The Balance of Trade in a Model of Temporary Equilibrium with Rationing

Abstract

The importance of accepting the failure of prices to adjust to their Walrasian equilibrium levels instantaneously is now widely recognized. When economic activity is attempted at such sticky prices, it is the adjustment of quantities that leads to a short run or temporary equilibrium. The first effect is that in any market where the price fails to adjust, the short side of the market determines the actual amount transacted, and the long side is rationed. But even more important are the repercussions that arise as transactors who have failed to satisfy their initial demands or supplies in one market recalculate their actions in other markets. This is Clower's dual decision hypothesis, which leads to a distinction between such recalculated or effective demands or supplies and the original or notional ones. The nature of the initial market imbalance depends on the values taken by the sticky prices, and the resulting temporary equilibria with rationing are of different kinds. Recent years have produced some models of closed economies based on this approach. In particular, Barro and Grossman (1976) and Malinvaud (1977) have completed the classification of possible equilibria in a model with labour, aggregate output and fiat money. They divide the wage-price space into regions corresponding to three kinds of equilibria. In the first region the real wage is too high, and consumers face rationing both when buying commodities and when selling labour; this is labelled the region of classical unemployment. The second region has Keynesian unemployment in the sense that there is excess supply in both the commodity and the labour market. The third region has excess demand in both markets, and corresponds to repressed inflation. In these two cases, the real balance effect on demand is an important force. These developments have not so far touched international trade theory. The conventional approach embodied in the diagrams of Swan (1963) and Mundell (1968) is a simple income-expenditure one. It largely neglects wages and prices, and assumes output to be demand-determined. This is a poor choice theoretic framework. It is at best an ad-hoc way of approaching effective demand-determined or Keynesian equilibria, but is quite inappropriate for the other kinds. The work of Meade (1951), from which this approach can be said to derive, pays more attention to some prices, but still falls short of giving a proper logical account of the dual decision process. On the other hand, the monetary approach which has recently come into prominence following Frenkel and Johnson (1976), while paying more attention to prices and choices, usually goes to the other extreme and assumes instantaneous attainment of Walrasian equilibrium in commodity and labour markets. An exception is Rodriguez's paper in that volume, but he admits labour market disequilibrium simply by replacing that component of the standard monetary model by an income-expenditure one. This brings in the attendant flaws mentioned above. This paper is a first attempt at giving a more satisfactory model of the balance of trade,