The gains from trade in a small monetary economy

Abstract

In general equilibrium under constant returns to scale and perfect competition the normative theory of international trade is examined for a monetary, not a barter, economy. Persons exhibit flow demand for real balances just as they do for commodities because money provides well-being salient utility insofar as its content is desire fulfilment, satisfaction or usefulness. For such a monetary small open economy, an additional terms-of-trade effect or inflationary effect of a tariff is identified, which drives many unusual results including the sub-optimality of free trade, unless the exchange rate is flexible and the commodities and real balances are weakly separable.

Key words:

• Monetary economy
• international trade
• normative theory
• tariff
• quota
• voluntary export constraint
• exchange rate

Acknowledgements

We are grateful to Murray Kemp and Peter Neary for insightful comments.

Notes

¹ We are grateful to a referee for bringing this important case to our attention.

² We do not focus attention on the gains from trade issues in the context of a large country, nor on the various cases of domestic distortions analyzed in the literature. The interested reader may consult Corden's (1984) recent survey of the normative theory of international trade for these matters. Bhagwati and Srinivasan (1983) is another excellent source. In Neary (1988) and Neary and Ruane (1988) the welfare analysis of tariffs, quotas and voluntary export restraints is extended to economies with internationally mobile factors of production, which is a matter we do not deal with here, although Neary's Le Chatelier results about the greater responsiveness of an equilibrium system's remaining endogenous variables to external shocks will remain true if more and more endogenous factor price are made exogenously determined. We do not deal with this matter here.

³ Most of the work on an open, monetary economy has dealt with the issue of stability of equilibrium (see Hahn, 1959; Amano, 1972; Negishi, 1972; Kemp, 1969; and Takayama, 1972, among others), and the effect of a devaluation on the balance of payments (see also, Kemp, 1970; Pierce, 1961; and Negishi, 1968). Also see Kemp (1982) on the pattern of trade implications of monetary expansion. Negishi (1972), in particular, is most explicit on both the stability and the balance of payments issues. With regard to normative issues, Blejer and Hillman (1982) and Daniel et al. (1985) have investigated the non-equivalence of tariffs and quotas in a monetary economy.

⁴ This section arose from the comments by Peter Neary.

⁵ This Section arose from the comments by a referee of this journal.

⁶ A single period model positing a real balance effect in the utility function, can be viewed as a surrogate for a two-period model in which utility depends only on consumption, or as a steady state of a fully dynamic model. In the one-period set up, real balances enter the utility function as a proxy for second period consumption, and money balances are held in equilibrium, to be exchanged for consumption goods in the second period.

⁷ Sometimes p ₁ and p ₂ are also referred to as nominal prices.

⁸ The implications of a flexible exchange rate are considered in the fifth section.

⁹ On this see Neary (1988).

¹⁰ See Neary (1988).

¹¹ With the quantity theory of money equation added to the model, we recover all of the results for a fixed exchange rate economy stated below, even if domestic money supply changes are permitted.

¹² Contrast this with Neary (1988, p. 722), who states that in a barter economy, ‘the introduction of a small tariff when the initial situation is one of free trade has no first-order effect on welfare.’

¹³ See Samuelson and Sato (1984) and Dusansky (1989) for a further elaboration of this point, and on the recoverability of the Slutsky – Hicks properties.

¹⁴ For further details regarding the issue of stability in a Walrasian general equilibrium model, see Arrow and Hurwicz (1958) and Hahn (1958).

¹⁵ Notice that an export tax, since it reduces p ₁, definitely causes the under production of the exportable good compared to the free trade level. We cannot, however, say that it causes an over consumption of this good because, in general,dc ₁/d₁><0 irrespective of the non-inferiority or otherwise of good 1. What we can say is that by appeal to the stability argument.

¹⁶ It is useful to contrast the effects in equations (14a) and (14b) with those in a barter economy. First of all, in a barter economy the terms of trade effects are absent. Second, from the barter economy balance of trade constraint we have dE ₁ = dI ₂ by setting . Hence for equal values of t ₂ and e ₁ we have dy/dt ₂ = dy/de ₁, or that an export tax and a tariff are equivalent.

¹⁷ That this distinction matters operationally can be seen by examining the relationship between M/P and P, In the short run, M/P depends on P; in the long run, M/P is independent of P.

¹⁸ The weakly separable nature of the utility function (1a) ensures that the marginal rate of substitution between commodities is independent of real balances. Further, this separability implies that the price index P = φ(p ₁, p ₂), which is also the true cost-of-living index, is really the unit expenditure function dual to the utility function (1a).

¹⁹ This Section was provoked by a comment by a referee of this journal.