Comparative Advantage, Trade, and Payments in a Ricardian Model with a Continuum

of Goods
Author(s): R. Dornbusch, S. Fischer and P. A. Samuelson
Source: The American Economic Review , Dec., 1977, Vol. 67, No. 5 (Dec., 1977), pp. 823-
839
Published by: American Economic Association

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 Comparative Advantage, Trade, and Payments
in a Ricardian Model with a Continuum of Goods -

By R. DORNBUSCH, S. FISCHER, AND P. A. SAMUELSON*

This paper discusses Ricardian trade and I. The Real Model

payments theory in the case of a continuum
of goods. The analysis thus extends the de- In this section we develop the basic real
velopment of many-commodity, two-coun- model and determine the equilibrium rela-
try comparative advantage analysis as pre- tive wage and price structure along with the
sented, for example, in Gottfried Haberler efficient geographic pattern of specializa-
(1937), Frank Graham (1923), Paul Samuel- tion. Assumptions about technology are
son (1964), and Frank W. Taussig (1927). specified in Section IA. Section IB deals with
The literature is historically reviewed by demand. In Section Ic the equilibrium is
John Chipman (1965). Perhaps surprisingly, constructed and some of its properties are
the continuum assumption simplifies the explored. Throughout this section we as-
analysis neatly in comparison with the dis- sume zero transport costs and no other im-
crete many-commodity case. The distin- pediments to trade.
guishing feature of the Ricardian approach
emphasized in this paper is the determina- A. Technology and Efficient
tion of the competitive margin in produc- Geographic Specialization
tion between imported and exported goods.
The analysis advances the existing literature The many-commodity Ricardian model
by formally showing precisely how tariffs assumes constant unit labor requirements
and transport costs establish a range of (a,,..., a,) and (al*,..., a*) for the n com-
commodities that are not traded, and how modities that can be produced in the home
the price-specie flow mechanism does or and foreign countries, respectively. The
does not give rise to movements in relative commodities are conveniently indexed so
cost and price levels. that relative unit labor requirements are
The formal real model is introduced in ranked in order of diminishing home coun-
Section 1. Its equilibrium determines the try comparative advantage,
relative wage and price structure and the
al*1a, > ... > ... > Ol*ai > ... > an*la,
efficient international specialization pattern.
Section II considers standard comparative where an asterisk denotes the foreign coun-
static questions of growth, demand shifts, try.
technological change, and transfers. Exten- In working with a continuum of goods,
sions of the model to nontraded goods, we similarly index commodities on an inter-
tariffs, and transport costs are then studied val, say [0, 1], in accordance with diminish-
in Section III. Monetary considerations are ing home country comparative advantage.
introduced in Section IV, which examines A commodity z is associated with each
the price-specie mechanism under stable point on the interval, and for each com-
parities, floating exchange rate regimes, and modity there are unit labor requirements in
also questions of unemployment under the two countries, a(z) and a*(z), with rela-
sticky money wages. tive unit labor requirement given by

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

(z)
(z) A'(z) < 0
comments from Ronald W. Jones are gratefully
acknowledged. Financial support was provided by a
Ford Foundation grant to Dornbusch, NSF GS-41428 The relative unit labor requirement function
to Fischer, and NSF 75-04053 to Samuelson. in (1) is by strong assumption continuous

823

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824 THE AMERICAN ECONOMIC REVIEW DECEMBER 1977

and by construction (ranking or indexing of The relative price of home produced z in

goods), decreasing in z. The function A (z) terms of a commodity z" produced abroad
is shown in Figure 1 as the downward slop- is by contrast
ing schedule.
(7) P(z)/P(z") = wa(z)/w*a*(zP")
Consider now the range of commodities
produced domestically and those produced = wa(z)1a*(z'');
abroad, as well as the relative price struc- z < z < z"
ture associated with given wages. For that
purpose we define as w and w* the domestic In summarizing the supply part of the
and foreign wages measured in any (com- model we note that any specified relative
mon!) unit. The home country will effi- real wage is associated with an efficient geo-
ciently produce all those commodities for graphic specialization pattern characterized
which domestic unit labor costs are less by the borderline commodity z(w) as well as
than or equal to foreign unit labor costs. by a relative price structure. (The pattern is
Accordingly, any commodity z will be pro- "efficient" in the sense that the world is out
duced at home if on, and not inside, its production-possibil-
ity frontier.)
(2) a(z)w < a*(z)w*
B. Demand
Thus
On the demand side, the simplest Mill-
(2') w < A (z)
Ricardo analysis imposes a strong homo-
where (3) defines the parameter w, funda- thetic structure in the form of J. S. Mill or
mental to Ricardian analysis, Cobb-Douglas demand functions that asso-
ciate with each ith commodity a constant
(3) w/w*
expenditure share, bi. It further assumes
This is the ratio of our real wage to theirs identical tastes for the two countries or uni-
(our "double-factoral terms of trade"). It form homothetic demand.
follows that for a given relative wage w the By analogy with the many-commodity
home country will efficiently produce the case, which involves budget shares
range of commodities
bi= PiCi/Y bi= bi*
(4) 0 < z < (w) n

where taking (2') with equality defines the Z bi = I

borderline commodity z, for which
We therefore prescribe for the continuum
(5) Z = A-I(w)
case a given b(z) profile:
A-'( ) being the inverse function of A( ).
(8) b(z) = P(z)C(z)/Y > 0
By the same argument the foreign country
will specialize in the production of com- b(z) = b*(z)
modities in the range
fb(z) dz I
(4') (w) < z <
The minimum cost condition determines where Y denotes total income, C demand
the structure of relative prices. The relative for and P the price of commodity z.
price of a commodity z in terms of any Next we define the fraction of income
other commodity z', when both goods are spent (anywhere) on those goods in which
produced in the home country, is equal to the home country has a comparative advan-
the ratio of home unit labor costs: tage:

(6) P(z)/P(z') = wa(z)/wa(z')

z

(9) 0(z) b b(z)fdz > 0

= a(z)/a(z');
z < z, z' < z 0 (z)= b(z) > 0

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

where again (0, 2) denotes the range of com-

modities for which the home country enjoys B(Z; L*/L)
a comparative advantage. With a fraction t
of each country's income, and therefore of
world income, spent on home produced
goods, it follows that the fraction of income
spent on foreign produced commodities is

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

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

C. Equilibrium Relative Wages 0 . I

and Specialization
FIGURE 1

To derive the equilibrium relative wage

and price structure and the associated pat- labor (goods) would decline.' A rise in the
tern of efficient geographic specialization, domestic relative wage would then be re-
we turn next to the condition of market quired to equate the demand for domestic
equilibrium. Consider the home country's labor to the existing supply.
labor market, or equivalently the market An alternative interpretation of the B( )
for domestically produced commodities. schedule as the locus of trade balance equi-
With z denoting the hypothetical dividing libria uses the fact that (10) can be written
line between domestically and foreign pro- in the balance-of-trade form:
duced commodities, equilibrium in the mar-
ket for home produced goods requires that
(10") [1 - 0(2)]wL = 0(2)w*L*
domestic labor income wL equals world This states that equilibrium in the trade bal-
spending on domestically produced goods: ance means imports are equal in value to
exports. On this interpretation, the B( )
(10) wL = 0(2)(wL + w*L*) schedule is upward sloping because an in-
crease in the range of commodities hypo-
Equation (10) associates with each z a value thetically produced at home at constant
of the relative wage -w/w* such that market relative wages lowers our imports and raises
equilibrium obtains. This schedule is drawn our exports. The resulting trade imbalance
in Figure 1 as the upward sloping locus and would have to be corrected by an increase
is obtained from (10) by rewriting the equa- in our relative wage that would raise our
tion in the form: import demand for goods and reduce our
exports, and thus restore balance.
(10') I = l - D(@)( (L*/L) - B(z;L*/L) The next step is to combine the demand
side of the economy with the condition of
where it is apparent from (9) that the sched- efficient specialization as represented in
ule starts at zero and approaches infinity as equation (5), which specifies the competitive
z approaches unity. margin as a function of the relative wage.
To interpret the B( ) schedule we note Substituting (5) in (10') yields as a solution
that it is entirely a representation of the the unique relative wage 5, at which the
demand side; and in that respect it shows world is efficiently specialized, is in bal-
that if the range of domestically produced
goods were increased at constant relative
'Throughout this paper we refer to "domestic"
wages, demand for domestic labor (goods) goods as commodities produced in the home country
would increase as the dividing line is shifted rather than to commodities that are nontraded. The
-at the same time that demand for foreign latter we call "nontraded" goods.

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826 THE AMERICAN ECONOMIC REVIEW DECEMBER 1977

anced trade, and is at full employment with being of the representative person-laborer
all markets clearing: at home relative to the well-being of the
representative foreign laborer.
(11) z = A(z) = B(-;L*/L)

The equilibrium relative wage defined in II. Comparative Statics

(11) is represented in Figure 1 at the inter-
section of the A( ) and B( ) schedules.2 The unique real equilibrium in Figure 1
Commodity z denotes the equilibrium bor- is determined jointly by tastes, technology,
derline of comparative advantage between and relative size, L*/L. We can now exploit
commodities produced and exported by the Figure 1 to examine simple comparative
home country (O < z < z), and those com- static questions.
modities produced and exported by the for-
eign country (z < z < 1). A. Relative Size
Among the characteristics of the equilib-
rium we note that the equilibrium relative Consider first the effect of an increase in
wages and specialization pattern are deter- the relative size of the rest of the world. An
mined by technology, tastes, and relative increase in L*/L by (10) shifts the B( )
size (as measured by the relative labor trade balance equilibrium schedule upward
force).3 The relative price structure asso- in proportion to the change in relative size
ciated with the equilibrium at point E is and must, therefore, raise the equilibrium
defined by equations (6) and (7) once (11) relative wage at home and reduce the range
has defined the relative wage z and the of commodities produced domestically. It
equilibrium specialization pattern z(Z). is apparent from Figure 2 that the domestic
The equilibrium levels of production relative wage increases proportionally less
Q(z) and Q*(z), and employment in each than the decline in domestic relative size.
industry L(z) and L*(z), can be recovered The rise in equilibrium relative wages due
from the demand structure and unit labor to a change in relative size can be thought
requirements once the comparative advan- of in the following manner. At the initial
tage pattern has been determined. equilibrium, the increase in the foreign rela-
We note that with identical homothetic tive labor force would create an excess sup-
tastes across countries and no distortions, ply of labor abroad and an excess demand
the relative wage Z- is a measure of the well- for labor at home-or, correspondingly, a
trade surplus for the home country. The re-
sulting increase in domestic relative wages
2See the Appendix for the relation of the diagram
serves to eliminate the trade surplus while
to previous analyses.
3The construction of the B( ) schedule relies heavily
on the Cobb-Douglas demand structure. If, instead,
demand functions were identical across countries and
B(z; L*/L)
homothetic, an analogous schedule could be con- LU\/
structed. In the general homothetic case, however, a set
B(z; L*/L)O
of relative prices is required at each z to calculate the
equivalent of the B( ) schedule; the relative prices are
those that apply on the A (z) schedule for that value
of z. In this case the independence of the A ( ) and
B( ) schedules is obviously lost. In the general homo-
thetic case there is still a unique intersection of the
A ( ) and B( ) schedules. For more general nonhomo-
thetic demand structures, it is known that an equilib-
rium exists; but even in the case of two Ricardian
goods there may be no unique equilibrium even though
there will almost always be a finite number of equi- I ~~~~A (z)
libria. See Gerard Debreu and Stephen Smale. Exten-
sions of our analysis with respect to the demand struc- Go 0 A
ture and the number of countries are developed in un-
published work by Charles Wilson. FIGURE 2

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

at the same time raising relative unit labor (13) P(z) - P(z") = co - d*(z") > 0
costs at home. The increase in domestic
relative unit labor costs in turn implies a where a "hat" denotes a proportional
loss of comparative advantage in marginal change. Domestic real income increases, as
industries and thus a needed reduction in does foreign real income.4 The range of
the range of commodities produced domes- goods produced domestically declines since
tically. domestic labor, in efficiency units, is now
The welfare implications of the change in relatively more scarce.
relative size take the form of an unambigu- An alternative form of technical progress
ous improvement in the home country's real that can be studied is the international
income and (under Cobb-Douglas demand) transfer of the least cost technology. Such
a reduction in real income per head abroad. transfers reduce the discrepancies in relative
We observe, too, that from the definition unit labor requirements-by lowering them
of the home country's share in world in- for each z in the relatively less efficient
come and (10), we have country-and therefore flatten the A (z)
schedule in Figure 1. It can be shown that
(12) wL/(wL + w*L*) = -()
such harmonization of technology must
It is apparent, as noted above, that a reduc- benefit the innovating low-wage country,
tion in domestic relative size in raising the and that it may reduce real income in the
domestic relative wage (thereby reducing high-wage country whose technology comes
the range of commodities produced domes- to be adopted. In fact, the high-wage coun-
tically) must under our Cobb-Douglas de- try must lose if harmonization is complete
mand assumptions lower the home country's so that relative unit labor requirements now
share in total world income and spending- become identical across countries and all
even though our per capita income rises. our consumer's surplus from international
trade vanishes.5
B. Technical Progress

To begin with, we are concerned with the C. Demand Shifts

effects of uniform technical progress. By
equation (1), a uniform proportional reduc- The case with a continuum of commodi-
tion in foreign unit labor requirements im- ties requires a careful definition of a demand
plies a reduction in a*(z) and therefore a shift. For our purposes it is sufficient to
proportional downward shift of the A (z) ask: What is the effect of a shift from high z
schedule in Figure 1. At the initial relative commodities toward low z commodities? It
wage a, the loss of our comparative advan- is apparent from Figure 2 that such a shift
tage due to a reduction in foreign unit labor will cause the trade balance equilibrium
costs will imply a loss of some industries schedule B( ) to shift up and to the left. It
in the home country and a corresponding follows that the equilibrium domestic rela-
trade deficit. The resulting induced decline
in the equilibrium relative wage serves to 4The purchasing power of foreign labor income in
restore trade balance equilibrium, and to terms of domestically produced goods is w* L*/wa(z) =
offset in part our decline in comparative L*/a(z)z and in terms of foreign goods L*/a*(z).
advantage. The fact that foreigners' real income per head rises is
guaranteed by our Cobb-Douglas demand assumption.
.The net effect is therefore a reduction in In the general homothetic case, a balanced reduction
domestic relative wages, which must fall in a* (z) can be immiserizing abroad if the real wage
rproportionally short of the decline in rela- falls strongly in terms of all previously imported
tive unit labor requirements abroad. The goods; however, the balanced drop in a* (z) in the gen-
eral homothetic case always increases our real wage.
home country's terms of trade therefore im-
5Complete equilization of unit labor requirements
prove as can be noted by using (7) for any implies that the A( ) schedule is horizontal at the
two commodities z and z", respectively, level w = A (z) = 1. In this case geographic specializa-
produced at home and abroad: tion becomes indeterminate and inessential.

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828 THE AMERICAN ECONOMIC REVIEW DECEMBER 1977

tive wage will rise while the range of com- relative price structure and the range of
modities produced by the home country de- goods traded.
clines. Domestic labor is allocated to a
narrower range of commodities that are A. Nontraded Goods
consumed with higher density while foreign
labor is spread more thinly across a larger To introduce nontraded goods into the
range of goods. analysis we assume that a fraction k of in-
Welfare changes cannot be identified in come is everywhere spent on internationally
this instance because tastes themselves have traded goods, and a fraction (1 - k) is
changed. It is true that domestic relative spent in each country on nontraded com-
income rises along with the relative wage. modities. With b(z) continuing to denote
Further we note that since Zi rises, the rela- expenditure densities for traded goods, we
tive well-being of home labor to foreign have accordingly
labor (reckoned at the new tastes) is greater
than was our laborers' relative well-being (14) k b a (z) dz < 1
(reckoned at the old tastes).
where z denotes traded goods.6 As before
D. Unilateral Transfers the fraction of income spent on domesti-
cally exportable commodities is O(z), except
Suppose foreigners make a continual uni- that t now reaches a maximum value of
lateral transfer to us. With uniform homo- (1)= k.
thetic tastes 'and no impediments to trade, Equation (1) remains valid for traded
neither curve is shifted by the transfer since goods, but the trade balance equilibrium
we spend the transfer exactly as foreigners condition in (10 ") must now be modified to:
would have spent it but for the transfer. The
new equilibrium involves a recurring trade (15) [1 - 0(z) - (1 - k)]wL
deficit for us, equal to the transfer, but there
= O(Z)W*L*
is no change in the terms of trade. As Bertil
Ohlin argued against John Maynard since domestic spending on imports is equal
Keynes, here is a case where full equilibra- to income less spending on all domestically
tion takes place solely as a result of the produced goods including nontraded com-
spending transfers. When we introduce non- modities. Equation (15) can be rewritten as
traded goods below, Ohlin's presumption
will be found to require detailed qualifica- (15') W = k (!) (L*/L)
tions, as it also would if tastes differed geo-
graphically.
where k is a constant and therefore inde-
pendent of the relative wage structure.
III. Extensions of the Real Model We note that (15') together with (5) de-
termines the equilibrium relative wage and
Extensions of the real model taken up in efficient geographic specialization, (Co, z).
this section concern nontraded goods, Further it is apparent that (15') has exactly
tariffs, and transport costs. The purpose of the same properties as (10') and that ac-
this section is twofold. First we establish cordingly a construction of equilibrium like
how the exogenous introduction of non- that in Figure 1 remains appropriate. The
traded goods qualifies the preceding analy- equilibrium relative wage again depends on
sis. Next we turn to a particular specifica-
tion of tariffs and transport costs to establish
6We can think of the range of nontraded goods as
an equilibrium range of endogenously de- another [0, 1] interval with commodities denoted by x
termined nontraded goods as part of the and expenditure fractions on those goods given by
equilibrium solution of the model. Trans-
c(x). With these definitions we have f c(x) dx-
fers are then shown to affect the equilibrium
I - k, a positive fraction.

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

relative size, technology, and demand con- tive wage increases and the range of com-
ditions. In this case demand conditions modities produced domestically is reduced.
explicitly include the fraction of income The steps in achieving this result are, first,
spent on traded goods: that at the initial relative wage only a frac-
tion of the transfer is spent on imports in
k- - -= A(z) the home country, while foreign demand for
k T- (z) L domestic goods similarly declines only by a
This nicely generalizes our previous equilib- fraction of their reduced income. The re-
rium of (11) to handle exogenously given sulting surplus for the home country has to
nontraded goods.7 be eliminated by, second, an increase in the
Two applications of the extended model domestic relative wage and a corresponding
highlight the special aspects newly intro- improvement in the home country's terms
duced by nontraded goods. First consider a of trade.8
shift in demand (in each country) toward The analysis of nontraded goods there-
nontraded goods. To determine the effects fore confirms in a Ricardian model the
on the equilibrium relative wage we have to "orthodox" presumption with respect to the
establish whether this shift is at the expense terms of trade effects of transfers.9
of high or low z commodities. In the former
case the home country's relative wage in- B. Transport Costs: Endogenous
creases while in the latter case it declines. Equilibrium for Nontraded Goods
If the shift in demand in each country is
uniform so that b(z) is reduced in the same The notion that transport costs give rise
proportion for all z in both countries, then to a range of commodities that are non-
the relative wage remains unchanged. traded is established in the literature and is
Consider next a transfer received by the particularly well stated by Haberler (1937).
home country in the amount T measured in In contrast with the previous section we
terms of foreign labor. As is well known, shall now endogenously determine the
and already shown, with identical homo- range of nontraded commodities as part of
thetic tastes and no nontraded goods, a the equilibrium. We assume, following the
transfer leaves the terms of trade unaf- "iceberg" model of Samuelson (1954), that
fected. In the present case, however, the transport costs take the form of "shrink-
condition for balanced trade, inclusive of age" in transit so that a fraction g(z) of
transfers, becomes: commodity z shipped actually arrives. We
further impose the assumption that g = g(z)
(16) T= (k - )[wL + T]
is identical for all commodities and the
[L - T] same for shipments in either direction.
or, in equilibrium, The home country will produce commod-
ities for which domestic unit labor cost
(16')
falls short of foreign unit labor costs ad-
=k = I (TIL) + k ( ) (L*/L) justed for shrinkage, and we modify (2') ac-
cordingly:
It is apparent from (16') that a transfer
(17) wa(z) < (1/g)w*a*(z)
receipt by the home country causes the
trade balance equilibrium schedule in Fig- or w < A(z)/g
ure 1 to shift upward at each level of z.
8At constant relative wages the current account
Accordingly, the equilibrium domestic rela-
worsens by [(1 - k -. tY) + 0IJdT = (1 - k)dT which
is less than the transfer, since it is equal to the fraction
7Diagrams much like Figures of income1 and
spent 2 again
onI nontraded goods. apply:
the descending A (z) schedule is as before; and now the 9The pre-Ohlin orthodox view of Keynes, Taussig,
new rising schedule looks much as before. As before, a Jacob Viner and other writers is discussed in Viner
rise in L*/L and a balanced drop in a* (z) will raise Z (1937) and Samuelson (1952, 1954). A recent treatment
and lower z. with nontraded goods is Ronald Jones (1975).

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830 THE AMERICAN ECONOMIC REVIEW DECEMBER 1977

(20) X(gw) f b(z)dz X'(gw) < 0

A(z)/g

A(z)g
X*(W/g) j b(z)dz X*'(W/g) > 0

U~~~~ I
The dependence of X( ) and X*( ) on the
variables specified in (20) and the respective
derivatives follow from (21) below.
The limits of integration z and z* are
i I \
derived from the conditions for efficient
production in (17) and (18) by imposing
equalities and so defining the borderline
exportobles z nontroded z importobles I
commodities. Thus, in Figure 3, z is the
FIGURE 3 borderline between domestic nontraded
goods and imports for the home country,
and z* denotes the borderline between
Similarly the foreign country produces foreign nontraded goods and the home
commodities for which foreign unit labor country's exports:
cost falls short of adjusted unit labor costs
(21) z* = A-'(w/g) di*/d(w/g) < 0
of delivered imports:
z = A-1(gw) df/d(gw) < 0
(18) w*a*(z) < (l/g)wa(z)
Of course, equilibrium z and z* are yet to
or A(z)g < w
be determined by the interaction of tech-
In Figure 3 we show the adjusted relative nology and demand conditions.
unit labor requirement schedules A (z)/g From (21) an increase in the relative wage
and A (z)g. It is apparent from (17) and (18) reduces the range of commodities domesti-
that for any given relative wage the home cally produced and therefore raises the frac-
country produces and exports commodities tion of income spent on imports. Abroad
to the left of the A (z)g schedule, both the converse holds. An increase in the do-
countries produce as nontraded goods com- mestic relative wage increases the range of
modities in the intermediate range, and the goods produced abroad and therefore re-
foreign country produces and exports com- duces the fraction of income spent on im-
modities in the range to the right of A (z)/g. ports. It follows that we can solve:
To determine the equilibrium relative
wage we turn to the trade balance equilib- (19') = - 1 - X*(&/g) (L*/L)
rium condition in (19)-together with (20)
and (21)-which is modified to take account 1- X(;L*IL,g) d</d& < O
of the endogenous range of nontraded for the unique equilibrium relative wage as
goods: a function of relative size and transport
costs:
(19) (1 -X)wL = (1 - X*)w*L*
(22) F = Fv(L*/L,g)
The variable X is the fraction of home
country income spent on our domestically Because (19')'s right-hand side declines as X'
(or home) produced goods-exportables rises, a rise in L*/L must still raise 3; a rise
and nontraded-and X* is the share of in g can shift X in either direction, depend-
foreigners' income spent on goods they pro- ing on the B(z) and A (z) profiles.
duce. Both X and X* are endogenously de- The equilibrium relative wage in (22),
termined because the range of goods pro- taken in conjunction with (21), determines
duced in each country depends on the rela- the equilibrium geographic production pat-
tive wages. tern, z and z-*. Since the range of nontraded

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

goods z* < z < z depends in this formula- The implicit relations (25) can be solved for
tion on the equilibrium relative wage, it is the equilibrium relative wage as a function
obvious that shifts in given parameters will of relative size and the tariff structure:
shift the range of nontraded commodities.
(26) Z) = Co(L*/L, t, t*)
Thus, a transfer that raises the equilibrium
relative wage at home causes previously ex- From (26) and (23) it is apparent now
ported commodities to become nontraded, that the range of nontraded goods will be a
and previously nontraded commodities to function of both tariff rates. It is readily
become importables. shown that an increase in the tariff im-
proves the imposing country's relative wage
C. Tariffs and terms of trade. Furthermore, as is well
We consider next the case of zero trans- known, when all countries but one are free
port cost but where each country levies a traders, then one country can always im-
uniform tariff on imports at respective rates prove its own welfare by imposing a tariff
t and t*, with proceeds rebated in lump sum that is not too large.
form. This case, too, leads to cost barriers A further question suggested by (26) con-
to importing, and to a range of commodi- cerns the effect of a uniform increase in
ties that are not traded, with the boundaries world tariffs. Starting from zero, a small
defined by: uniform increase in tariffs raises the relative
wage of the country whose commodities
(23) = A-1 command the larger share in world spend-
ing. This result occurs for two reasons.
and - A'(w(1 + t*)) First, at the initial relative wage a larger
share of spending out of tariff rebates falls
From (23) it is apparent that on the goods
theofpresence
the country commanding
of a
tariffs in either or both countries must give larger share in world demand. Second, the
rise to nontraded goods because- in this case tariff induces new nontraded goods and
therefore increases net demand for the
The trade balance equilibrium condition borderline commodity of the country whose
at international prices becomes, in place of residents have the larger income, or equiv-
(19), alently, the larger share in world income.
If countries are of equal size as measured
(24) (1 - X)Y/(1 + t) =
by the share in world income, such a uni-
(1 - X*)Y*/(1 + t*) form tariff increase has zero effect on rela-
where Y and Y* denote incomes inclusive tive wages, but of course reduces well-being
of lump sum tariff rebates. Using the fact in both places. Multilateral tariff increases,
that rebates are equal to the tariff rate times in this case, unnecessarily create some non-
the fraction of income spent on imports, we traded goods, and artificially raise the rela-
arrive at the trade balance equilibrium con- tive price of importables in terms of do-
dition in the form:'0 mestically produced commodities in each
country exactly in proportion to the tariff.
(25) X(1 -*) 1 + t*x* (L*/L)
IV. Money, Wages, and Exchange Rates
where X and X* are functions of (w,t,t*).
In this section we extend the discussion of
I0Tariff rebates in the home country are equal to the Ricardian model to deal with monetary
R = (I - A) Yt/(l + t). With Y = WL + R we there- aspects of trade. Specifically we shall be in-
fore have Y = WL(l + t)/(l + At) as.an -expression terested in the determination of exchange
for income inclusive of transfers. From equations (20)
rates in a flexible rate system, in the process
and (23) we have X = A[w/(1 + t)] and A* =
A*[w(1 + t*)], having substituted the tariff instead of adjustment
of to trade imbalance under
transport costs as the obstacle to trade. fixed rates, and in the role of wage sticki-

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832 THE AMERICAN ECONOMIC REVIEW DECEMBER 1977

ness. The purpose of the extension is to in- tary changes or velocity changes in one
tegrate real and monetary aspects of trade. country will be reflected in equiproportion-
ate changes in prices in that country and, in
A. Flexible Exchange Rates the exchange rate in the fashion of the
neutral-money Quantity Theory. However,
The barter analysis of the preceding sec- a real disturbance, as (28) shows, definitely
tions is readily extended to a world of does have repercussions on the nominal ex-
flexible exchange rates and flexible money change rate as well as on the real equilib-
wages. Assume a given nominal quantity of rium.
money in each country, M and M*, re- Using the results of Section II, we see
spectively. Further, in accordance with the that an increase in the foreign relative labor
classical Quantity Theory, assume constant force causes, under flexible exchange rates
expenditure velocities V and V*.ll A flexible and given M and M*, a depreciation in the
exchange rate, and our stipulating the ab- home country's exchange rate as does uni-
sence of nonmonetary international asset form technical progress abroad. A shift in
flows, will assure trade balance equilibrium real demand toward foreign goods likewise
and therefore the equality of income and leads to a depreciation of the exchange rate
spending in each country. The nominal as well as to a reduction in real Z. A rise in
money supplies and velocities determine foreign tariffs will also cause our currency
nominal income in each country: to depreciate. Each of these real shifts is
assumed to take place while (M, M*) are
(27) WL = MV and W*L* = M* V*
unchanged and on the simplifying proviso
where W and W* (now in capital letters) that real income changes leave V and V*
denote domestic and foreign money wages unchanged.
in terms of the respective currencies. Fur-
ther, defining the exchange rate e as the B. Fixed Exchange Rates
domestic currency price of foreign ex-
change, the foreign wage measured in terms In the fixed exchange rates case we as-
of domestic currency is e W*, and the rela- sume currencies are fully convertible at a
tive wage therefore is w W/e W*. parity pegged by the monetary authorities.
From the determination of the equilib- In the absence of capital flows and steriliza-
rium real wage ratio co by our earlier "real" tion policy, a trade imbalance is reflected in
relations, we can now find an expression for monetary flows. In the simplest metal
the equilibrium exchange rates: money model, the world money supply is
redistributed toward the surplus country at
(28) e = (1/&I)(W/W*) = precisely the rate of the trade surplus. We
assume that the world money supply is
(11F.) (MV/M* V*) (L*/L)
given and equal to G, measured in terms of
where (27') defines equilibrium money domestic currency. The rate of increase of
wages: the domestic quantity of money is therefore
(27') W = MV/L equal to the reduction in foreign money,
valued at the fixed exchange rate e:
and
(29) M=
W* = M* V*/L*
where Al dM/dt.
In this simple structure and with wage For a fixed rate world we have to de-
flexibility, we can keep separate the de- termine in addition to the real variables Co
terminants of all equilibrium real variables and z, the levels of money wages W and W*
from all monetary considerations. Mone- as well as the equilibrium balance of pay-
IIThis is a strong assumption since it makes ments
spend- associated with each short-run equi-
librium.
ing independent of income and nonliquid assets even in In the long run the balance of pay-
the short run. ments will be zero as money ends up

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

redistributed internationally to the point W R'

where income equals spending in each
country. In the short run an initial misallo- G/
cation of money balances implies a dis-
crepancy between income and spending and
an associated trade imbalance. To char-
acterize the preferred rate of adjustment of

//
cash balances in the simplest and most man-
ageable way, we assume that spending by
each country is proportional to money
holdings.'2 On the further simplifying as-
sumption that velocities are equal in each
country, V = V*,13 world spending is equal
to
0 -
(30) VM + eV*M* - VG
FIGURE 4
For the tastes and technology specified in
Section I, world spending on domestically
produced goods is given by ing from (11) for the equilibrium relative
wage Zi, we can employ equations (32) and
(31) VG f b(z)dz t- (w)VG (33) to determine money wage levels.
The equilibrium determined by equations
z= A-'(w) (32) and (33) can be analyzed in terms of
Figure 4. The figure emphasizes the separa-
In equilibrium, world spending on our tion of real and monetary aspects of the
goods must equal the value of our full-em- equilibrium under our assumptions of
ployment income WL: traded goods only, and no distribution ef-
fects. From the ratio of (32) and (33) we ob-
(32) WL = t(w) VG
tain the equilibrium relative wage C as a
Equilibrium requires, too, that world spend- function of tastes and technology solely
ing on foreign goods equals the value of from the barter model. This equilibrium re-
foreign full-employment income: lative wage is plotted as the ray OR in Fig-
ure 4.
(33) eW*L* = [1 - (w)]V6
The equality of world income and spend-
Equations (32) and (33) express what ing
would seem to be the joint determination of
real and monetary variables. But, in fact, (30') WL + eW*L* = VG
we could have taken the shortcut of recog-
nizing that the real equilibrium is precisely is shown as the downward sloping straight
that of the barter analysis developed in Sec- line GG, which is drawn for given velocity,
tion I. Dividing (32) by (33) and substitut- world quantity of money, and labor forces.
Point E is the equilibrium where relative
prices and the level of wages and prices are
12The assumption that spending is proportional to such that all markets clear. At a level of
cash balances is only one of a number of possible
wages and prices higher than point E, there
specifications. Conditions for this expenditure function
to be optimal are derived in Dornbusch and Michael would be a world excess supply of goods,
Mussa. In general, expenditure will depend on both and conversely at points below E.
income and cash balances. Figure 4 immediately shows some com-
131n the long-run equilibrium, higher V than V* parative static results. Thus a doubling of
leaves us with a smaller share of the world money
stock than foreigners, but with nominal and real in-
both countries' labor forces, from the
come shares in the two countries the same as when analysis of the barter model, will leave the
V= V*. relative wage unaffected but will double

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834 THE AMERICAN ECONOMIC REVIEW DECEMBER 1977

world output. Given unchanged nominal the adjustment process: changes in the
spending VG, wages and prices will have to terms of trade, in home and/or foreign
halve. This would be shown by a parallel price levels, in relative prices of traded and
shift of the GG schedule halfway toward the nontraded goods (there being none of the
origin. A shift in demand toward the home latter), in double factoral terms of trade;
country's output by contrast would rotate and any discrepancies in the price of the
the OR ray to a position like OR' since it same commodity between countries. The
raises our relative wage. The ensuing mone- features of the adjustment process of this
tary adjustment is then an increase in our section rely on 1) identical, constant expen-
money wage and money income and a de- diture velocities, 2) uniform-homothetic de-
cline in foreign wages, prices, and incomes mand, and 3) the absence of trade impedi-
(point E'). ments. If velocities were constant but
The real and nominal equilibrium at differed between countries, the absolute
point E in Figure 4 is independent of the levels of money wages and prices, though
short- and long-run distribution of the not relative wages or prices, would depend
world quantity of money. The independence on the world distribution of money. Relaxa-
of the real equilibrium derives from the uni- tion of the uniform-homothetic taste as-
form homothetic tastes. The independence sumption would make equilibrium relative
of the nominal equilibrium is implied by prices a function of the distributions of
identical velocities. What does, however, spending. Finally, the presence of non-
depend on the short-run distribution of traded goods would, together with Ricardo's
world money is the transition periods' bal- technology, provide valid justification for
ance of payments. As in the absorption ap- some of the behavior of relative prices and
proach of Sidney Alexander (1952), we price levels frequently asserted in the litera-
know this: when goods markets clear, the ture; this behavior is studied in more detail
trade surplus or balance of payments M of in the next section.
the home country is equal to the excess of
income over spending, or: C. The Price-Specie Flow Mechanism
under More General Conditions
(34) M= WL- VM

With the nominal wage independent of the We now discuss the adjustment process
distribution of world money, equation (34) to monetary disequilibrium and enquire
therefore implies that the trade balance into the price effects associated with a redis-
monotonically converges to equilibrium at tribution of the world money supply when
a rate proportional to the discrepancy from there are nontraded goods. Common ver-
long-run equilibrium:"4 sions of the Hume price-specie flow mech-
anism usually involve the argument that in
(34') M = V(M - M); M = 0 ()G
the adjustment process, prices decline along
The assumptions of this section were de- - with the money stock in the deficit country,
signed to render inoperative most of the tra- while both rise in the surplus country. There
ditional mechanisms discussed as part of is usually, too, an implication that the defi-
cit country's terms of trade will necessarily
14Suppose V> V* and our share of the world worsen in the adjustment process and in-
money supply is initially larger than our equilibrium
deed have to do so if the adjustment is to be
share. Then, as we lose M, total world nominal income
and nominal GNP falls. Always our share of nominal
successful.
world GNP stays the same under the strong demand Section IVB demonstrated that the redis-
assumptions. Total world real output never changes tribution of money associated with mone-
during the transition; only regional consumption tary imbalance need have no effects on real
shares change. Therefore, both countries' nominal
variables (production, terms of trade, etc.)
price and wage levels fall in the transition, but such
balanced changes have no real effects on either the and on nominal variables other than the
transient or the final real equilibrium. money stock and spending. While this is

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

clearly a very special case, it does serve as a ing to nontraded goods, shifting some of
benchmark since it establishes that the our resources to their production at the ex-
monetary adjustment process would be ef- pense of our previous exports. We not only
fective even in a one-commodity world. export fewer types of goods, but also import
To approach the traditional view of the more types, and import more of each
adjustment process more clearly and pro- (& rises and z falls).
vide formal support for that view, we con- During the transition, while the real
sider an extension to the monetary realm of transfer corresponding to our deficit is tak-
our previous model involving nontraded ing place, our terms of trade are more
goods. We return to the assumption that a favorable than in the long-run state. The
fraction (1 - k) of spending in each coun- new gold raises both their W* and our W,
try falls on nontraded goods, and accord- but in addition, our W is up relative to their
ingly equations (32)- and (33) become: W*. Therefore the price level of goods we
continue to produce is up relative to the
(32') WL = 0 (w) VG + (1 - k)yVG;
price level of goods they continue to pro-
yMI G duce. This is true both for our nontraded
(33') eW*L* = [k - O(w)]VG goods and for our exportables. The prices
of goods we produce rise relative to the
+ (1 - y)(1 - k)VG
prices of goods they produce in proportion
These hold both in final equilibrium, and in to the change in relative wages.
transient equilibrium where specie is flow- Thus the price levels in the two countries
ing. Equations (32') and (33') imply that have been changed differentially by the
the equilibrium relative wage does depend specie flow and implied real transfer. But
on the distribution of the world money sup- that does not mean that any traded good
ply. Solving these equations for the equilib- ever sells for different prices in two places.
rium relative wage we have: In fact the divergence in weighted average
(consumer) price levels is due to nontraded
(35) z = zi5 d > goods. The price level will rise in the gold-
discovering country relative to the other
An increase in the home country's initial country the greater is the share of non-
share in the world money supply y raises traded goods in expenditure, 1 - k. It is a
our relative wage. bit meaningless to say, "What accom-
Using this extended framework, we can plished the adjustment is the relative move-
draw on the analysis of the transfer problem ments of price levels for nontraded goods in
in Section II to examine the adjustment that the two countries," since we have seen that
follows an initial distribution of world the adjustment can and will be made even
money between the two countries that dif- when there are no such nontraded goods.
fers from the long-run equilibrium distribu- It is meaningful to say, "The fact that peo-
tion. ple want to direct some of their expenditure
Suppose our M is initially excessive, say to nontraded goods makes it necessary for
from a gold discovery here. Assume also resources to shift in and out of them as a re-
that the gold discovery occurred when the sult of a real transfer, and such resource
world was in long-run equilibrium with the shifts take place only because the terms of
previous world money stock. As a result of trade (double-factoral and for traded goods)
our excess M, we spend more than our do shift in the indicated way."
earnings, incurring a balance-of-payments The adjustment process to a monetary
deficit equal to the rate at which our M is disturbance is stable in the sense that the
flowing out. In effect, the foreign economy system converges to a long-run equilibrium
is making us a real transfer to offset our distribution of money with balanced trade.
deficit. As seen earlier, we, the deficit coun- To appreciate that point, we supplement
try, are devoting some of our excess spend- equations (32') and (33') with (34) that con-

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836 THE AMERICAN ECONOMIC REVIEW DECEMBER 1977

tinues to describe the monetary adjustment lative price, wage, and income movements.
process. We note, however, that now W and They are, of course, in no way essential to
W* are endogenous variables whose levels the existence of a stable adjustment process,
in the short run do depend on the distribu- nor is there at any time a need for a dis-
tion of the world money supply. A redistri- crepancy of prices of the same commodity
bution of money toward the home country across countries in either case. 16
would raise our spending and demand for A final remark concerns the adjustment
goods, and reduce foreign spending and de- to real disturbances such as demand shifts
mand. As before, spending changes for or technical progress. It is certainly true
traded goods offset each other precisely so that whether the exchange rate is fixed or
that the net effect is an increase in demand flexible, real adjustment will have to take
for nontraded goods at home and a decline place and cannot be avoided by choice of an
abroad. As a consequence our wages will exchange rate regime. So long as wages and
rise and foreign wages decline. Therefore, prices are flexible, it is quite false to think
starting from full equilibrium, a redistribu- that fixed parities "put the whole economy
tion of money toward the home country will through the wringer of adjustment" while
create a deficit equal to in floating rate regimes "only the export
and import industries have to make the real
(36) dM/dM= -V(1 6) 0 < 1 < I
adjustment." It is true, however, that once
where 6 is the elasticity of our nominal we depart from flexible wages and prices
wages with respect to the quantity of money there may well be a preference for one ex-
and is less than unity.'5 Equation (36) im- change rate regime over another. The next
plies that the price-specie flow mechanism section is devoted to that question.
is stable.
It is interesting to observe in this context D. Sticky Money Wages
that the presence of nontraded goods in fact
slows down the adjustment process by com- The last question we address in this sec-
parison with a world of only traded goods tion concerns the implications of sticky
(contrary to J. Laurence Laughlin's turn. of money wages. For a given world money
the century worries). As we saw before, with supply, downward stickiness of money
all goods freely tradeable, wages are inde- wages implies the possibility of unemploy-
pendent of the distribution of money, and ment. We assume upward flexibility in
accordingly 6 = 0. Further we observe that wages, once full employment is attained.
the speed of adjustment depends on the re- We start with a fixed exchange rate e.
lative size of countries. Thus the more equal The relation between wages and the world
countries are in terms of size, the slower quantity of money is brought out in Figure
tends to be the adjustment process. 5. Denote employment levels in each coun-
In concluding this section we note that try, as opposed to the labor force, by the
nontraded goods (and/or localized de- new symbols L and L*, respectively; denote
mand) are essential to the correctness of nominal incomes by Y and Y*. The equality
traditional insistence that the adjustment of world income and spending is again
process necessarily entails absolute and re- shown by the GG schedule, the equation of
which now is

I5The value of 6 can be calculated from equations (37) VG = Y + eY* - WL + W*L*

(32') and (33') to be
16The continuum Ricardian technology is special in
that there can be no range of goods both imported and
6 (1 - k)y(l Y(
- k- kY)
) + E
produced at home. Therefore, the cross elasticity of
supply between nontraded goods and exports must be
where e is the elasticity of the share of our traded greater than the zero cross elasticity between non-
goods in world spending, e -tYw/lt > 0. The traded goods and imports. Consequently, a transfer
elas-
ticity 6 is evaluated at the long-run equilibrium where must shift the terms of trade (for goods and factors) in
y t-/k. If A '(z) falls slowly, e will be large. the stated orthodox way, favorably for the receiver.

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

Y R' plied reduction in our relative wages and

G /
the resulting increase in our relative income
are shown in Figure 5 by the rotation from
\/t OR to OR'.

E ~~~R The new equilibrium is at E' where our

money income and employment have risen
while income and employment decline
y~~
abroad. Thus an increase in the foreign
wage rate, by moving the terms of trade
against us, shifts comparative advantage
and employment toward the home country.
The extent to which the home country bene-
Y eY* fits from the adverse terms of trade shift in
0 ET* terms of employment will depend on both
FIGURE 5 the substitutability in demand and the elas-
ticity of the A (z) schedule in Figure 1. We
observe, too, that the move from E to E'
where W and W* are the fixed money will bring about a transitory balance-of-
wages set at too high sticky levels. The payments surplus. Given the initial distribu-
schedule is drawn for given money wages, a tion of money and hence of -spending, the
given world quantity of money, and a foreign decline in income and the increase
pegged parity for e. The ray OR now is pre- at home implies that we will spend less than
determined by the given sticky relative wage our income and therefore have a trade sur-
i = W/eW*. From equations (32) and (33) plus. This surplus persists until money is re-
the ratio of money incomes Y/eY* is just a distributed to match the new levels of in-
function of the relative wage now given ex- come at '.
ogenously by rigid money wages and the ex- Next we move to flexible exchange rates.
change rate: Under flexible rates an increase in the for-
eign money wage W*, given money supplies
(38) Y/eY* - (WeW*) in each country, will similarly have real re-
percussion effects on relative prices and em-
'(W) < 0 ployment at home. Now employment in
each country is determined by money sup-
Point E is the nominal equilibrium where
plies and prevailing wages:
by assumption the world quantity of money
is insufficient relative to wage rates to en- (39') L = VM/ W; L* - VM*/ W*
sure full employment. Although that equi-
librium is one with unemployed labor, it is Given the employment levels thus deter-
efficient in other respects. Specifically, geo- mined, we know from the analysis of the
graphic specialization follows comparative earlier barter model that there is a unique
advantage as laid out above, but now labor relative wage at which the trade balance
employed adjusts to sticky wage patterns of achievesequilibrium. The higher is M*/ W*,
specialization. the higher will be employment abroad-
Employment levels Land L* now are de- and, therefore, the higher will be our rela-
termined by (39) tive wage a. It is thus apparent that an in-
crease in the foreign money wage, W*, will
(39) L-= Y/W, L* -
reduce employment abroad. Employment
where Y and Y* are the equilibrium levels declines only in proportion to the increase
of nominal income determined by equations in wages and thus declines by less than it
(37) and (38) or by point E in Figure 5. would under fixed exchange rates when
Consider now the impact of a foreign in- specie is lost abroad.
crease in money wages. The effect of the im- We saw in the barter model that a reduc-

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838 THE AMERICAN ECONOMIC REVIEW DECEMBER 1977

tion in effective foreign labor causes a de- surplus causes our exchange rate to appre-
cline in our relative wage, but that the ciate until the initial employment levels and
decline in our relative wage falls propor- therefore trade balance equilibrium are re-
tionately short of the foreign reduction in stored. The demand shift is fully absorbed
labor. Now, at the initial exchange rate, the by a change in the terms of trade and a shift
increase in foreign wages reduces our rela- in competitive advantage that restores de-
tive wage and their employment in the same mand for foreign goods and labor.
proportion. The decline in our relative wage Real and nominal equilibria are thus seen
is therefore excessive. Domestic goods are to be uniquely definable in our continuum
underpriced and the exchange rate appre- model with constant-velocity spending de-
ciates to partly offset the gain in cost com- terminants. The difference between sticky
petitiveness. The net effect is therefore a and flexible wage rates under fixed exchange
decline in our relative wage and an appre- rates is understandable as the difference be-
ciation of our exchange rate (a decline in e) tween (a) having the crucial relative wage zi
that falls short of the foreign increase in be imposed in the sticky wage case with em-
wages. Since our terms of trade unambig- ployments having then to adjust; or (b) hav-
uously deteriorate without any compensat- ing the full employments be imposed and C
ing gain in employment, it must be true that having to adjust. Under floating exchange
welfare declines at home. Abroad, the loss rates, sticky nominal wages impose employ-
in employment is offset by a gain in the ment levels in each country and the crucial
terms of trade, but there too the net effect is relative wage Z then adjusts to those em-
a loss in welfare under our strong Mill- ployment levels.
Ricardo assumption.
APPENDIX
The adjustment to money wage distur-
bances under fixed and flexible rates differs Historical Remark
in several respects. Under fixed rates em-
ployment effects are transmitted, while Figure 1 seems to be new. G. A. Elliot
under flexible rates they are bottled up in (1950) gives a somewhat different diagram,
the country initiating the disturbance. one that makes explicit the meaning of
Under fixed rates the terms of trade move Marshall's 1879 "bales" (which, by the way,
one for one with money wage, while under happen to work only in the two-country
flexible rates exchange rate movements constant labor costs case). In terms of the
partly offset increases in the foreign money present notations, Elliott plots for the U.S.
wage rate. offer curve the following successive points
The difference between fixed and flexible traced out for all w on the range [0, oo ]: on
rates in relation to the adjustment process is the vertical axis is plotted our total real im-
further brought out by an example of a real ports valued in foreign labor units ("our
disturbance. Consider a shift in world de- demand for bales of their labor," so to
mand toward our goods. Under fixed rates speak), namely,
the resulting increase in our relative income
will, from (38), move us in Figure 5 from
f [P*(z)/w*]C(z)dz = j a*(z)C(z)dz
E to E'. Employment rises at home and falls
abroad. Demand shifts are fully reflected in
employment changes. Under flexible rates, and on the horizontal axis, our total real
by contrast, with given wages and money, a exports valued in home labor units ("our
demand shift has no impact on employ- supply of bales of labor to them"), namely,
ment-as we observe from (39). At the ini-
tial exchange rate the demand shift would rz
give rise to an excess demand for our goods J[P(z)/w][Q(z) - C(z)]dz=
and to an excess supply abroad. Domestic
income and employment would tend to rise L - a(z) C(z)dz
while falling abroad. The resulting trade

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

It is to be understood that 2 is a function of G. A. Elliott, "The Theory of International

w, namely the inverse function A '(w); also Values," J. Polit. Econ., Feb. 1950, 58,
that C(z) are the amounts demanded as a 16-29.
function of our real income L and of the F. Graham, "The Theory of International
P(z)/ W function defined for each, namely Balances Re-Examined," Quart. J. Econ.,
min [wa(z), a*(z)]. Because we have a con- Nov. 1923, 38, 54-86.
tinuum of goods, we avoid Elliott's Gottfried Haberler, The Theory of Inter-
branches of the offer curve that are seg- national Trade, London 1937.
ments of various rays through the origin. R. W. Jones, "Presumption and the Transfer
The reader will discern by symmetry con- Problem," J. Int. Econ., Aug. 1975, 5,
siderations how the' foreign offer curve is 263-74.
plotted in the same (L, L*) quadrant, by James Laurence Laughlin, Principles of Money,
varying w to generate the respective coor- New York 1903.
dinates John S. Mill, Principles of Political Economy,
London 1848.
rz David Ricardo, On the Principles of Political
a(z)C*(z)dz,
Economy and Taxation, 1817; edited by
P. Sraffa, London 1951.
L* a*(z)C*(z)dz P. A. Samuelson, "The Transfer Problem and
Transport Costs: The Terms of Trade
When Impediments are Absent," Econ.
Our model forces the Elliott-Marshall J., June 1952, 62, 278-304; reprinted in
diagram to generate a unique solution under Joseph Stiglitz, ed., Collected Scientific
uniform-homothetic demand. Unlike our Papers of Paul A. Samuelson, Vol. 2,
Figure 1, the Elliott diagram can handle Cambridge, Mass., ch. 74.
the general case of nonhomothetic demands , "The Transfer Problem and the
in the two countries; but then, as is well Transport Costs, II: Analysis of Effects
known, multiple solutions are possible, of Trade Impediments," Econ. J., June
some locally stable and some unstable. The 1954, 64, 264-89; reprinted in Joseph
price one pays for this generality is that, as Stiglitz, ed., Collected Scientific Papers
Edgeworth observed, the Marshallian of Paul A. Samuelson, Vol. 2, Cambridge,
curves are the end products of much im- Mass., ch. 75.
plicit theorizing, with much that is inter- , "Theoretical Notes on Trade Prob-
esting having taken place offstage. lems," Rev. Econ. Statist., May 1964, 46,
145-54; reprinted in Joseph Stiglitz, ed.,
Collected Scientific Papers of Paul A.
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G. Debreu, "Economies with a Finite Set of national Trade, New York 1937.
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