Relative Prices, Expenditure and the Trade Balance: A Note

Abstract

Recent discussion has attempted to fill a gap in the theory of consumption. The question is, what will be the effect of a change in relative prices on aggregate consumption from a given income ? Ackley and Suits' have asked whether the effect of a change in consumers' real income arising from a change in relative prices will be the same as the effects arising from the corresponding change in real income when relative prices are unchanged. A very important practical example of a shift in relative prices is the shift in the relationship between the prices of home and of imported goods when the exchange rate is changed or when there is a change in the general price level at home or abroad. Laursen and Metzler2 and Harberger3 have considered the effects of changes of the terms of trade upon the total of expenditure from a given money income, and so on the level of activity and on the conditions for exchange stability. Two major problems are involved in this question. Firstly, there is the index number problem. Secondly, we have to ask whether a rise in one price will affect the real consumption function in the same way as some corresponding lesser rise in all prices. In Hicksian terms, we have three commodities on which the individual can spend money; good x, good y, and saving. Now it may be that a relationship of close complementarity or of close substitution exists between one of the goods (x or y) and saving. The main purpose of this paper is to consider when we might expect such relationships to arise, and to investigate their implications. It is all too easy, in this discussion, to fall into the trap involved in the index number problem. If we compare two situations, one before relative price changes and one after, we cannot measure the price index which is the ratio of the compensating income to the initial income, but can only say that it approximates to one limit or the other; that is, to the Paasche or to the Laspeyres type of index. We cannot say that a rise in some prices but not in all corresponds to a uniquely defined fall in income4. In order to avoid the index number problem, this paper will consider a case where some prices rise and other prices remain unchanged, and where each consumer's money income is initially unchanged. (This can be conceived of as a sort of period analysis. Consumer expenditure