity of demand for imports implies Sm, which in turn implies a certain level of internal trade (given imports).

Instead of making a separate assumption about the elasticity of each country’s import demand, however, it was decided to assume that ηm equals 1.5 (in absolute value) for all countries taken together. This assumption implies that Sm for the world as a whole must be 0.5 (given σ and η). To satisfy this condition, in turn, without disturbing the relative sizes of the figures for internal trade initially obtained, the latter figures had to be scaled down by a factor of about 0.16. In short, the effective size of the import-competing sector in any given country was assumed to amount to somewhat less than one third of the reported value added in agriculture, mining, and manufacturing.

On the basis of the formula above, the higher a country’s internal trade, given its imports, the higher is its elasticity of demand for imports, and vice versa. The import elasticities generated by the procedure described above, and which underlie results shown in the earlier tables, are given in Table 8.

Table 8.

Implicit Price Elasticities of Demand for Imports and Exports in Volume

(Expressed in absolute value)

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Price elasticities of demand for exports from each country are also shown. Variation in these elasticities from country to country is small and depends mainly on the size of the exporting country; the larger it is as a supplier to the world market, the smaller tends to be the elasticity of demand for its exports. The general level of these elasticities—relative to the substitution elasticity universally set equal to 2—depends to some extent on internal trade in foreign markets: the lower the latter, the lower the export elasticities.

It is perhaps unnecessary to emphasize that the procedure described above is crude; it will certainly be revised if enough evidence regarding import and substitution elasticities by country can be adduced to permit a country-by-country analysis of the effective size of foreign trade sectors.

The link between spending and income

As noted in the text (p. 494), the proportion of any change in a country’s money income that is spent in turn on tradable merchandise—the parameter mj in the model42—is assumed to be the ratio of total spending on tradable merchandise to GNE. A country’s total spending on tradable merchandise is, of course, the sum of its imports and its internal trade as obtained through the method just described. The resulting merchandise/GNE ratios (based on trade and GNE figures for 1966–68) are as follows:

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The proportion of any change in income that is spent on imports (abstracting from the effects of price changes) is given by the ratio of imports to GNE. Consider, for example, the first numerical illustration given in the text (Solution I). A first-round reduction in (say) Canada’s exports to the United States of (say) $100 would reduce Canada’s spending on tradable merchandise by $25, according to the tabular matter above. The import share of the domestic market, as measured for present purposes, is 0.696,43 so the first-round decline in Canada’s imports is about $17.5. The ratio of imports to GNE in Canada in 1966–68 was about 0.175. In effect, then, an equivalence has been assumed between average and marginal “propensities” to import (both variables expressed in value terms).

In the present model, spending “leakages” into sectors other than tradable merchandise (as measured) do not create further feedback effects on trade. Pursuing the example just above, Canada’s spending on nontradable merchandise and on services would fall by $75 (ignoring a possible change in nominal saving), but the model provides no link between this reduction and any further reduction in spending on tradable merchandise that might be induced.44 Because “leakages” into nontradable merchandise and service sectors are large and because feedback from these sectors is not taken into account, the model in its present form may understate the deflationary impact of adjustments such as those considered in Solutions I and II. A multiclass extension of the model would allow this problem to be dealt with systematically (see Section VI).

B. Summary of Method Used to Solve the Model45

For computational convenience the system of 5n equations and 5n unknowns is reduced to n equation in n unknowns. First, the demand and supply equations are substituted into the market-equilibrium equations and into equations (5a) and (5b). The expression (p*i+p¯*i) replaces P*i. These steps yield a system of 2n equations in 2n unknowns, i.e., the expenditure changes and the endogenous price changes. On present assumptions, the change in any given country’s expenditure can be expressed as a function of only one unknown—namely, that country’s endogenous price change.46 Therefore, the system can be reduced to n equations in the n endogenous price changes.

The process of computation itself involves three steps.

First, the coefficients of the explanatory variables in the demand equations are calculated, using the external and internal trade data and the assumed substitution elasticities and elasticities of demand for tradable merchandise. The trade data are shown in Table 9. The coefficients of the expenditure and price variables in the demand equations are shown in Tables 10 and 11, respectively.

Using these results, the n-by-n matrix of coefficients of the reduced system is set up, inverted, and multiplied by a vector of constants embodying the trade targets and the assumed exogenous changes in expenditures and prices, if any. The supply elasticities are also introduced in this step. Once the endogenous price changes are determined, the changes in expenditures and P*i are calculated directly.

The third step is a calculation of the changes in trade caused by the changes in expenditures and prices, using the demand equations. Changes in spending are spread over all sources of supply in proportion to initial market shares. A change in price results in a matrix of changes in trade, in the manner shown in the article that is cited in footnote 3. The elasticities and trade data used in the third step must, of course, be identical to those used in the first step; otherwise, the targets would be missed.

C. Basic Tables

Table 9.

Direction of External and Internal Trade of the Selected Countries, 1966-68 1

(Annual averages, in millions of U.S. dollars)

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Sources: Organization for Economic Cooperation and Development (OECD), Foreign Trade, Series A: Overall Trade by Countries; OECD, National Accounts Statistics.

External trade data refer to total merchandise trade as reported (see footnote 2 to this table). Figures for internal trade have been derived through a procedure explained in Appendix A.

Foreign sales of the 14 individual countries are their f.o.b. export data. Foreign sales of the Rest of the World, treated here as a single country, are generally based on c.i.f. import data of the individual countries and a standard conversion factor from c.i.f. to f.o.b. Owing to asymmetries in the collection of data and other statistical problems, the figures labeled “Total, imports” as well as “Total, exports” of the Rest of the World may differ substantially from reported import and export data, respectively.

Table 10.

Market Shares of the Selected Countries, 1966–68 1

(In per cent)

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Source: Table 9.

These data are the coefficients of the expenditure variables in the demand equations. See Armington, “A Many-Country Model of Equilibrating Adjustments in Prices and Spending,” published as the appendix to Rudolf R. Rhomberg, “Possible Approaches to a Model of World Trade and Payments,” Staff Papers, Vol. XVII (1970), p. 25, equation (1).

Table 11.

Partial Price Elasticities of World Demand for Each Country’s Output with Respect to Each Country’s Price Level1

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Source: Derived from Table 9 and from the underlying elasticity assumptions, in the manner described in Armington, ‘The Geographic Pattern of Trade and the Effects of Price Changes,” Staff Papers, Vol. XVI (1969), pp. 179–201. See especially Table 4 of that paper.

These data are the coefficients of the price variables in the equations. See Armington, appendix to article in Staff Papers (cited in footnote 1 to Table 10), p. 25, equation (1). The direct elasticities appear on the diagonal and are expressed in value terms (i.e., subtract 1 to obtain the volume elasticities). The cross elasticities comprise all figures off the diagonal. The elasticity of substitution in each market is assumed to be 2 (absolute value), and the elasticity of each country’s demand for merchandise-in-general is assumed to be 1 (absolute value).

Ajustement de la balance commerciale : quelques expériences avec un modèle d’échanges internationaux

Résumé

Dans le présent document on a analysé plusieurs moyens d’ajuster les balances commerciales de manière à atteindre les objectifs fixés. Les ajustements sont censés s’effectuer en agissant sur la demande, ou encore par une action sur la demande s’accompagnant de réductions directes du niveau des prix. Le document montre comment les variations des dépenses et les mouvements des prix qui conduisent à une certaine amélioration de la balance commerciale d’un pays provoquent simultanément une détérioration correspondante de la situation commerciale d’autres pays, et comment divers types de politiques, concurrentielle, protectionniste ou coopérative, pratiqués par d’autres pays, en ce qui concerne leur propre balance commerciale, pourraient affecter les résultats commerciaux de chaque pays ainsi que le commerce mondial.

Dans le modèle présenté ici, un pays qui cherche à améliorer sa balance commerciale réduira normalement ses dépenses au titre des marchandises négociables sur les marchés internationaux, l’ampleur de cette réduction dépendant (entre autres) du genre de politique pratiquée par ses partenaires commerciaux les plus importants, c’est-à-dire, d’une politique concurrentielle ou complémentaire. Etant donné que la charge de l’ajustement des dépenses d’un pays dépend de l’évolution concomitante de ses marchés d’exportation, il est nécessaire de déterminer simultanément toutes les variations de dépenses. De même, dans ce modèle, un pays qui cherche à améliorer sa balance commerciale en agissant sur la demande, profitera généralement d’une plus grande compétitivité tant de ses marchés étrangers qu’intérieurs; plus les élasticités de l’offre de marchandises négociables sur les marchés internationaux sont faibles, plus les variations des prix relatifs et des marchés d’exportation des différents pays ont tendance à être importantes. L’effet des prix sur la balance commerciale peut également résulter de déplacements dans les fonctions de l’offre provoqués par des mesures qui réduisent directement le niveau des prix.

On a utilisé le modèle, tout d’abord, pour calculer les effets qu’aurait une augmentation de 2 milliards de dollars par an de l’excédent commercial des Etats-Unis, étant entendu que la politique commerciale des autres pays ne change pas et qu’il n’y a aucune réaction de leur part. On a ensuite établi une série d’objectifs pour les balances commerciales des autres pays, notamment (en plus de l’objectif américain) un accroissement de 1 milliard de dollars pour le Royaume-Uni, des balances commerciales nécessairement inchangées pour le Canada et les pays de production primaire, et des diminutions des balances de l’Allemagne, de l’Italie et du Japon. Le nombre maximum d’objectifs pouvant être atteints simultanément est inférieur de un au nombre total de pays ou régions identifiés.

Les solutions sont analysées ou comparées par rapport aux chiffres du commerce mondial, la charge de l’ajustement des dépenses revenant aux Etats-Unis, et à l’ajustement des positions des autres pays. L’application d’une politique restreignant directement le niveau des prix, au lieu d’avoir entièrement recours à des réductions de dépenses, peut modifier sensiblement ces résultats. La mesure dans laquelle une solution donnée peut être déflationniste dépend non seulement des objectifs commerciaux mais également du dosage de mesures adoptées dans différents domaines et de la répartition géographique du commerce. Le rôle de cette dernière est particulièrement souligné dans la présente étude. Dans la mesure où les valeurs supposées des élasticités ne constituent que des conjectures raisonnables, les caractéristiques intéressantes des solutions que comporte le modèle sont celles qui traduisent le plus directement les données relatives à la structure du commerce.

El ajuste de las balanzas de intercambios: algunos experimentos con un modelo de intercambio entre muchos países

Resumen

En este trabajo se presenta un análisis de la forma en que podrían ajustarse las balanzas de intercambios con el fin de alcanzar determinados objetivos. Se supone que los ajustes se efectúan actuando sobre la demanda, o bien mediante una actuación sobre la demanda suplemen-tada con restricciones directas sobre el nivel de precios. En este trabajo se explica cómo los movimientos de los gastos y de los precios que conducen a una determinada mejora en la balanza de intercambios de un país ocasionan simultáneamente un deterioro correspondiente en las posiciones de otros países, y la forma en que los diversos tipos de acciones competitivas, defensivas, o cooperativas emprendidas por esos otros países, con respecto a la posición de sus propios intercambios, podría afectar los resultados para cada país y para los intercambios mundiales.

En el modelo aquí presentado, un país que esté tratando de mejorar su balanza de intercambios, normalmente reducirá su gasto en las mercancías que son objeto de intercambio, y la medida de esa reducción dependerá (inter alia) de si los países más importantes con quienes comercia siguen una política competitiva o complementaria. Como la carga que el ajuste del gasto represente para un país cualquiera depende de lo que ocurra al mismo tiempo en los mercados de exportación, hay que determinar plenamente de forma simultánea las variaciones que se produzcan en el gasto. También, en este modelo, un país que trate de mejorar su balanza actuando sobre la demanda, normalmente se beneficiará al tener una mejor posición competitiva tanto en el mercado interno como en el exterior; las variaciones en los precios relativos y en la participación en los mercados tenderán a ser más importantes cuanto menor sea la elasticidad de oferta de las mercancías que son objeto de intercambio. Los efectos de los precios sobre la balanza de intercambios pueden surgir también como consecuencia de desplazamientos en las funciones de oferta, causados por una política que restrinja directamente el nivel de precios.

El modelo se utiliza, en primer lugar, para calcular los efectos de un ajuste al alza por valor de US$2.000 millones al año en el superávit de intercambio de Estados Unidos, suponiendo que en los otros países no se tome ninguna medida de acción o de reacción. Luego se van añadiendo objetivos para las balanzas de otros países, incluyéndose (además del objetivo de Estados Unidos) una mejora de US$1.000 millones para el Reino Unido, el requisito de que las balanzas de Canadá y de los países de producción primaria permanezcan invariables, y reducciones de objetivos en las balanzas de Alemania, Italia y Japón. El número máximo de objetivos que pueden satisfacerse al mismo tiempo es uno menos que el número total de países o áreas identificadas.

Las soluciones se analizan o comparan en términos de los resultados que den para el comercio mundial, para la carga de ajuste del gasto que cae sobre los Estados Unidos, y para los ajustes en las posiciones de los otros países. Si se recurre a una política que restrinja directamente el nivel de precios, en vez de depender totalmente de una política que reduzca el gasto, los resultados pueden quedar alterados sustancialmente. Lo defla-cionista que sea una solución determinada depende, no solamente de los objetivos comerciales, sino también de la combinación de medidas de política y de la configuración geográfica de los intercambios. A este último factor se le atribuye importancia especial en este trabajo. En tanto que los valores supuestos de las elasticidades no sean más que conjeturas razonables, los aspectos interesantes de las soluciones del modelo son los que reflejan más directamente los datos sobre la estructura de los intercambios.

*

Mr. Armington, a graduate of Swarthmore College and the University of California at Berkeley, was an economist in the Current Studies Division of the Research Department of the Fund when this paper was prepared. He has now joined the Balance of Payments Division of the Organization for Economic Cooperation and Development.

1

The trade model illustrated in this paper is part of a study on the methodology of forecasting the effects of changes in exchange rates. As a preliminary step in this longer-range study, the paper shows how the model works in a relatively simple framework in which exchange rates are fixed and in which adjustments in external positions are brought about through policies affecting spending and price levels.

2

Throughout most of this paper it is assumed that national policies affect trade directly through their effects on levels of total spending and indirectly through changes in prices induced by the changes in spending. This assumption is modified in Section V, however, which deals with a case wherein policies directly restrain the price level as well as the level of total spending. In this paper, the term “total spending,” or “total demand,” will refer to a measure of the domestic market for imports and import-competing products taken together. A discussion of this measure will be found in Appendix A.

3

Indeed, B’s competitiveness vis-à-vis all other countries taken together (including A) could actually improve, so that the sum of all price effects on B’s trade balance could be positive (see p. 499). In such a case, B’s price level, while dropping less than A’s, falls markedly relative to price levels in third countries; declines in B’s share of markets where A is a principal supplier (such as market A itself) may be more than offset by increases in B’s share of markets where third countries are the principal suppliers. A concrete measure, applicable in this context, of the change in a country’s competitiveness vis-à-vis all other countries is given in Paul S. Armington, “The Geographic Pattern of Trade and the Effects of Price Changes,” Staff Papers, Vol. XVI (1969), pp. 190–92. The “effects” referred to in the first sentence of this footnote are the partial-equilibrium effects of price changes on demand, holding constant each country’s total spending.

4

Paul S. Armington, “A Many-Country Model of Equilibrating Adjustments in Prices and Spending,” published as the appendix to Rudolf R. Rhomberg, “Possible Approaches to a Model of World Trade and Payments,” Staff Papers, Vol. XVII (1970), pp. 23–26.

5

See ibid., pp. 23 and 24, and the references cited there.

6

More exactly, the maximum number of targets is one less than the number of countries or areas identified, owing to the redundancy of the policy instrument of the nth country. For a recent statement of this problem, see Robert A. Mundell, “The Redundancy Problem and the World Price Level,” in Monetary Problems of the International Economy, ed. by Robert A. Mundell and Alexander K. Swoboda (University of Chicago Press, 1969), pp. 379–82. In the present model, the matrix to be inverted turns out to be singular if every country or area is assumed to have a trade target.

7

In this paper, the term “target-change” (target-increase, target-decrease) will refer to the adjustment in the actual trade balance necessary to reach the desired level of surplus or deficit. The term “target” will refer to this desired level. The United States recorded a trade surplus in the years 1966–68 that averaged about $3½ billion per annum. The surplus declined to about $1½ billion in 1968. The target-increase assumed in Solution I implies a target of about $5½ billion per annum, or a cumulative increase of $6 billion in the surplus for the three years taken together. The model does not indicate how this cumulative increase should be spread among the three years.

8

In this paper, the term “primary producing countries” is used synonymously with “Rest of the World,” a residual group of nations treated in these calculations as if they were a single country. This residual includes the CMEA countries, mainland China, etc., as well as the countries that are usually referred to, for analytical purposes, in the International Monetary Fund’s Annual Report as primary producing.

9

See Armington, “The Geographic Pattern of Trade and the Effects of Price Changes” (cited in footnote 3), pp. 193–94.

10

See Appendix A, pages 512–14.

11

The “other things” are the elasticity of substitution between imports and import-competing products and the price elasticity of demand for merchandise-in-general (that is, imports and import-competing merchandise taken together).

12

Price elasticities in this paper are expressed in volume terms in absolute value, unless otherwise specified.

13

See Table 8, page 514.

14

See Paul S. Armington, “A Theory of Demand for Products Distinguished by Place of Production,” Staff Papers, Vol. XVI (1969), pp. 167–68 and p. 172.

15

See footnote 11, above.

16

In contrast to the assumptions regarding the demand elasticities, for which some support can be found in the econometric and theoretical literature, the assumption of a unitary elasticity of supply of tradable merchandise should be viewed as notional. As indicated in Section I, it seems likely that demand management can affect the price level and in so doing affect trade, and the simplest way to represent this process in the model is to introduce finite supply elasticities. Ruling out infinite supply elasticities, although an important step in itself, admittedly leaves a wide range of options, and all that can be said on behalf of an assumed supply elasticity of 1 is that it falls within a range of values that yields plausible results, judging from different kinds of experiments with the model. In practical applications, the following sort of question should be confronted: If A’s projected output were modified in a certain way as a consequence of the adjustment process under consideration, what would be the associated modification in the projected price level? The present and projected tautness of the economy would probably be taken into account, and different elasticity assumptions for different countries (and for each individual country in different periods) could well be the result. The model provides for this contingency.

17

For further explanation, see Appendix A, pages 514–15.

18

The present use of the terms “price effects” and “expenditure effects” should not be confused with other uses of these terms in the literature on trade models. In this paper, changes in all prices and expenditures are endogenous, and such changes, when substituted into the demand equations of the model, yield what are here called price and expenditure effects. Elsewhere in the literature these terms may refer to the effects of exogenous changes in prices or expenditures on the endogenous variables of a system, taking account of all relevant constraints, including those of supply.

19

The link between total spending and imports derives from the specification of the demand functions; see Armington, appendix to article in Staff Papers (cited in footnote 4), p. 25, equation (1).

20

As noted above, the results of the model represent adjustments relative to actual values in 1966–68; the results presented here do not necessarily imply declines through time. In fact, in most cases considered in this paper, the minus-number results of the model suggest reduced rates of increase in the flows and price variables, rather than actual declines over the period.

21

In particular, the relative contribution of price effects varies directly with the substitution elasticities and inversely with the supply elasticities.

22

This deficiency may be overcome eventually; see Section VI.

23

In less precise but more realistic terms, the U.S. counterinflationary action results in a relatively large reduction in Canada’s rate of inflation.

24

See Table 1, footnote 3.

25

This conclusion is found to hold true under conditions of much more elastic supply than those assumed above.

26

Price changes shown in the first column of Table 2 are here weighted by total exports (from Table 9).

27

This argument is used in a somewhat similar context by Fred Hirsch and Ilse Higgins in their paper, “An Indicator of Effective Exchange Rates” (see pp. 458–59 of this issue).

28

The target-change for the United Kingdom, a total of $3,000 million, would have brought the United Kingdom to a roughly balanced position on trade account for the three-year period as a whole. Again, the allocation of the total change by years or by parts of years is not determined in the model.

29

Mechanically, the trade targets of these countries are taken to be the balances that actually prevailed in the period 1966–68.

30

This reduction, about 7 per cent, is probably unrealistically small, because the adverse feedback effects on the United Kingdom and the United States in Solutions I and II are probably understated. See Appendix A, page 515.

31

The reflection of this decline on the export side is to be found in the generally unfavorable developments in export markets (first column of Table 6). Even export markets of the United States decrease on average, although the United States itself is the main source of deflation in this solution. The only countries whose export markets increase on average are the partners of Germany and Italy in the Common Market, as well as Austria and Switzerland.

32

See Armington, appendix to article in Staff Papers (cited in footnote 4), p. 26, equations (2) and (3). It should not be assumed that a downward shift in a country’s supply, in the above sense, is apt to affect the trade position in the same way as will a devaluation of the currency in the same proportion. Supply shift and devaluation may have essentially similar effects on exports, but they will have quite different effects on imports in dollar value.

33

The model can be solved on the basis of given price policies (i.e., supply shifts) in any number of countries in conjunction with combinations of trade targets.

34

Present elasticity assumptions imply an elasticity of demand for U.S. exports of 0.793 in value terms (absolute value) and a domestic-price cross elasticity of U.S. demand for imports of 0.730. These figures, together with the values of U.S. exports and imports in 1966–68 (Table 9), yield the result of 4.4.

35

The price changes indicated above represent reductions relative to the actual 1966–68 levels and do not imply declines through time. Suppose, for example, that the U.S. price level had actually increased by 1 per cent from year to year over the period 1963–68. In this event, the result given in the text, —3 per cent, would imply approximate price stability, comparing the period 1966–68 with the period 1963–65. Since, by any reasonable measure, the U.S. price level actually increased more rapidly than 1 per cent per annum over most of this period, the result given in the text would only suggest a reduction in the rate of inflation.

36

The breakdown of the totals into price and expenditure effects is bound to be quite sensitive to the assumptions about elasticities. In particular, it can be shown that higher supply elasticities would give the price policy more leverage, reducing the extent to which the domestic market must contract to reach the external target. Just the opposite is true if the sole mechanism of adjustment is demand management: higher supply elasticities would yield smaller price effects, increasing the necessary contraction of the domestic market.

37

In Solution I the change in the volume of world trade was —0.4 per cent (Table 4), and in Solution V, 0.1 per cent.

38

Of course, the results would then refer only to manufactures, or only to chemicals; for example, one would be calculating changes in the balance of trade in chemicals.

39

See Armington, “A Theory of Demand for Products Distinguished by Place of Production” (cited in footnote 14), pp. 162–63.

40

See Appendix A, page 515.

41

See Armington, “A Theory of Demand for Products Distinguished by Place of Production” (cited in footnote 14), p. 167 and p. 175, equation 26.

42

See Armington, appendix to article in Staff Papers (cited in footnote 4), p. 26, equation (5a).

43

Unity minus the diagonal element for Canada in Table 10.

44

The second-round reduction in Canada’s imports reflects only (1) a reduction of $7.5 in domestic absorption of tradable merchandise ($7.5 is the difference between the $25 reduction in spending on tradable merchandise and the $17.5 import “leakage”), which would in turn reduce imports by $1.3, and (2) the effects of second-round reductions in Canada’s exports to the United States and to third countries.

45

The text below presumes a close reading of the appendix by Armington to article in Staff Papers (cited in footnote 4), pp. 24–26.

46

One assumption in particular is needed here, namely, that the elasticity of demand for the good, tradable merchandise, is equal to 1. If this elasticity were not unity, then a country’s spending on tradable merchandise would depend not only on the change in its own price level (operating through its supply function) but also on changes in price levels abroad (operating through its demand functions). If the model as presently programed is run with nonunitary elasticities of demand for tradable merchandise, the trade target set for a country is missed by an amount equal to the change in its spending owing to the change in the world price level of tradable merchandise.

IMF Staff papers: Volume 17 No. 3
Author: International Monetary Fund. Research Dept.