North-South Trade and the Non-Neutrality of International Money

Transcription

1 Deartment of Economics Issn Discussion aer 8/0 North-South Trade and the Non-Neutralit of International Mone Wenli Cheng and Dingsheng Zhang Abstract: This aer develos a Ricardian model ith mone to stud North-South trade that is mediated b the currenc of the North. The model shos that an increase in the sul of Northern mone results in inflation being eorted to the South. The increase in the sul of Northern mone also has real effects: ( it transfers real resources from the South to the North, loers the age rate in the South relative to that in the North, and orsens the terms of trade for the South; and ( it leads to structural changes in both economies b encouraging the eansion of the tradable sector in the South and the eansion of the non-tradable sector in the North. JEL classification: F, F4, E4 Keords: North-South trade, demand for mone, demand for foreign echange, monetar olic, mone non-neutralit Deartment of Economics, Monash Universit, Australia. Corresonding author: enli.cheng@buseco.monash.edu.au China Economics and Management Academ. Central Universit of Finance and Economics 00 Wenli Cheng and Dingsheng Zhang All rights reserved. No art of this aer ma be reroduced in an form, or stored in a retrieval sstem, ithout the rior ritten ermission of the author

2 North-South Trade and the Non-Neutralit of International Mone. Introduction When an Indian eorter sells to the US market, chances are that he ill rice his goods in US dollars and hail accet US dollars in ament. An US eorter, on the other hand, is unlikel to accet a ament in Rubee from an Indian buer. Particiants in international trade choose to use the US dollar and a small number of other currencies in their transactions for good reasons, including transaction cost savings (Krugman, 980 and cometition considerations (Goldberg & Tille, 008. What s also interesting is that their choices of currencies as media of echange have imortant imlications for the a shocks, eseciall monetar shocks, are transmitted across countries. The urose of this aer is to stud some of these imlications. Secificall, e investigate ho a monetar shock originated from a countr hose currenc is used internationall is likel to affect this countr and its trading artners. We conduct our investigation b develoing a monetar model of North-South trade in a Ricardian orld. There is a large literature on North-South trade, addressing a variet of issues, for eamle, the gains of trade and its distribution (Chui, Levine, & Pearlman, 00; Matsuama, 000, the effect of trade on age and income inequalit (Askena, 005; Choi, 007 and the role of technolog transfer (Hoekman & Javorcik, 006. Hoever, to our knoledge, fe researchers have carefull studied the imlications of a rominent feature of North-South trade, namel that the trade is usuall mediated b the currenc of a Northern countr. Imagine a orld consisting of a to countries, the South and the North. If the South uses the currenc of the North in the trade beteen them, there is a demand b individuals in the South for holding the Northern currenc. As ith the demand for domestic mone, Southern individuals (nominal demand for Northern mone deends on, among other things, nominal income. When there is an increase in the sul of Northern mone, the nominal income of the North goes u, hich raises the demand for Southern goods. This increase in demand ushes u the rices of Southern goods, hich in turn ut uard ressure on nominal age

3 rate and nominal income, thus inflation arrives in the South (ith the additional inflo of Northern mone. The rise in nominal income in the South also increases the demand for Northern mone b Southern individuals. Since the increase in the holdings of Northern mone is made ossible onl b an increase of Southern net eorts to the North, there is a transfer of real resources from the South to the North. The increase in demand for Northern mone artl offsets the donard ressure on the echange rate (i.e., the Southern mone rice of Northern mone, such that the echange rate falls b less than roortionall relative to the increase in the sul of Northern mone. Corresondingl, the terms of trade orsens for the South, hich means more goods have to be eorted for the same amount of imorts. In the ne equilibrium therefore, the eort sector in the South needs to be larger, and that in the North needs to be smaller. In other ords, the increase in the mone sul in the North leads to structural changes of roduction in both countries. In the folloing section, e resent a simle Ricardian model hich formalises our conjecture described above about the likel consequences of an increase in the sul of Northern mone. The model adds vigour to our intuitive analsis and allos us to see more clearl the interrelationshi among the variables of interest. We offer some concluding remarks in section 3.. The model Consider a Ricardian orld ith to countries: the South ith a oulation of N, and the North ith a oulation of N. There are three goods X, Y and Z. We assume that the South secialises in the roduction of good X, and the North in the roduction of good Y. Good Z is roduced in both countries, and is not traded internationall. Assume further that trade ithin each countr is mediated b the countr s domestic currenc; hereas international trade is mediated b the currenc of the North. As a result, an individual in the South has a demand for Southern mone (used in internal trade and a demand for Northern mone (used in international trade. We can rite the reresentative Southern individual s decision roblem as:

4 ma,,, m/ P, FX/ m FX α α m α FX U U (,,,, ( ( α α P P s.t. + ( e + + m + FX e + m + FXe α+ α + α3+ α4 + α5 here,, are quantities of goods X, Y, and Z demanded; P is the average rice of good X and good Z (hich are bought ith Southern mone; is the rice of good Y; m / P is the demand for real balances in Southern mone; FX / is the demand for real balances in foreign echange (Northern mone; domestic and foreign currenc, resectivel; e is the echange rate. m and FXeare initial mone holdings in In the North, the reresentative individual consumer has a similar decision roblem as that of the Southern individual ecet that the Northern individual has no demand for Southern mone. ma,,, m/ P m β m U U (,,, ( β β β 3 4 P P ( / e m + m s.t. β+ β + β3+ β4 Solving the consumer decision roblems, e obtain the demand functions for goods, domestic mones and foreign echange: α ( + m+ FXe β ( + m e ; ( α ( + m+ FXe β ( + m ; ( e α 3( + m+ FXe β 3( + m ; (3 α4( m + m + FX e ; m β4( + m (4 FX α + + e 5( m FXe (5

5 On the sul side, e assume that all goods are roduced ith labor onl. The roduction functions are: South: X al; Z al North: Y a L ; Z al Under the assumtion of erfect cometition, the rices of goods are driven to the levels of roduction cost, thus e have ; a ; a a (6 a (7 In equilibrium, all markets clear. Secificall the folloing market clearance conditions are met: In the South: Labour market: L + L N (8 Market for good Z: N Z (9 In the North: Labor market: L + L N (0 Market for good Z: N Z ( International: Market for good X: N+ N X ( Market for good Y: N+ N Y (3 Market for Northern mone: N( FX+ N( + NFX (4 e Solving equations (-(4, e obtain the equilibrium values of all the endogenous variables, of hich the folloing are of articular interest to us. ( Quantities demanded for foreign echange holdings and for goods FX α [ β Nm + ( β + β + α β NFX] 5 4 ( αβ 4 + αβ 5 + αβ 5 4 N αa [ βnm+ ( β+ β4+ αβ NFX] ( α β Nm + [( α + α ( β + β + α β ] NFX 4 3 4

6 αa ( β+ β4 N[ βnm + ( β+ β4 + αβ NFX ] [ αβ+ ( αβ + αβ+ αβ( β + β] NNm + α( β+ β NNFX α3a [ βnm+ ( β+ β4+ αβ NFX] ( α4 βnm + [( α+ α3( β+ β4 + αβ] NFX β a N [ α N FX + ( α + α N m ] 5 ( α4 βnnm + [( α+ α3( β+ β4 + αβ] NNFX βa ( β+ β4[ αnfx + ( α + α5 Nm] α ( β + β NFX + [( α β + α β + α β ( β + β + α β ] Nm β a ( β + β [ α N FX + ( α + α N m ] α( β+ β4 NFX + [( αβ4 + α5β+ α5β4( β + β3 + αβ] Nm We can see that the equilibrium quantities of goods are influenced b the sul of Northern m m mone (, but not b the sul of Southern mone (, that is, Southern mone is neutral, but Northern mone is not. Also, e derive from above that: FX > 0 e ( + m α5 ( e < 0, FX ( m+ FX e m m α ( ( ( ( ( < 0, e + m + m + FX e e α ( e < 0, FX ( m+ FX e m m α 3 ( ( ( > 0 e + e + + m e β (

7 m β ( > 0, m β3 ( > 0 The above comarative statics suggest that ith an increase in Northern mone, there is an increased demand in the South for holding Northern mone. At the same time, the quantities of all goods consumed in the South fall, hereas the quantities of all goods consumed in the North increase. This means that associated ith an increase in the sul of Northern mone, there is a corresonding transfer of real resources from the South to the North. The negative imact of the monetar shock on the South is also reflected in other variables as e discuss belo. ( Consumer rices, relative age rate and the terms of trade The equilibrium echange rate, ages and rices are: e ( α β + α β + α β Nm α ( β + β NFX + α β Nm α m FX e ( α β Nmm+ [( α + α ( β + β + α β ] NFXm α4 α4( β+ β4 NFX + α4βnm β + β α Nm α ( β + β NFX + [( α β + α β + α β ( β + β + α β ] Nm m + β+ β4 α4( β+ β4 Ne ( αβ4 + α5β+ α5β4( β+ β4 N, a, a, a a Nm α ( β + β NFX + [( α β + α β + α β ( β + β + α β ] Nm a ( β + β4 N α4( β + β4 NFX + α4βnm e Clearl, an increase in the sul of Northern mone loers the urchasing oer of Northern mone therefore loers the echange rate, that is, < 0.

8 Moreover, e have > 0, d( e > 0, dm ( > 0. These suggest that an increase in the sul of Northern mone increases the monetar rices of all goods in the South, thus eorting inflation to the South. Turning to ages and the terms of trade, e see that > 0, > 0 ( / e < 0, ( / e < 0 That is, nominal ages in both the North and South rise as a result of an increase in the sul of Northern mone. Hoever, the age rate in the South falls relative to that in the North, and the terms of trade deteriorate for the South as ell. (3 Allocation of roductive resources If Northern mone is non-neutral as e have shon above, it is to be eected that an increase in the sul of Northern mone ill have ramifications for the structures of the economies through its imact on the allocation of roductive resources. From our model, e can derive relative shares of labor resources devoted to the tradable and non-tradable sectors in both the South and the North. N + N β( α + α + α5 + ( αβ + αβ 4 + ααβ + αβ αβ 3 + α3( β + β4 + αβ ] L a N N m N N FX] L N NNm NNFX a N + N L a NFX Nm ( αβ + αβ 4 + ααβ + αβ + ( αβ + αβ + αβ 5 N β3[ α + ( α + α5 ] L NFX Nm a It is straightforard to sho that L ( L > 0, L ( L < 0.

9 These iml that an increase in the sul of Northern mone leads to an eansion of the tradable sector (and a contraction of the non-tradable sector in the South and a contraction of the tradable sector (and an eansion of the non-tradable sector in the North. To summarie the above analsis, e have Proosition : In a Ricardian orld here international trade beteen the North and the South is mediated b the currenc of the North, an increase in the sul of Northern mone leads to inflation being eorted to the South. The increase in the sul of Northern mone also has real effects: ( it transfers real resources from the South to the North, loers the age rate in the South relative to that in the North, and orsens the terms of trade for the South; and ( it leads to structural changes in both economies b encouraging the eansion of the tradable sector in the South and the eansion of the non-tradable sector in the North. 3. Concluding remarks In this aer e have resented a simle Ricardian model ith mone to stud ho a monetar shock in the North ma have ramifications for itself and its Southern trading artner. B elicitl incororating both the demand for local mone and that for foreign echange, our model generates several testable hotheses in relation to the features of North-South trade and their corresonding consequences. 3 Our model also makes a contribution to the large literature on the transmission mechanism of monetar shocks (see, for instance, Melter, 995 b looking at the issue from the ersective of international trade. With some imagination, one might infer from our model that an eansionar monetar olic in the North ma generate a boom in the eort sector in the South, and a boom in the non-tradable sector in the North. When the boom turns into bust, the tradable sector in the South is forced to contract as is the non-tradable sector in the North. Of course, our model as it stands does not tell a comelling stor about business ccles. Hoever, it ma be ossible to etend our model, for instance, b incororating international caital flos, to investigate various channels through hich ccle-generating monetar shocks ma be transmitted internationall. 3 To the etent that some North-North trade is mediated b the currenc of one Northern countr, the results of our model also al.

10 References Askena, P. (005. Trade, Services, and Wage Inequalit. Oford Economic Paers, 57(4, Choi, E. K. (007. North-South Trade and Income Inequalit. International Revie of Economics and Finance, 6(3, Chui, M., Levine, P., & Pearlman, J. (00. Winners and Losers in a North-South Model of Groth, Innovation and Product Ccles. Journal of Develoment Economics, 65(, Goldberg, L. S., & Tille, C. (008. Vehicle Currenc Use in International Trade. Journal of International Economics, 76(, Hoekman, B., & Javorcik, B. S. e. (006. Global Integration and Technolog Transfer. Washington, D.C.: World Bank Krugman, P. R. (980. Vehicle Currencies and the Structure of International Echange. Journal of Mone, Credit, and Banking, ( Matsuama, K. (000. A Ricardian Model ith a Continuum of Goods under Nonhomothetic Preferences: Demand Comlementarities, Income Distribution, and North-South Trade. Journal of Political Econom, 08(6, Melter, A. H. (995. Monetar, Credit and (Other Transmission Processes: A Monetarist Persective. The Journal of Economic Persectives, 9(4, 49-7.