Multipliers and Elasticities in Foreign-Trade Adjustments

Abstract

TN THE last fifteen years many contributions Have altered the theory of balance-of-trade adjustments to accommodate Keynesian income analysis. Under the classical mechanism of adjustment, price elasticities played the paramount role in bringing about a correction whenever an international imbalance existed. National price levels were altered in relation to one another, either through gold movements or through exchange-rate adjustments; and these adjustments caused relative prices of home and imported goods to alter. Substitution against imports and in favor of home goods took place in the country with the reduced price level, and the reverse process took place abroad. WYhen the foreign-trade multiplier was introduced by the work, notably, of Robinson, Salant, Metzler, and Machlup, attention was concentrated for a time on this mechanism. It was used to show how economic fluctuations were transmitted between countries; how capital and reparations transfers could be made; and how an exchange depreciation could be used to raise a country's income and employment at the expense of its neighbors. More recently the price-substitution and multiplier mechanisms have been combined to describe the simultaneous effects of the two on domestic income, foreign income, and the balance of trade. Contributions to the solution of this problem have been made by Tinbergen, IHarberger, and Polak.2 More recently still, Alexander has treated the international adjustment mechanism in a novel fashion, which he calls the approach.3 Alexander concludes that, in general, an exchange-rate adjustment will not succeed in improving significantly the trade balance of a deficit country, for any improvement in the balance (in foreign-currency terms) must be met by a greater increase in real income than in real absorption (domestic consumption and investment). But generally, according to Alexander, absorption will change by just as much as income, because the marginal propensity to absorb is usually in the neighborhood of unity.4 This disarmingly simple approach, which, its author thinks, says everything important about devaluation and its effects, has been criticized by Machlup, who believes that he has found a number of defects in the income-absorption treatment, in particular its complete neglect of the price-substitution effects which played such an important role in other formulations.5 My present purpose is to clarify Alexander's approach and to show how it fits in with more accepted versions of the adjustment mechanism, such as those of Polak and Harberger. By using standard definitions and behavioral relations, I shall derive results which can easily be trans-