University of Southern California Dissertations and Theses

Balance of trade, economic activity and public policy

(USC Thesis Other)

Balance of trade, economic activity and public policy

PDF

Download

Open document

Flip pages

Download a page range

Download transcript

Copy asset link

Request this asset

Transcript (if available)

Content BALANCE OF TRADE, ECONOMIC ACTIVITY AND PUBLIC POLICY by Alaa Eldin Abou-Alam A Dissertation Presented to the FACULTY OF THE GRADUATE SCHOOL UNIVERSITY OF SOUTHERN CALIFORNIA In Partial Fulfillment of the Requirements for the Degree of DOCTOR OF PHILOSOPHY (Business Administration) August, 1982 UMI Number: DP22586 All rights reserved INFORMATION TO ALL USERS The quality of this reproduction is dependent upon the quality of the copy submitted. In the unlikely event that the author did not send a com plete manuscript and there are missing pages, th ese will be noted. Also, if material had to be removed, a note will indicate the deletion. Published by ProQ uest LLC (2014). Copyright in the Dissertation held by the Author. GHssettstfon Publishing UMI DP22586 Microform Edition © ProQ uest LLC. All rights reserved. This work is protected against unauthorized copying under Title 17, United S tates Code ProQ uest LLC. 789 East Eisenhower Parkway P.O. Box 1346 Ann Arbor, Ml 4 8 1 0 6 -1 3 4 6 UNIVERSITY O F S O U T H E R N CA LIFO RN IA TH E GRADUATE SC H O O L U N IV ERSITY PARK LO S A N G ELES. C A LIFO R N IA 9 0 0 0 7 ‘ Q7. This dissertation, written by Alaa Eldin Abou-Alam ftV under the direction of h..is... Dissertation C om mittee, and approved by all its members, has been presented to and accepted by The Graduate School, in partial fulfillment of requirements of the degree of D O C T O R O F P H I L O S O P H Y Dean D a te Septemher.17.,.. 1.982 . . . DISSERTATION COMMITTEE \atrman ACKNOWLEDGEMENTS I wish to express my appreciation and gratitude for their ideas, advice, time and help to.all members of my guidance and dissertation committees, Professor Victor A. Canto, Professor Richard V. Eastin, Professor Terence C. Langetieg, Professor Arthur B. Laffer and Professor Arvid Pardo. I am particularly thankful to Professor Arthur B. Laffer for his valuable contributions, academically and intellectually, Professor A. Canto for his patience to get down to the nitty gritty, and Professor Dennis R. Cappoza for his support during the early stages of my graduate program. I am thankful to my friends at the University of Southern California who shared with me the worries which accompany graduate study, my personal friends in the United States and Egypt, and my brothers, sisters, nephews and nieces for their perpetual correspondence and encouragement. Finally, I wish to thank Helen Fairweather for typing the manuscript. ii TABLE OF CONTENTS ■ Page ACKNOWLEDGEMENTS...................... ............. ii LIST OF TABLES..................... iv LIST OF ILLUSTRATIONS.......... V CHAPTER I. INTRODUCTION Determinants of the Trade Balance in an Integrated World Economy........ 1 Theoretical Approaches to the Balance of Trade....................... 4 The Elasticities Approach.........• ••• 5 The Absorption Approach............... 12 The Monetary Approach-;............... 19 II. THE MODEL The Framework of Analysis................ 23 Implication and Explanation......... 25 Developing the Behavioral Equations..... 26 The Effects of Public Policy........ . 29 Effects of the Tax Policy............. 31 Effects of Government Consumption 32 How the Private Sector Valuation of Government Consumption Affects the Levels of Income and Demand... 33 Developing the Model..................... 35 III. TESTING THE MODEL The Testing Techniques................... 39 Data Sources and Description........... 41 Statistical Properties of the Data.... 42 Empirical Results.......... 46 The Balance of Trade: Plot of Actual and Fitted Data........... 52 Further Testing................. 59 FOOTNOTES.............. 61 BIBLIOGRAPHY........................................ 65 LIST OF TABLES Table Page 1. Statistical Properties of the Data........... 44 ' 2. Single Equation Estimates of Twelve Major Industrial Countries of the World....-..... 48 3. Seemingly Unrelated Regression of Nine European Countries of the Largest Output.... 50 4. Seemingly Unrelated Regression of Nine Countries of the Largest National Output.... 51 5. Seemingly Unrelated Regression of Twelve Major Industrial Countries of the World 60 iv LIST OF ILLUSTRATIONS Page 1. Change in the Trade Balance to GNP 1965-1979 for Australia and Austria.......... 53 2. Change in the Trade Balance to GNP 1965-1979 for Denmark and Germany........................ 54 3. Change in the Trade Balance to GNP 1965-1979 for Holland and Italy.......................... 55 4. Change in the Trade Balance to GNP 1965-1979 for Japan and Spain............................. 56 5. Change in the Trade Balance to GNP 1965-1979 for Sweden and Switzerland................. 57 6. Change in the Trade Balance to GNP 1965-1979 for the United Kingdom and the................. 58 United States v DEDICATION This Dissertation is dedicated to the memory of my parents vi CHAPTER I INTRODUCTION Determinants of the Trade Balance in an Integrated World Economy International trade literature has been concerned with determining different factors affecting volume, type and direction of goods and services among countries. In theorizing about such issues we formularize a model presumably logical, coherent and sound. What counts most are empirical interpretations of results when the model is to be confronted by observation. This forethought will form the scope of work of the dissertation. The purpose is to build, a model capable of explaining the changes in the trade balance of a country. The model will be based on the pure theory of international trade, incorporating relevant macro- economic arguments, and within the framework of the absorption approach to the balance of trade. 1 Unlike the traditional barter models of international trade,^ this is not only a supply model, but also a general equilibrium one. The model is developed in a world of two goods and two factors of production. One good and one factor can move costlessly among countries of the world, while the other good and factor of production are immobile. Technology used in producing the goods does not differ from one country to another. Tastes and preferences are identical everywhere as well. These conditions are sufficient to establish 2 factor price equalization. However, the introduction of policy actions of various countries may lead to a different, result. For example, because of levying taxes on factors of production, not at the same rate in all countries, there will be.different before- and after-tax returns to these factors. Such returns will not necessarily be equalized. Nevertheless it is these very government measures that affect the flow of trade among nations. Policy actions within a country affect the supply of factors in the market place, and consequently affect the levels of' production, consumption, and 3 trade. For instance, an increase m marginal tax rates on wages of labor should reduce the supply of labor to the market, since the incentive to engage in market production is reduced. Because both the traded good and capital move costlessly among countries, in equilibrium, worldwide, there is one price for the traded good and an equilibrated after-tax return on capital. Changes in public policy actions will lead, to a new worldwide equilibrium, where supply and demand of any of the 4 factors of production or goods are equal. However, there might be a new price for the market good and new set Of returns to factors of production. These ideas form the core of the suggested model. The first part is concerned with the literature review, where the major approaches to the balance -of trade will be presented. While summarizing the fundamental theoretical notions underlying the various approaches, contrasting different related concepts is being considered for the purpose of explanation, each approach will be supplemented by a detailed model. Results of empirical testing will be drawn upon to clarify the validity of the models. Developing the model will start with laying down the underlying assumptions. Implications of the general framework and the underlying assumptions will be discussed. Behavioral relationships will be formulated. Equations representing the various constraints will be developed. By having the system of equations, it is possible to express the changes in the balance of trade in terms of three independent variables which represent differential terms of growth rate, government consumption, and taxes. The final equation will be subjected to testing. The testing techniques and the data will be described. Empirical results will be presented. Theoretical Approaches to, the Balance of Trade Since this study is concerned with the movements of goods and services among countries of the world, attention will be directed to the different theoretical approaches to the balance of trade. The expression of the trade balance one adopts affects the theoretical frame of the analysis. Therefore, we expect to have different theoretical approaches to the trade balance, where each is based on a particular representation. However, sometimes a combination of more than one approach is used to formulate the trade balance representation. Traditionally, the trade balance is based on one of three approaches; the elasticities approach, the 5 absorption approach, or the monetary approach. The Elasticities Approach to the Balance of Trade The elasticities approach was the first of a series of approaches adopted by economists in search of an explanation to the changes in trade balances of different countries. The standard elasticities model assumes that all goods are traded and can be divided g into export or import goods. Consequently, the trade balance of a country is expressed as: TB = X - M Where X and M are the country’s levels of exports and imports, respectively. The above expression forms the starting point for developing models based on this approach. Models differ on how to express X, the level of exports, and M, the level of imports, in terms of exogenous variables. Basically, in most of the models, X and M are expressed as functions of levels of national income and prices. Consequently, these functions are to be estimated with the primary purpose of driving estimates of the price elasticities in order to test whether the Marshall-Lerner condition for improvement of the trade balance following devaluation is met. 5 An exhaustive survey of most of the relevant literature has been presented by Magee (1975). Nevertheless, presenting a model in detail will help explain the addressed issue of the elasticities approach. Houthakker and Magee (1969) estimate demand elasticities for both imports and exports with respect to income and price for a number of .countries. Each of total imports and exports is expressed in a simple double logarithmic equation as a function of income and price. The import equation used is of the form: log Mi = AQ + Ax log Y + A2 log (PM/WPI) where M is the country1s.imports of merchandise during one year in constant dollars, Y is an index of the country's national product, PM is a price index; A^, A2 are the elasticities with respect to income and price respectively. The export equation used is of the form: log X± = Bq + log YW + B2(PX/PXW) where X is the country's exports of merchandise to all countries during one year, YW is an index of Gross National product for 26 importing countries, PX is an index of export prices of 26 other exporting countries. 6 The ordinary least-squares method was used to estimate the above equations for a number of countries. The regression coefficients of income are invariably significant. The price variables do not perform nearly as well, with many insignificant estimates. This poor performance may be due to the inadequacies of import and export indexes. However, for a number of countries the sum of the import and export price elasticities appears to be greater than one in absolute terms, as required to satisfy the Marshall-Lerner condition for successful devaluation. The elasticities approach has been criticized from both vantages: The theoretical and the empirical. Orcutt (1950) presents a five-reason list explaining why empirically estimated import price elasticities might be lower than the actual 7 elastxcxties. The most serxous outstandxng problem xs the aggregation one. Houthakker and Magee (1969) in an attempt to solve this problem have estimated elasticities of imports and exports by commodity class. The most significant theoretical problem of the standard elasticities model is its partial equilibrium approach, ignoring the interaction of trade with securities and money markets. Historically, much of the analysis of the effects of devaluations is carried out within the framework of the elasticities approach. Conceivably, devaluation will increase the cost of' the initial volume of imports, resulting in diverting domestic expenditure, from abroad partially, and supposedly this adverse switch will not be offset by a complete substitution of domestic for foreign goods at home. Also, it is implicitly assumed that there exist unemployed resources that could be used to produce additional goods needed to satisfy the favorable effects of devaluation. The elasticities model proved to be inadequate especially in the post-World War II era. Connolly and Taylor (1976) treat the theoretical problems of the standard elasticities approach by analyzing the dynamics of adjustment to devaluation in a framework which stresses the role played by nontraded goods and money. The analysis provides specific solutions for the time path of the balance of payments and the price of nontraded goods following devaluations. Laffer (1973) questions, on both theoretical and empirical grounds, the conventional presumption underlying the favorable effect of a devaluation on the trade balance of the devaluing country. There is an opposition to the notion that changes in exchange rates per se affect the trade balance. Four conditions if, and only if, each of which is developed, will result in an improved trade balance due to a devaluation. The meaning of each condition is explored in terms of a general equilibrium model of market goods. The four conditions for devaluation to lead .to an improvement in the. trade balance are broadly stated as follows: A. The terms of trade must change and not just the exchange rate B. The combined effect of demand responses in the import markets of the devaluing and revaluing areas must dominate the combined effect of demand responses in the export markets C. Effects of devaluation on demand for exportables must dominate supply effects. D. The increase in exports plus the reduction in imports must be sufficiently large to offset the effects of the rise in domestic prices generally and the shift in the terms of trade. This requirement corresponds to the Marshall-Lerner condition. 9 It seems to be Implausible that these four conditions will be satisfied in practice. A great deal of information is required to predict the equilibrium result of a devaluation. Based on a rigorous theoretical analysis it is concluded that it is impossible to determine whether trade balances should improve, worsen, or even change at all after devaluation. In order to study the equilibrium result of devaluations, some 15 separate three-year episodes on either side of devaluation are examined and three cases of revaluation have been assembled for examination. The overall picture provided by these episodes gives little or no evidence to support the view that a country's trade balance is any more likely to improve than deteriorate after the country devalues its currency. Salant (1974) uses the same general methodology as Laffer (1973) , but with two differences: (1) He expresses the trade balances in dollars instead of local currencies; (2) He examines the behavior of the overall balance of payments for a larger sample of countries both before and after adjustments in exchange rates. Regarding the first point, Salant finds that eight devaluations, rather than the six found by Laffer, were associated with subsequent improvements in the trade 10 balance. Salant also found an improvement in the overall balance of’ payments for thirteen of the fifteen countries following, a devaluation. Miles (1978) discusses theories of devaluation and empirical studies of the effects of devaluation as well. Although these studies are few in number and limited in scope, nevertheless, they do provide preliminary indications as to which of the theories discussed are more empirically correct. In general, the empirical results on the effects of devaluation are mixed. Results are based on a procedure where the levels of the trade balance and/or the balance of payments from a few years prior to devaluation are-compared to the levels until a few years after. The main drawback of such a procedure is that it refers all changes in the levels of the accounts following devaluation only to devaluation. Never theless, the level of the balance of payments accounts can be affected by. government policies as well as by nongovernment factors. However, the implications of empirical studies is that there is considerably more evidence of the balance of payments improvement 0 following devaluation than the trade balance. 11 The Absorption Approach to the Balance of Trade It has always been possible to examine a phenomenon from different perspectives. The absorption approach is not more than a treatise other than the elasticities approach to the balance of trade. The. main difference between the two approaches stems from the way we express the trade balance in each case. The essence of the absorption approach is to view the trade balance as a relation between aggregate output and expenditure (absorption) of the economy. Basically, the balance of trade of any country is expressed as follows: TB = X - M where X and M are the values of exports and imports respectively. The aggregate national output and expenditure can be expressed respectively as follows: Y = X + Cd + Id + G Y = S + C E = M + C d +Id +G E = S + I consequently, the trade balance can be expressed as follows: 12 TB = X - M (1) TB = S - I (2) TB = Y - E {3) where = the domestic consumption out of national production ' I = the domestic investment out of national d production C = total national consumption I = total national investment S = total national savings. The above three expressions are basically the same. The first, which is adopted by the elasticities approach, expresses the trade balance as the excess of exports over imports. The second expresses the trade balance as the excess of national investments over national savings. The third, which is adopted by the absorption approach, expresses the trade balance as the 9 excess of national output over national consumption. The absorption approach to the balance of trade has emerged in the post-World War II era as an alternative to the elasticities approach due to the inability of the latter to fully explain problems related to the balance of trade. The development of the absorption approach is to be found in works of Alexander (1952), Meade (1951) among others.According to 13 Johnson (1976) the absorption approach focuses on two aspects: It presents the problems of adjustment in a way which highlights their policy implications and it accommodates for full employment and inflation. In general, policies to bring about changes in the current account can be classified into measures directed toward increasing output and measures aimed at reducing expenditure. Nevertheless, income and absorption are interdependent. Any changes in either income or expenditure will initiate changes in both of them. However, so long as the total increase in output is not offset by the change in the aggregate absorption, the balance on the current account will improve. Efforts have been exerted, to reconcile the elasticity and the absorption approaches. Alexander (1959) uses a synthesis of both approaches to analyze the effects of devaluation. Laffer (1969) uses the absorption approach to finally express the trade balance in terms of growth rates differential. Laffer's model includes an export function, an expenditure function and an import function. The export function of country i is represented by: 14 where X = the level of exports Y = the level of output or income x = the marginal propensity to export x and b are assumed constant. The expenditure function of country (i) is Ei - a i + Ci-Yi + ei-iY± (2) where E = the level of expenditure d,c,e, are constants AY = the change in output or income The expenditure function is of a basic Keynesian form, including a change in income term. The term e. aY relates expenditure to wealth rather than income. The import function is derived by substituting (1) and (2) into the absorption relationship TB± = X± - Mi = Y± - E± (3) This yields M. = X. + E. - Y. x I X x M. = (b. + d.) + (X. + C. - 1) Y. + e. AY. X XX XX X X X Then two additional factors have been accounted for. Firstly, the relative size of the country, which is handled through the export function as follows: X. = b. + X..Y. + v..P. (4) x x x x x x where P^ is defined as Y. P, = ---— (5) £ Y. x 15 or the proportion of the world's income represented by- country i. v^ is a constant whose value is assumed to be less than zero. If the country represents the whole world, then P/ = 1 and there are no exports. Solving for v. x Vi =■ -b± - Xi.Y. (6) substituting back in (4) X± - (1—P.).bi ■+ (l-Pit.Xi.Yi (7) which is the final form of the export function. Secondly, the real rate of interest is incorporated through the expenditure function E. = c..Y. + e.. AY. + h..r (8) x x 1 x x x where r is the real rate of interest and h. is assumed x constant and negative. For the world as a whole, output is equal to expenditure n n E Ei - EY± = 0 (9) Substituting (8) into (9) yields a world budget constraint and if all countries are assumed to have the same values of constants, we get r = Z-CZ - eg Z (10) where Z = Y./h. and g = EY./ EY. x x ^w x x Substituting (10) into (8) we get E. = Y. + e.(AY. - Y.g ) (11) x x x x^w • 16 The final import function can be derived by substituting the final export function (7) and expenditure equation (11) into the absorption relationship (3) M. = (l-P.).b: + (1-P.) .X. .Y. + e. (ay. - Y. . g ) 1 x i x x x x x Subtracting imports from exports yields the trade balance. TB± = (1-Pi).bi + (l-Pi).Xi.Yi (12) - Cl-Pi).bi - (l-Pi).Xi.Yi - e(AY. - Y.gJ TB. __i = -e(gi - gw) (13) where g. = Ay ./Y. yx x x Laffer (1976.) carried out empirical tests in conjunction with a developed theoretical model similar to that of equation (13) with one modification. The only difference is that the numerator on the left hand side of the equation is replaced by the changes in the trade balance. Hence, we get d TB. (14) yT^ “ -e< *9± - gw> Four economic regions were selected to test equation 14. The United States, Canada, Japan, and the European Economic Community. 17 All tests were based on annual data for the period of 1961-1974. The results conform quite closely to the hypothesized relationship in the model. The results support the existence of such relationships in the four economic regions. Although Laffer's tests used the growth rate differential of a country versus the rest of the world as the only independent variable to explain the variations in the trade balance differential versus the output of a country, Miles (1978) added other factors as independent variables to the same hypothesized model. Miles' model is expressed in the form A(TB/Y)i = aQ + a± A(g±-gR)•+ a2 A(M±-MR) + a3 A <G.-GR> where TB^ = level of the trade balance in country i = level of output in country i g.,gp = growth rates in country i and rest of 1 the world M.,MR = ratio of average level of high-powered money to output in country i and rest of the world. G.,Gr = ratio of government consumption to output a ,a,,a„,a, are constants o 1 2 3 The equation is tested for thirteen countries. 18 The data are annual observations. Statistical tests showed that the growth rate variable has a negative sign and is significant in six .countries. The monetary and government consumption variables are each negative and significant in only two countries. The results of the trade balance equation estimations are consistent with changes in the growth rate differential having a significant and negative effect on the trade balance. The Monetary Approach to the Trade Balance The recent adoption of the monetary approach to the balance of trade came into existence as a result of the revival of the monetary approach to the balance of payments which had been historically the traditional 11 approach based on international monetary theory. A departure from that approach was occasioned by the international monetary collapse of the 1930s. The monetary approach to the balance of payments focuses on the determinants of the excess domestic flow demand for or supply of money. The balance of payments can be expressed as: BoP = A Md - A MS where AMd = the change in the money demand of a particular country g AM = the change m the money supply of the same country 19 The use of the budget constraint enables us to analyze the money account in terms of the current account and the capital account. The monetary approach to the balance of trade is based on the notion that the surplus or deficit in the current account measures the extent to which■the economy is accumulating claims on future income from abroad and vice versa. The accumulation of foreign assets is equally represented by the sum of the balances on the capital account and the money account. This approach is of general equilibrium nature. Correcting a deficit in the current account is related to all operations of the economy rather than treating it as one sector of the economy in isolation. The monetary approach has been used in analyzing the balance of payments more extensively than in addressing the trade balance problems. Frenkel and Johnson (1976) cover theoretical and empirical literature relevant to the monetary approach to the balance of payments. Literature pertaining to the monetary approach to the balance of trade as such is very limited. Nevertheless, the flow of goods has been analyzed within the context of the monetary approach to currency 12 devaluation. 20 Craig (1981) uses an absorption-monetary approach to develop a model of the balance of trade. He begins by writing the trade balance as an absorption identity B = Y - C 1 where Y and C are levels of output and consumption, respectively The level of consumption is expressed as: C = YP + Yj(M/P - Md/P) 2 where C is real consumption, Yp is real permanent income, M is the money supply, Md is the demand for money, P is the price level, Y-l is analogous to an interest rate. Where the time subscripts are omitted. By specifying a simple money demand equation as Md/P = Y + 6xi a^O, Bi<0 3 Where i is the relevant interest rate. Substituting equations 2 and 3 into equation 1 yields the final testable form: B = 6(Y - YP) - Yi(MS/P) + (y 1a1) Y + (y^ U 4 A data set of annual observations for the eleven major industrial countries, excluding the United states, over the period 1953-1970 was used to estimate equation 4. 21 The empirical results corroborate ' the theoretical model. The ordinary least squares (OLS) results are characterized for the most part . by a negative coefficient between zero and unity on the real money supply, a positive coefficient on real income, and a negative coefficient on interest rate, as expected a priori. The money coefficients for seven countries are significant. For ten countries the transitory income variable is negatively significant, contrary to prior expectations. Some difficulty was experienced in estimating the interest rate coefficients. For nine countries the interest rate coefficients are insignificant. An important implication of the foregoing study is that there is a "natural" trade balance, measured by the constant terms, • most of which are significantly different from zero, around which the current trade balance varies. 22 CHAPTER II THE MODEL The Framework of Analysis The developed model is concerned with arguments related to the goods and services balances among nations, apart from any other international transactions. Such balance which is equivalent to the balance on the current account of the balance of payments, excluding transfer payments, will be denoted as the balance of trade hereafter. The model explains the changes in the trade balance of a country versus the rest of the world in an integrated economy context. That is in contrast to a conventional view where the world is viewed as a composite of loosely connected closed economies. The concept of a system of world markets or the integrated world economy is one of the major cornerstones of the classical and neo-classical schools of economics. The basic notion is that there is no isolation of any country's factors of production or 23 products and the rest of the world's. Consequences of the adoption of the integrated economy approach will be explained whenever appropriate. The underlying assumptions of the model are: ° There are only two factors of production in the world; namely, capital and labor. Capital is free to move costlessly across the boundaries of all countries, where the labor factor faces a prohibitive barrier. ° All countries have access to the same 13 technology. . The production function is identical everywhere. ° Only two kinds of goods are produced in the world; a market good which can move among all countries at no cost and does not face any barriers' and a nonmarket good which is produced and consumed in the home country. ° Market and nonmarket goods are imperfect substitutes in both supply and demand. ° Individuals of a given country have the same preference toward the consumption of market and nonmarket goods. ° Perfect competition is the feature of the market structure. 24 ° The market good is the numeraire in our model. All values are measured in terms of the market good. Implication and Explanation Based on the assumptions underlying the model and since we have one identical market good, and in the absence of transportation costs, arbitrage will assure that "The law of one price holds." The market good will have one worldwide price. By the same token, international arbitrage will bring about an equality to the rate of return to capital. In equilibrium, the world supply of, and demand for, the market good will be equal and the one worldwide price for the market good prevails. Divergencies between each country's expenditure and income act as a stimulus to the conditions of trade. The increase in demand and/or supply for the market good in one country, the diminished supply and/or demand in others, would be sufficient to necessitate a change in the general equilibrium condition. Such a disturbance will trigger an adjustment process, which is featured by the movements of the market good from countries of increase in excess supply over demand to countries of 25 increase in excess demand over supply. The adjustment process will lead us to a new worldwide price for the market good which is not necessarily equal to the pre-change one. The same analysis applies to the capital market. A new equilibrium condition might lead to another worldwide cost of capital. Developing the Behavioral Equations The market output within each country is produced with a similar linear, homogenous twice differential production function of two indispensable inputs — labor and capital. In any country the per capita level of market output, Y^, can be expressed as a function of capital and labor, respectively. Y± = F (K,L) 14 which can be written as Y. = L.F(K/L) l l where L. is the level of labor services supplied to the 1 market sector. A property of the above-mentioned production function is that a given wage-rental ratio (W/r) is associated with a given capital-labor ratio (K/L). There is a positive relationship between the wage-rental ratio and the capital-labor ratio; when capital is cheaper, relative to labor, firms will employ more capital per worker and vice versa. 26 Hence, the per capita level of market output can be expressed as: 15 Y. = L.f(w/r). x x x (1) Labor services can be employed in the production of market good or the household .commodity, the nonmarket production function of two indispensable inputs, namely labor and the market good, respectively. Z = g(L,X) where L,X are levels of labor services and the amount . of market good supplied to nonmarket production, respectively. The choice by an individual between the two activities, market (L ) and nonmarket (L ) is m n determined, in part, by the level of his disposable income (Y^) , the opportunity cost of market employment (W*) , the after-tax wage rate, and the after-tax return to capital (r*). In any country the per capita nonmarket services can be expressed as: The labor services demanded by the market sector (L ) is expressed as a function of the market output and the gross of tax wage-rental ratio. good. 16 The nonmarket good (Z) is produced with a ('+) (-) (-) L = L (Y. , (W/r) . ) m x' x (+) (-) 27 The total of labor services employed by both sectors, market and nonmarket, is subject to the total available time (T) . In equilibrium, the total labor services supplied to both activities is equal to the total available time. L + L = T (2) m. n. 1 1 Equation (2) describes the full employment condition of labor in a given, country. It should be noticed that an increase in the 'personal income (Y^) will lead to an increase in the labor services supplied to the nonmarket activity. This is due to the income effect. Conversely, increases in the after-tax wage rate will roll back labor services rendered to the nonmarket activity. This is due to the substitution effect. Since the rental rate represents compensation from foregoing current consumption in favor of future consumption, an increase in the after-tax cost of capital will increase the labor services supplied to the market activity.^ The labor services employed in the market are positively related to the market output. However, such services are negatively related to increases in the before-tax wage-rental ratio. If the wage rental ratio increases, producers tend to employ more capital. 28 The world supply of capital (K) is completely inelastic in the short-run. The demand for capital in any country (K^) is expressed as a function of market output and the before-tax wage-rental ratio. Ki = K(Y., (W/r)i) (3) The demand for capital varies positively with the level of market output and the before-tax wage-rental ratio. As the gross of tax wage-rental ratio rises, producers will tend to use more capital. The trade balance of a country can be expressed as the difference between the market production (Y^) and the aggregate demand (AD..) of the country for the market good. TB. = Y. - AD. (4) l 1 x On a country level market production may be different from the aggregate demand which will result in a surplus or a deficit. However, in an integrated global economy the world trade balance will always be zero. The Effects of Public Policy The concern will be limited to two public policy issues — taxes and government consumption. In the absence of any government economic intervention, economies of individual countries are expected to run in 29 a similar way. In an integrated world economy with mobile market goods and capital as .well and without government intervention, factor price equalization will 18 be realized. The capital rental rate should be equalizied across countries. Also, there will be one global wage rate. The price of the market good should be the same everywhere. Hence, differences ■ in performances among individual economies can be attributed to government economic intervention. Government policies affect the economic activities through two channels: (1) altering after-tax returns to factors of production, and (2) changing the level of national disposable incomes. These policies do produce substitution and income effects in the economyi The substitution effect is related to changes in after-tax wage rates of the immobile factor. The income effect is the resultant of both effects, taxation and government consumption. The quantity of labor supplied in the market is sensitive to both effects, hence the market output will be altered. Total expenditure will be affected as well. The balance of trade may change due to the variations in output and demand. 30 Effects of the Tax Policy Governments may levy taxes on wage or return to capital such that the after-tax wage rate and cost of capital in.any country become W* = W.(1-t, ) 1 i 1. x r! - ri(1 - •*.> X where W£'ri are t^ ie before-tax wage rate and cost of capital, respectively and t^ , t^ are rates of taxes imposed on the returns to labor and capital, respectively. Unless the tax rates across the countries are equal for each of the returns on capital and to labor, factor price equalization will not hold true, even in an 19 xntegrated world economy. Under the prevailxng differences in the tax rates among countries, neither the before-tax nor the after-tax returns to labor will be equalized . across countries. In addition, the before-tax cost of capital may vary from one country to another. Nevertheless, the capital mobility will assure that the after-tax cost of capital will be equalized across the countries. However, the before-tax returns and the tax rates on capital may vary from one country to another. Examining the set . of equations which 31 describe the economy will lead to the following conclusion: By levying taxes we cause the capital-labor ratio, level of income, and consumption to differ among the countries of the world. This will result in asymmetrical economic activities in the world nations. Effects of Government Consumption In any country it is possible for the goveifnment consumption to affect the levels of income, expenditure, and consequently the trade balance. It is assumed that government consumption is financed by neutral taxes. It is expected that every additional dollar of government expenditure raises measured aggregate expenditure by one dollar. Meanwhile, private sector purchases fall by one 20 dollar. This can be described as crowding out, which can be explained as follows: If the government provides free lunches for everyone, individuals will cease buying their own lunches. The government replaces the private sector as a purchaser of lunches. In fact, this effect depends on the value of lunches to the private sector. If the government buys lunches of spinach and Spam, many people will simply discard the government lunches and buy their own. However, if the lunches are steak, potatoes, and ice cream, most individuals replace their 32 21 lunches with the government ones. The reduction in private expenditures depends on (G), the government consumption, and (Y), the value to the private sector of government expenditure as a percentage Of its cost. If lunches are steak, potatoes, and ice cream, (Y) is close to, equal to, or even greater than one. If lunches are spinach and Spam, (Y) is very close to zero. How the Private Sector Valuation of the Government Consumption Affects, the Levels of Income and Demand The measure of disposable income utilized assumes that in addition to the after-tax income, people include the value of government consumption. Thus, Y, = Y. + G. - TX. (5) d . 1 1 1 l where TX^ per capita tax payment. The economy1s aggregate demand for goods and services is influenced by government actions, disposable income anc^ factor rewards (after-tax wage and interest rate). In any country the per capita aggregate demand is expressed as: AD± = D±(Yd , W|, r*) + (1 -Y)G± ( + ) ( + ) (-) 33 where D. = denotes the private sector's desired expenditure level, which differs from actual purchases by the valuation of the government consumption G^. Changes in the private sector's demand is positively related to changes in the disposable income and the after-tax wage rate, but negatively related to changes in net of tax cost of capital. If the disposable income and/or the after-tax wage rate increase, individual level of current consumption will rise. On the other hand, if the after-tax cost of capital rises, individuals will be willing to forego current expenditure for future consumption. The effect on the aggregate demand of an increase in the government consumption depends on the value of (Y). If (Y) is less than one, then a positive relationship to be established between aggregate demand and government expenditure. If ( y ) is zero, government expenditure will not affect aggregate demand. But if (Y) is greater than one, then increases in government expenditure will affect the aggregate demand adversely. Thus, the balance of trade of any country can be expressed as: TB± = Y±(w/r), - D±(Yd , W* , r*) - (1 - Y)G± (6) ( + ) ( + ) (-) 34 In summary, the transition from a world equilibrium position to another is the outcome of the intervention of governments in the form of fluctuations in tax rates and/or alterations in the level of government expenditure. Where a new equilibrium position does not necessarily have the same set of values of the parameters as the previous one. On the country level, there might be changes in the before and after tax wage rates and/or before tax interest rate. On the global level, there might be a new world price for the market good and/or another after tax cost of capital. A new equilibrium position, if different .from its predecessor, leads to changes in levels of country's output and demand which will result in new levels of trade balances. Where trade balances of some countries will deteriorate, and some other trade balances will show improvement. The whole process is a zero-sum game, where the global trade balance will always remain zero. Developing the Model What has been explained so far is the relationships among all the factors related to the balance of trade. A set of equations have been 35 developed to describe the interrelationship binding various variables with due consideration to the underlying assumptions and constraints. The concern is to develop a model to explain the variations in the balance of trade of a country. The aim is to explain such variations by using independent variables where each is expressed as the relative performance of an economic variable of a country to the world's average. The system of equations is represented by equations (2) , (3), (6). From equation (6) , in any country a change in the trade balance can be expressed as the difference between the changes in the market output and the aggregate demand. dTB. = dY. - dAD. (7) i l l In equilibrium the world trade balance is zero. 0 = Y - AD (8) w w Equation (8) can be written in a difference form 0= dY - dAD (9) w w where Yw and ADw are the world's per capita output and aggregate demand, respectively. By subtracting equation (9) from equation (7), meanwhile expanding the aggregate demand term, we get: 36 dTB. = (1- l •si > + [ (l-¥) 3D 3Yd (dw* - dw*) 3w* 1 w (1-Y)] (dG.-dG ) X w (10) Expressing equation (2) in a difference form and substituting in equation (10) to eliminate the wage rate term, we get the final form: dTB. = x . r-_. . 3L 3L 3L 3L + tf* ‘ W2 + + + ( 1 - <«±-a V r , n 3L 3L 3L - - 3y! + 3^)-(|f-(l-¥) + (l-Y))](dGr aGw) a a 3L 3L 3L 3L + O ' W 2 + <Twi-Tw„> - W 2 (Tri-Tr„» > i . <11 > where in any country / unit of time Twi is per capita tax on wages Tr. X is per capita tax on capital in the world / unit of ■ time Tw w is per capita tax on wages (average) Tr w is per capita tax on capital (average) 37* CHAPTER III TESTING THE MODEL First of all the model will be presented in a testable form- where it is possible to apply necessary techniques. Different suggested approaches to test the model will be reviewed. Sources-and descriptions of the ^data used will be touched upon. where t. and t are the average tax rate in a country and the world respectively. G^ and Gw are the per capita government consumption in a country and the worL •respectively Y^, Y^ per capita output in a country and the world respectively TB^ balance of trade of a country d is the change in a variable bQ is constant of the equation Equation (11) can be written in the form dTBi = b' + b1d(Yi + b„d(G.-G ) + B d(t.-t ) z 1 w J .1 w (12) 38 is coefficient of the change in per capita differential of Gross National Product of a country versus the world. b2 is coefficient of the change in per capita government consumption of a country versus the world b^ is coefficient of the change in' tax rates differential of a country versus the world. 22 A prion, b^ could be either positive or negative. It depends on the source of the shock to the system. A demand side shock will produce a negative coefficient, where a supply side shock will yield a positive one. The coefficient of the tax rate differential is unambiguously negative. A reduction in the average tax rate of country relative to’ the • world average is expected to lead to an improvement in the current account of the country. The sign of. the government differential consumption coefficient depends on how the private sector values the. government services. However, a priori, this coefficient is expected to have a negative sign based on the assumption that the private sector values the government services at less than its value. The Testing Techniques In . order to test the validity of the functional form, equation (12) is tested for twelve countries. First, the ordinary least square technique will be used ________________________________________________________ 39_ to estimate each equation. If the residuals show auto-correlation of the first-order level which can be tested by the significance of the Durbin-Watson Statistic, then the iterative Cochrane-Orcutt technique is to be used. This technique treats the problem of the first order auto-correlation among the residuals. Overcoming the autO-correlation problem increases the efficiency of coefficients estimation. Second, the seemingly unrelated regressions will be used. This technique employs generalized least squares to incorporate 'the covariance of errors among the countries in • estimating coefficients of the individual countries. One of the assumptions of ordinary least squares is that the errors of the individual country equations are unrelated. However, it is possible that such an assumption is not valid for the goods and services balance. For the world as a whole, the sum of all goods and services balance is considered to be zero. Thus, the error terms for all countries in the world are not independent. The first step of the procedure is to estimate the individual country equations by ordinary least squares. At this stage the equations are assumed to be unrelated. However, in the second step, the errors of 40 these equations are used to create a variance-coyariance matrix V. The final step is to reestimate the individual regression coefficients incorporating the information about the covariance of the errors. The estimate of the coefficient vector B is now B = (X'V_1X)-1 (X'V-1^) Where Y is a (N(country) x T(observation) x 1) vector of the dependent variable and X is a N.T x N.K (independent variable) matrix. Thus, seemingly unrelated regressions increase the efficiency of the estimators by incorporating information about the mutual correlation of disturbances. Data Sources and Description The two main sources of data are the International Monetary Fund statistics and the Organization of Economic Cooperation and Development publications. Observations, are yearly values expressed in United States current dollars for the years 1964- 1979. The availability of consistent data on tax revenues is the constraint for limiting our testing.to this period of time. All figures represent per capita values. The world figures represent average per capita values for the twenty-two member countries of the Organization for Economic Co-operation and Development (OECD). 41 The level of market output is represented by the per capita Gross National Product. The government purchases of goods and services are represented by the per capita government consumption. In the process of constructing the model, a term denoting per capita tax payment is included. This term is represented by the average tax collection in dollars per capita. The tax ratio in any country is calculated by dividing the country's aggregate tax collected by the total national output of the same country. The balance of trade of a country is constructed as the net of exports minus imports of goods and services of this country versus the rest of the world for one year. All data are obtained from OECD publications except for the trade balance figures which are obtained from the International Financial Statistics source. Statistical Properties of the Data One way to analyze the data is to examine the time-series structure of the variables. The same set of data pertaining to twelve countries, which is used to test the final model, is being analyzed in a univariate time-series context. 42 Following the methodology . discussed in Nelson (1973), the sample auto-correlations and partial auto-correlations of the various series were computed in order to identify models for the underlying processes. The univeriate models are described as (P, d, q), where P is the order of the auto-regressive process of the series, d is the order of differencing, and q is the order of moving average process. Since the data used is represented by yearly observations, no consideration was given to seasonality. The variables used in estimating the model are in a difference form which renders stationarity to the series. The statistical properties of the time series for the twelve countries are presented in Table 1. In addition to the mean and variance, significant auto-regressive coefficients are reported. An auto-regressive coefficient is significant if it is greater than twice the estimated standard error. Significant coefficients are indicated by the letter, S. Insignificant coefficients are simply indicated by an asterisk (*). The symbols used in the table are: art - the estimate of the auto-regressive coefficient of order t. TB - the ratio of the change in the trade balance to national output 43 Statistical Time TABLE 1 Properties of the Data -Series Analysis Country Variable Mean' Variance ARl AR2 AR3 AUSTRALIA TB 674E-3• .326E-3 * . * * DP 283E-2 .331E-2 * * * DG 386E-2 .221E-3 * * * DX 587E-6 .658E-11 * * * AUSTRIA TB 382E-2 .204E-3 * * * DP .201E-2 .112E-2 S * * DG 551E-2 .828E-3 * * * DX .391E-5 .455E-9 * * * DENMARK TB 474E-2 .198E-3 * * S DP .398E-1 .112E-2 * * * DG .176E-1 .928E-4 * * * DX .313E-5 .820E-10 * * * ITALY TB .205E-2 .331E-3 * * * DP 569E-1 .147E-2 * * * DG 199E-1 . . 914E-3 * ★ DX 764E-6 .902E-10 * * * HOLLAND TB .176E-2 .157E-3 * * * DP .249E-1 .763E-3 * * * DG .228E-2 .259E-3 * * * DX .539E-5 .369E-9 * * * SPAIN TB 147E-2 .245E-3 * * * DP -.923E-1 .44E-2 * . * * DG - -.376E-2 .652E-2 * * * DX 999E-5 .11E-8 * * * (continued) 44 Statistical Time TABLE 1 (continued) Properties of the Data -Series Analysis Country Variable Mean Variance ARl AR2 AR3 SWEDEN TB 105E-2 .127E-3 * * * ' DP .320E-1 .142E-2 * * * DG .219E-1 .199E-3 * • k * DX .308E-5 .112E-9 * * * SWITZERLAND TB .719E-2 .228E-3 * * * DP .405E-1 .125E-1 * * * DG .454E-3 .151E-3 * * * DX 111E-5 .195E-10 * * * JAPAN TB .151E-2 .142E-3 * * * DP .117E-1 .341E-2 * * * DG 268E-1 .413E-2 * * * DX 571E-5 .204E-9 * * * UNITED TB .915E-4 .138E-3 * * * KINGDOM DP 411E-1 .321E-2 * * * DG -.343E-2 .179E-3 * * * DX .1008E-5 .138E-9 * * * UNITED TB 557E-3 .551E-4 * * * STATES DP .724E-2 .405E-3 * * * DG .783E-2 .395E-3 * * * DX 624E-6 .646E-11 ★ * * GERMANY TB .238E-2 .109E-3 * * * DP .333E-1 .197E-2 * * * DG .895E-2 .255E-3 * * * DX .1656E-5 .11E-9 * * * 45 DP - the ratio of the change in the country's output differential to national output DG - the ratio of the change in the country's government expenditure differential to national output DX - the ratio of the change in the country's average tax rate differential to national output All of the . variables except two have insignificant auto-correlation and partial auto-correlation coefficients. For the country of Denmark the ratio of the change in the trade balance to the national output can be represented by the time series (3,0,0). For the country of Austria, the ratio of the change in • the country's output differential to national output can be represented by the time series (1,0,0). Empirical Results. The results for the twelve countries can be found in Table 2. In the absence of first-order serial correlation, the results of an ordinary least squares (OLSQ) equation are reported. Otherwise a Cochrane-Orcutt iterative technique (CORC) is used in 46 estimating the equation. The type of equation is indicated for each country in Table 2. Examining the trade balance equations, we find that in eight of the twelve countries the coefficient of the output differential term has a negative sign. Government expenditure differential term has a negative coefficient in six countries. In seven countries the tax rate differential coefficient has a negative sign. The national output variable is significant at 95 percent level in five countries. The government consumption variable is negative and significant in one country; positive and significant in two countries. The tax rate variable is negative and significant in three countries. The results are characterized for the most part by a negative coefficient on the national output differential term. The results are mixed with respect to the coefficient on the government expenditure term. The coefficient is negative in one-half the countries. However, it is negative and significant in one country. The results are not consistent with the government consumption having a strong negative effect on the trade balance. 47 COUNTRY TABLE 2 SINGLE EQUATION ESTIMATES OF TWELVE MAJOR INDUSTRIAL COUNTRIES OF b0 bl b2 b3 THE WORLD R2 F DW SE AUSTRALIA OLSQ -.004 .073 -1.11 -4434 .435 2.82 2.83 .015 (1.00) (.537) (1.22) (2.04) (90) AUSTRIA CORC -.006 -.32 1.21 -1059 .263 1.19 1.94 .014 (1.19) (1.83) (1.72) (.61) .DENMARK CORC -.007 -.25 . .69 -57 .301 1.43 2.21 .014 (.76) (1.00) (1.21) (.049) GERMANY OLSQ .005 -.009 .18 940 .09 .366 1.77 .011 (1.28) (.73) (.44) •(.74) HOLLAND CORC .0027 .645 -2.7-7 -587 .326 1.294 2.09 .015 (.38) (2.04) (1.93) (.32) ITALY CORC .01 -.057 .64 1653 .48 3.14 2.49 .015 (1.36) (.64) (1.79) (2.53) (90) JAPAN CORC .022 -.22 4.13 -4194 .62 2.76 1.72 .011 (1.48) (1.4) (2.29) (2.3) SPAIN OLSQ -.008 -.12 .16 342 .28 1.47 1.49 .015 (.64) (1.7) (.27) (.88) SWEDEN CORC .0045 -.045 -.169 -413’ .30 1.46 2.6 .011 (.72) (.58) (.49) (.39) SWITZERLAND CORC .0013 . 195 -.741 6803 .501 2.34' 1.42 .0014 (.177) (2.82) (1.66) (2.4) UNITED OLSQ .007 .259 -1.00 30.5 .239 1.15 1.89 .011 KINGDOM (1.49) (1.78) (1.61) (.057) UNITED CORC -.007 -.13 -.14 -4071 .91 10.1 1.67 .0048 STATES (5.16) (.93) (.13) (7.6) (95) . Numbers in parenteses below coefficients are t-statistics ^ DW is the Durbin-Watson Statistics 00 Numbers in parentheses below F-statistics are significance levels• The coefficient of the tax rate differential term, while negative in seven countries, is negative and significant in three countries. This sheds some doubt on the assumption of the negative effect of the tax rate differential on the trade balance. In general, using the seemingly unrelated technique did not bring about much better results. Table 3 presents the results of nine European countries of the largest national product. Table 4 presents the results of nine countries of the largest national output of the countries included in the sample. In Table 3 seven countries have significant output coefficients. The government consumption term has three negative coefficients of which two are significant. The tax rate term has three negative coefficients,' none of which is significant. 49 TABLE 3 SEEMINGLY UNRELATED REGRESSION NINE EUROPEAN COUNTRIES OF THE LARGEST NATIONAL COUNTRY bQ b± b2 OUTPUT b3 AUSTRIA -.005 -.335 1. 20 -.045 (1.37) (3.81) (3.01) (. 729) DENMARK -.0044 -.028 . 06 -.036 (.687) (2.28) (2.19) (.707) GERMANY .0037 -.046 . 104 .056 (1.12) (.721) (.658) (1.1) HOLLAND -.003 .309 -.066 . 0013 (.70) (1.73) (.955) (1.69) ITALY .008 -.16 .458 .061 (1.12) (.24) (1.51) (1.13) SPAIN -.01 -.128 . 114 312 (1.63) (3.51) (.422) (2.15) SWEDEN . 0045 -.046 -.225 -.021 (1.23) (1.75) (1.71) (.45) SWITZERLAND . 0058 .091 .624 . 0032 (1.51) (2.83) (2.67) (2.94) UNITED .0069 .231 -. 97 187 KINGDOM (1.94) (3.75) (3.57) (.78) Numbers in parentheses t-statistics. below coefficients are 50 TABLE 4 SEEMINGLY UNRELATED REGRESSION NINE COUNTRIES OF THE LARGEST NATIONAL PRODUCT COUNTRY bo bl b2 b3 AUSTRALIA -.0045 . 079 1. 05 -.0044 (1.05) (.995) (1.95) (3.36) GERMANY . 0047 -.059 .036 . 051 (1.29) (.556) (.115) (.568) HOLLAND -.004 .41 -.828 .091 (.99) (2.24) (1.06) (1.06) ITALY . .015 .109 .386 .086 (1.86) (1.3) (1.09) (1.45) JAPAN .00 2 -.02 -.029 .036 (.37) (.43) (.068) (.446) SPAIN -.009 -.093 -.001 .001 (.91) (1.87) (.002) (2.25) SWITZERLAND .004 . 123 -.54 . 0039 (1.18) (3.25) (1.78) (3.02) UNITED . 005 . 15 -.586 . 023 KINGDOM (1.22) (1.69) (1.53) (.69) UNITED -.0066 -.081 -.005 -.082 STATES (.27) (.93) (.012) (1.46) Numbers in parentheses below coefficients are t-statistics 51 The Balance of Trade: Plot of Actual and Fitted Data For the purpose of illustration a plot of a time series representing the change in the trade balance to national output, actual and fitted, has been presented. The charts represent the actual data and fitted values as estimated by the ordinary least squares technique. The data pertains to twelve countries of major national output and covers the time period 1965-1979. The independent variables of the regression equation is composed of three terms; each of which represent output growth differential, government consumption differential and average tax rate differential. 52 Actual Fitted Australia U1 U) Figure 1 Change in the Trade Balance to GNP 1965-1979 Austria Actual Fitted Denmark U1 Figure 2 Change in the Trade Balance to GNP 1965-1979 Germany Actual Fitted Holland Figure 3 Italy Ul Change in the Trade Balance to GNP 1965-1979 Actual Fitted rA rm Japan Figure 4 Spain U1 Change in the Trade Balance to.GNP 1965-1979 Actual Fitted Sweden Figure 5 Switzerland Change in the Trade Balance to GNP 1965-1979 Actual Fitted United Kingdom -i United States Change in the Trade Balance to GNP 1965-1979 Further Testing The same set of data, covering twelve major industrial countries of the world, is used to test the equation presented by Laffer (1976), where he expresses the change in the trade balance of country divided by the national output as a function of the growth rate differential of the national output of the country versus the rest of the world. This is represented as: dTB . — = b„. + b,.(EY. - EY ) Y^ Oi li i w where b^^ and bji are coefficients of country (i) - Table 5 presents the results using the seemingly unrelated regression. The empirical results support the theoretical model strongly. At the 95 percent level of significance, all of the coefficients of the growth rate differential are significant. However, three of these coefficients have a negative sign, and nine have a positive sign. Comparing these results to those of tables 3 and 4, we find that using the growth rate differential brought about more significant results than using a differential term representing the changes in per capita output of country versus the rest of the world. These results corroborate the notion of the relation between the growth rate differential and changes in the trade balance of a country. 59 TABLE 5 SEEMINGLY UNRELATED REGRESSION TWELVE MAJOR INDUSTRIAL COUNTRIES OF THE WORLD COUNTRY bo bl AUSTRALIA -.00061 (.11) -.0791 (5.4) AUSTRIA .00093 (.21) -.086 (2.2) DENMARK .00035 (.08) . -.057 (3.8) GERMANY .0019 (.72) -.059 (5.4) ITALY . 002 .(.33) . 056 (2.6) HOLLAND -.0045 (1.2) . 168 (7.8) SPAIN . 0042 (.97) -.119 (23.6) SWEDEN -.00039 (.10) -.143 (19.7) SWITZERLAND .0064 (.94) -.061 (3.8) JAPAN . 0079 (2.5) -.097 (5.0) UNITED KINGDOM . 002 (.69) . 059 (3.1) UNITED STATES -.0031 (1.8) -.034 (4.3) Numbers in parentheses t-statistics. below coefficients are 60 FOOTNOTES ^The traditional barter models discuss the factors of production, production possibilities and the sources of trade patterns. No reference is given to the demand side. See Ricardo, David (1817) Ch. 7, for the one-factor model, and the two-factor Hechscher-Ohlin model examined by Laffer (1982) pp. 85-88. 2 The seminal articles on this subject are Samuelson, P. (1948) "International Trade and the Equalization of Factor Prices," and Samuelson, P. (1949) "International Factor-Price Equalization Once Again." 3 The Ricardo model stresses the idea of comparative advantage and differences in technology among countries as reasons for different levels of production and trade. The Heckscher-Ohlin model attributes the existence of trade among countries to three possible differences, technology, tastes and preferences, and the relative endowments of factors of production. 4 For effects of public policy see Brunner, K., and Meltzer, A. "Monetary and Fiscal Policy in Open, Interdependent Economies with Fixed Exchange Rates" in Recent Issues in International Monetary Economics, ed. Classen, E., and Salin, P. (Amsterdam: North-Holland Publishing Company, 1976). 5 For general analysis of- differences among the three approaches, see Frenkel, J., and Johnson, H. (1976) pp. 22-32. ^Criticism of this assumption, stressing the presence of non-traded goods has been accompanied by the development of elasticity models of monetary and exchange rate adjustment aggregating goods into traded goods and non-traded goods. For an example see Dornbusch, R. (1973). 7 Orcutt's (1950) list includes the following reasons also: Simultaneity, random observation errors in the price indicies, timing (short-run elasticities are smaller than long-run elasticities), and quantum effects (elasticities are larger for large price changes). 61 -------g------------— ----------------------------------------------------- One plausible explanation is that currency depreciation raises the domestic price level and increases aggregate expenditure, causing an increase in the demand for money on the part of domestic residents. If the monetary authorities do not act to accommodate the additional demand, interest rates in the devaluing country will rise attracting funds from abroad. Another explanation is presented by Logue, D., and Willet, T. (1974). They argue that exchange rate changes will affect the share of foreign assets in portfolios and international investors pursuing portfolio rebalancing strategies would tend to invest relatively more in countries which devalue. The net result is that a devaluation will improve the capital account of a country's balance of payments. The authors offer some modest empirical evidence in support of their theoretical arguments. 9 Extensive efforts have been made to reconcile the - absorption approach and elasticity approach. Alexander (1952) attempts a reconciliation of the two approaches in a broad framework of analysis. Also see Yeager, L. "Absorption and Elasticity: A Fuller Reconciliation" Economica, XXXVII, Feb. 68-77, 1970. ^See in particular Tinbergen, T., On The Theory of Economic Policy (Amsterdam, 1952); Stuvel, G., The Exchange Stability Problem (Oxford, i951). ■^The modern revival of the monetary approach may be said to have begun with James Mead's "The Balance of Payments" (1951) , followed by Johnson, H., International Trade and Economic Growth (London: George Allen & Unwin, 1958) pp. 153-168 and Mundell, R., International Economics (New York: Macmillan, 1968). 12 For formal developments of the monetary approach to devaluation see Kemp, M. (1969) Ch. 14 and Mundel, R. (1971), Chs. 9-11. For a developed model based on this approach see Dornbusch (1973). However, acceptance of that approach has remained limited. ^McCulloch and Yellen (1982) show that when • capital is perfectly mobile, policies that impede technology transfer may have no effect on employment or income distribution, despite one country's clear technology superiority. Capital movements can serve as a substitute for technology transfer. 62' 14 By virtue of linear homogeniety of the Cobb- Douglas production function Y=F(K,L) it is possible to multiply the output and the arguments of the function by a factor 1/L, hence we get Y/L=F(K/L,1) then the function can be written as Y=LF(K/L). See Miller and Upton (1974) p. 67. 15 . For geometric analysis and detailed explanation of the association between capital-labor ratios and wage-rental ratios, see Laffer, A., and Miles, M. (1982) pp. 29-30. 16 The notion of the engagement of individuals in work or leisure activity has been fully explained by Becker, G. (1965). 17 It is. assumed that individuals by so doing maximize their utility. Wan and Majumdar (1980) develop a model of a competitive world in which several countries are engaged in the production, consumption and tra:de. The plans of economic agents are based on an optimization of a discounted sum of one period utilities. The main results of this model deal with the existence and characterization of the sequence of temporary equilibria. 18 In the seminal papers on this issue, Samuelson (1949, 1950) argues that in a perfect world of two countries, two goods and two factors of production, the mobility of goods between the two countries will establish factor price equalization, even though the factors of production are immobile. Mundel (197 5) argues that, under the same set of world conditions, if one of the factors, say capital, and one good are free to move costlessly between the two countries, while the other factor of production and the other good are immobile, factor price equalization will be established. It can be concluded that for factor price equalization to be realized, the.number of mobile factors and/or goods should be at least equal to the number of immobile factors and/or goods. 19 For example, m a two-country world we will have two values for each factor price, before- and after-tax, and two goods, while we have only one mobile factor and one mobile good. The number of independent equations is less than the number of unknowns. Consequently, factor price equalization may not be achieved. 63 20 For a detailed discussion of the effect of government expenditures on consumption goods and services on private households, see Baily (1971) pp. 152-164. 21 This notion has been adopted by Canto and Miles (1981). 22 For discussion and reasoning for the relationship between income growth and the trade balance see Kenen, P. (1975) pp. 199-200. 64 BIBLIOGRAPHY Alexander, S. "The Effects of Devaluation on a Trade Balance." IMF Staff Papers, II, No. 2, April 1952, 263-278. Alexander, S. "Effects of a Devaluation: A Simplified Synthesis .of Elasticities and Absorption Approaches." American Economic Review, XLIX, No. 2 (March 1959), 22-42. Baily, M. J. National Income and the Price Level: A Study in Macroeconomic Theory. 2d ed., New York: McGraw-Hill, 1971. Baldwin, R., and Richardson, J. International Trade and Finance, second edition, Boston: Little, Brown and Company,1981. Becker, G. "A Theory of the Allocation of Time." Economic Journal 75 (September 1965): 493-517. Bhagwati, J. "The Pure Theory of International Trade: A Survey." Economic Journal 74 (March 1964): 1-84. Bhagwati, J., ed. International Trade: Selected Readings. Middlesex: Penguin Books Ltd., 1969. Bhagwati, J. Trade, Tariffs, and Growth: Essays in International Economics. Cambridge, Massachusetts: The M.I.T. Press, 1969. Bhagwati, J. Trade, the Balance of Payments, and Growth. Amsterdam: North-Holland, 1971. Bhagwati, J., and Srinivasan, T. "The Theory of Wage Differentials: Production Response and Factor Price Equalization." Journal of International Economics 1, No. 1, pp. 19-35, Feb. 1971. Bhagwati, J., ed. International Trade: Selected Readings. Cambridge, Massachusetts: 1981. Black, F. "Transport Costs, Tariffs, and Taxes in a One Sector Model of Trade." Unpublished Manuscript, M.I.T., Revised March, 1973. 65 Black, F. "International Capital Market Equilibrium With Investment Barriers." Journal of Financial Economics 1 (4): 337-352, 1974. Boyer, Russel S. "Devaluation and Portfolio Balance." The American Economic Review, Vol. 67, No. 2, March 1977. Box, G, and Jenkins. Time Series Analysis. San Francisco: Holden-Day, Inc., 1970. Brunner, K., and Meltzer, A. "Monetary and Fiscal Policy in Open, Interdependent Economies With Fixed Exchange Rates" in Recent Issues in International Monetary Economics, ed., Claassen, E., and Salin, P. Amsterdam: North-Holland Publishing Company, 1976. Canto, V., and Miles, M.A. "A Short Run Supply-Side Model of Factor Policy, Relative Growth, and The Trade Balance in an Integrated World Economy," unpublished manuscript, University of Southern California, 1981. Canto, V., and Webb/ R. "Persistent Growth Rate Differentials Among States in a National Economy With Factor Mobility," University of Southern California, July 1981. Canto, V., and Laffer, A. "The Incidence of a Commodity Trade Embargo." Unpublished manuscript, University of Southern California, October, 1981. Caves, R., and Johnson, H., eds. Readings In International Economics. Homewood: Richard D. Irwin, Inc., 1968. Chipman, J.S. "A Survey of the Theory of International Trade." Econometrica, Vol. 33, July 1965; October 1965, Vol. 34, January 1966. Connolly, M., and Taylor, D. "Adjustment to Devaluation With Money and Nontraded Goods." Journal of International Economics 6 (1976) pp. 289-98. Cooper, Phillip, and Curtis, Gary. Econometric Software Package Users Manual. Chicago: University of Chicago, January 1976. Cooper, R. The Economics of Interdependence. New York: McGraw-Hill, 1968. '66.*' Cooper, R. "An Assessment of Currency Devaluation in Developing Countries." Government and Economic Development, ed. by Ranis, G. New Haven: Yale University Press, 1971. Craig, Gary A. "A Monetary Approach to the Balance of Trade." The American Economic Review. (June 1981) pp. 460-466. Dornbusch, R. "Devaluation, Money and Nontraded Good." The American Economic Review, Vol. 63, No. 5, December 1973. Dornbusch, R. "Exchange Rate Expectations and Monetary Policy." Journal of International Economics 6 (1976) pp. 231-44. Dornbusch, R. "A Portfolio Balance Model of the Open Economy." Journal of Monetary Economics, 1 (1), 1975. Dornbusch, R, "Capital Mobility, Flexible Exchange Rates and Macroeconomic Equalibrium." Recent Issues in International Monetary Economics, ed. Claassen E., and Salin, P. Amsterdam: North- Holland Publishing Company, 1976. Dornbusch, R. Open Economy Macroeconomics, New York, Basic Books, Inc., 1980. Fair, R. "On Modeling the Economic Linkages Among Countries," in International Economic Policy: Theory and Evidence, eds. Dornbusch, R., and Frenkel, J. Baltimore: The Johns Hopkins University Press, 1979. Frenkel, J. "Adjustment Mechanisms and the Monetary Approach to the Balance of Payments: A Doctrinal Perspective," in Recent Issues in International Monetary Economics, eds. Claasen, E. and Salin, P.. Amsterdam: North-Holland Publishing Company, 1976. Frenkel, J., and Johnson, H., eds. The Monetary Approach to the Balance of Payments. Toronto & Buffalo: University of Toronto Press, 1976. Gale, David. "The Trade Imbalance Story." Journal of International Economics, 4, No. 2 (May 1978): 119-137. 6 7 - ' Hamada, K. "Macroeconomic Strategy and Coordination . Under Alternative Exchange Rates" in International Economic Policy: Theory and Evidence, eds. Dornbusch, R. and Frenkel, J. Baltimore: The Johns Hopkins University Press, 1979. Harberger, A. "Currency Depreciation, Income, and the Balance of Trade." Journal of Political Economy, .Vol. LVIII, No. 1, Feb. 1950. Hauthakker, H., and Magee, S. "Income and Price Elasticities in World Trade." Review of Economics and Statistics, May 1969, 51, 11-25. Heckscher, E. "The Effect of Foreign Trade on the Distribution of Income," Ekonomisk Tidschrift 21 (1919): 497-512 (in Swedish), for an English translation see American Economic Association, Readings in the Theory of International Trade, Philadelphia: Blakiston, 1949. International Financial Statistics (Washington: IMF) on computer tapes. Johnson, H. "Factor Endowments, International Trade and Factor Prices," The Manchester School of Economics and Social Studies, 25 (September 1957): 270-283. Johnson, H. "The Monetary Approach to the Balance of Payments: A Nontechnical Guide." Journal of International Economics 7 (1977) pp. 252-68. Johnson, H. "Optimal Trade Intervention in the Presence of Domestic Distortions," in Baldwin et al ed. Trade, Growth, and Balance of Payments. Chicago: Rand McNally & Company, 1965. Johnson, Harry. International Trade and Economic Growth. Cambridge: Harvard University Press, 1967. Johnson, J. Econometric Methods, 2nd edition. New York: McGraw-Hill Book Company, 1972. Jones, R. "The Structure of Simple General Equilibrium Models." Journal of Political Economy, Vol. 73, Dec. 1965. Kapui, B. K. "Traded Goods, Nontraded Goods, and the Balance of Payments." International Economic Review, February 1981, pp. 167-178. 68 Kelejian, H. , and Oates, W. Introduction to . Econometrics. New York: Harper & Row, publishers, 1974. Kemp, M. C. The Pure Theory of International Trade and Investment. Englewood Cliffs: Prentice-Hall, Inc., 1969. Kindleberger, Charles. International Economics, sixth edition. Homewood, Illinois: Richard D. Irwin, 1978. Komiya, R. "Non-traded Goods and the Pure Theory of International Trade." International Economic Review, 8 (2), 1967. Laffer, A. B. "An Anti-Traditional Theory of the Balance-of-Payments Under Fixed Exchange Rates." Mimeographed. University of Chicago, February 1969. Laffer, A. B. "Exchange Rates, the Terms of Trade, and the Trade Balance." Mimeographed, University of Chicago, 1973. Laffer, A. B. "The Trade Balance and Economic Activity." Unpublished manuscript, University of Chicago, October 1976. Laffer, A. "The Economic Consequences of Devaluation of a Reserve Currency Country," in World Monetary Disroder edited by Boarman, P., and Tuerck, D. New York: Praeger publishers, 1976. Laffer, A. B., and Miles, M. International, Economics In an Integrated World. Glenview, Illinois: Scott Foresman and Company, 1982. Learner, E., and Stern, R. Quantitative International Economics. Chicago: Aldine Publishing Company, 1976. Logue, D., and Willet, T. "The Effects of Exchange Rate adjustment on International Investment," in The Effects of Exchange Rate adjustments, eds. Clark, P., Logue, D., and Sweeny, R. Washington, D.C.: OASIA Research, Department of the Treasury, Government Policy Office, 1974. Machlup, F. International Payments, Debts, and Gold. New York: Charles Scribner's Sons, 1964. .'69 Magee, S. International Trade and Distortions in Factor Markets. New York: Marcel Dekker, 1975. Magee, Stephen. "Prices, Incomes, and Foreign Trade," in Peter Kenen ed., International Trade and Finance: Frontiers for Research, Cambridge 1975. Magee, Stephen. International Trade. Reading, Massachusetts: Addison-Wesley Publishing Company, 1980. McCulloch, R., and Yellen, J. "Can Capital Movements Eliminate the Need For Technology Transfer?" Journal of International Economics 12 (1982) pp. 95-106. Meade, J. The Theory of International Economic Policy, Vol. I: The Balance of Payments (London, 1951). Miles, M. A. Devaluation, the Trade Balance, and the Balance of Payments. New York: Marcel Dekker, Inc., 1978. Miles, M. A. "The Effects of Devaluation on the Trade Balance and Balance of Payments: Some New Results." Journal of Political Economy, 87, No. 3, June, 1979. Miller, M., and Upton, C. Macroeconomics A Neoclassical Introduction. Homewood, Illinois: Richard IRWIN, Inc., 1974. Morgan, A. D. "Income and Price Elasticities in World Trade: A Comment," Manchester School of Economic and Social Studies, 4 (December 1970): 303-314. Mundell, R. International Economics. New York: Macmillan, 1968. Mundell, R. Monteray Theory. (Pacific Palisades, Goodyear, 1971). Mundell, R. "International Trade and Factor Mobility." American Economic Review, 57 (June 1975): 231-235. Murray, Tracy and Peter J. "An Examination of the Traditional Aggregate Import Demand Model." Review of Economics and Statistics, 58 (February, 1976): 178-180. 7 0 Mussa, M. "Macroeconomic Interdependence and the Exchange Rate Regime." international Economic Policy; Theory and Evidence, eds. Dornbusch, R., and Frenkel, J. Baltimore: The Johns Hopkins University Press, 1979. National Accounts. Statistics (Paris: Organization for Economic Cooperation and Development, 1981). Nelson, C. Applied Time Series Analysis For Managerial Forecasting. San Francisco: Holden-Day, 1973, Kmenta, J., and Gilbert, R. "Estimation of Seemingly Unrelated Regressions With Autoregressive Disturbances." Journal of American Statistical Association, . March, 1970, 65, pp. 186-197. Orcutt-Guy. "Measurement of Price Elasticities in International Trade." Review of Economics and Statistics. 32 (May 1950). Ohlin, B. Interregional and International Trade. Cambridge, Massachusetts: Harvard University Press, 1933. Pomery, J. "Uncertainty and International Trade" in International Economic Policy Theory' and Evidence, eds. Dornbusch, R., and Frenkel, J. Baltimore: The Johns Hopkins University Press, 1979. Revenue Statistics of OECD Member Countries, 1965-1980 (Paris: Organization for Economic Co-operation and Development, 1981). Root, F. R. International Trade Investment, 4th ed. Cincinnati, Ohio: Southwestern Publishing, 1978. Ricardo, D. Principles of Political Economy and Taxation. London, 1817. (Reprinted New York: Dutton, Everyman's Library, 1969). Salant, M. "Devaluations Improve the balance of payments even if not the Trade Balance," in The Effects of Exchange Rate adjustments, eds. Clark, P., Logue, D., and Sweeny, R. Washington, D.C.: OASIA Research, Department of the Treasury, Government Printing Office, 1974. Samuelson, P. "International Trade and Equalization of Factor Prices." Economic Journal, 58 (June, 1948): 163-183. :. 11 * Samuelson, P. "International Factor-Price Equalization Once Again," Economic Journal, 59 (June 1949): 181-197. Samuelson, P. "Equalization By Trade of The Interest Rate Along With the Real Wage," in Baldwin et al ed., Trade, Growth, and balanced payments, Chicago: Rand McNally & Company, 1965. Sargant, T. J. Macroeconomic Theory. New York: Academic Press, Inc., 1979. Steinherr, Alfred. "Effectiveness of'Exchange Rate Policy for Trade Account Adjustment." IMF Staff Papers, Vol. 28, No. 1, March, 1981. Stern, R. The Balance of Payments Theory and Economic Policy. New York: ALDINE Publishing Company, 1973. Stern, R. "Testing Trade Theories," in Peter Kenen ed., ' International Trade and Finance: Frontier for Research, Cambridge, 1975. Stuvel, G. The Exchange Stability Problem. (Oxford, 1951). Sweeney, R. "Inflation, The Balance of Trade and the Effects of Exchange Rate adjustments," in The Effects of Exchange Rate adjustments, eds. Clark, P., Logue, D., and Sweeny, R. Washington, D.C.: OASFA Research, Department of the Treasury, Government Printing Office, 1974. Theil, Henri. Introduction to Econometrics. Englewood Cliffs, New Jersey: Prentice-Hall, Inc. Tinbergen, J. On The Theory of Economic Policy. Amsterdam, 1952. Tinbergen, J. "International, National, Regional and Local Industries," in Baldwin et al ed., Trade, Growth, and Balance of Payments. ' Chicago: Rand McNally & Company, 1965. Wan, H., and Majumdar, M. "Trade Under Temporary Equilibrium Evolution in a Loglinear World." Journal of International Economics 10 (1980) pp. 37-62. 7 2 Whitman, M. "Global Monetarism and the Monetary Approach to the balance of payments." Brookings papers on Economic Activity, 3: 1975. Yeager, L. "Absorption and Elasticity: A Fuller Reconciliation." Economica, XXXVII, Feb., 68-77, 1970. Zellner, A. "An Efficient Method of Estimating Seemingly Unrelated Regression and Tests for Aggregation Bias." Journal of the American Statistical Association, 55, (1962), pp. 348-368. 73 u.

Linked assets

University of Southern California Dissertations and Theses

Conceptually similar

PDF

The output and employment effects of fiscal policy in a classical model

PDF

An Application of the Global Monetarist-Wedge model to post-1973 Chilean economic policies and the effects of these policies on macroeconomic, social and political variables

PDF

A contingent claims analysis of the equity interest in property-casualty insurance companies

PDF

Stock option events, performance plans, and returns variability

PDF

A quantitative model for the analysis of warranty policies

PDF

Communications medium and product class: Their effect on negotiation outcome

PDF

A study on the content and determinants of close exchange relationships in channels of distribution

PDF

An investigation of information requirements determination and analogical problem solving

PDF

Corporate Political Action Committee contribution tactics: Prime defense contractors, federal election cycle 1985-1986

PDF

An examination of the effect of environmental cues on audit judgments

PDF

An analysis of the Nigerian economy within the framework of the wedge model

PDF

An empirical investigation of variables related to management consulting engagement effectiveness as perceived by small business clients and their 'Big Eight' CPA consultants

PDF

Auditor evidence evaluation and aggregation as a cascaded inference task

PDF

Examining the portfolio balance theory of foreign exchange rates: A time series analysis

PDF

Auditors' risk attitudes: A hierarchical levels study within various decision contexts

PDF

A laboratory study of the effects of accounting valuation methods on manager performance under different inflation environments

PDF

North-South trade and the growth of the South

PDF

Cross-sectional tests of tax and regulatory costs of a change in depreciation methods in the railroad industry

PDF

Analyzing American social policy: A study of the development of the child support provisions of the Personal Responsibility and Work Opportunity Reconciliation Act of 1996 (PRWORA)

PDF

Allocative and opportunity structures and their interaction with career orientation.

Asset Metadata

Creator Abou-Alam, Alaa Eldin (author)

Core Title Balance of trade, economic activity and public policy

Degree Doctor of Philosophy

Degree Program Business Administration

Publisher University of Southern California (original), University of Southern California. Libraries (digital)

Tag Economics, General,OAI-PMH Harvest,sociology, public and social welfare

Language English

Contributor Digitized by ProQuest (provenance)

Advisor Laffer, Arthur B. (committee chair), Canto, Victor A. (committee member), Pardo, Arvid (committee member)

Permanent Link (DOI) https://doi.org/10.25549/usctheses-c17-748787

Unique identifier UC11345888

Identifier DP22586.pdf (filename),usctheses-c17-748787 (legacy record id)

Legacy Identifier DP22586.pdf

Dmrecord 748787

Document Type Dissertation

Rights Abou-Alam, Alaa Eldin

Type texts

Source University of Southern California (contributing entity), University of Southern California Dissertations and Theses (collection)

Access Conditions The author retains rights to his/her dissertation, thesis or other graduate work according to U.S. copyright law. Electronic access is being provided by the USC Libraries in agreement with the au...

Repository Name University of Southern California Digital Library

Repository Location USC Digital Library, University of Southern California, University Park Campus, Los Angeles, California 90089, USA