"The Transfer Problem & Exchange Stability" Word Doc

The Transfer Problem and Exchange Stability
Definition:
“Consider a unilateral payment from one country to the other. This involves two parts: a financial (monetary) transfer and a real transfer. The monetary transfer refers to the accumulation and liquidation of debt on the part of individuals or governments in each country, while the real transfer refers to the induced movement of goods.
...Assume that A is the transferring country. Whatever the type of transfer ... domestic expenditure in A is reduced, and in B (transferor) is increased, by the amount of the transfer. These changes in expenditure induce changes in demand that, at constant terms of trade, create disequilibrium in the balance of payments. The transfer problem may then be posed as the problem of determining the direction and extent of the change in the terms of trade required to eliminate”.
http://www.columbia.edu/~ram15/ie/ie-02.html
Examples:
U.S.A:-. In order to transfer resources in real (non-financial) terms from the rest of the world, the U.S. runs very large trade deficits in manufactures from surplus-saving industrial economies such as China, Japan etc. This “real” transfer of manufactures needed to cover the shortfall in American saving speeds the contraction in employment in U.S. manufacturing beyond the “natural” rate of decline experienced by other mature industrial economies.
Why is this a problem?
The upshot is a protectionist backlash in the United States, particularly by members of Congress with manufacturing constituencies. These people incorrectly blame “unfair” foreign trading practices—undervalued currencies, substandard labor practices,or “dumping” of subsidized exports in American markets—instead of America’s own deficient saving covered by foreign borrowing.
http://www.aeaweb.org/annual_mtg_papers/2007/0106_1015_0702.pdf
Thailand:- The reversal in the current account: the country was forced by the reversal of capital flows to go from a deficit of some 10 percent of GDP in 1996 to a surplus of 8 percent in 1998. The need to effect such a huge change in the current account represents what may be history's most spectacular example of the classic “transfer problem” debated by Keynes and Ohlin in the 1920s. In practice this swing has been achieved partly through massive real depreciation, partly though severe recession that produces a compression of imports.
http://web.mit.edu/krugman/www/FLOOD.pdf

Classical approach – equality between income and expenditure equating to full employment of resources.
Keynesian approach – economy has perfectly elastic supply of labour and demand for labour and commodities at fixed wage and price level.
Two Problems:
(a) Will method of transfer finance affect each countries demand for imports enough to create trade surplus/deficit needed to affect transfer?
· Finance will reduce As demand for goods and increase Bs. This improves As balance of trade and worsens Bs.
· This usually implies disequilibrium which must be adjusted. How?
Classical - price inflation/deflation to change terms of trade.
Keynesian – price inflation/deflation to change terms of trade or devaluation.
(b) Will adjustment mechanism restore equilibrium? Factors:
· Direction – will a small downgrade in A or Bs terms of trade improve or worsen its’ trade balance? Stability Problem!
· Magnitude of influence – if such a downgrade does improve terms of trade, can trade balance increase be enough to achieve surplus?
Classical approach – we assume full employment. So if a decrease in As expenditure = increase in Bs expenditure this means no multiplier effect. A’s balance of trade improves due to decrease in demand for imports & increase in demand for exports.
• Total improvement = ∑ As Import expenditure change + Bs Import expenditure change
• If ∑ As Import expenditure change + Bs Import expenditure change > unity => Transfer is undereffected so terms of trade will change against A – and vice versa also applies
Focusing on proportions of expenditure change, we assume expenditure proportions can be related to A and Bs marginal propensities to spend on imports/exports. We highlight 3 cases:
1. Free Trade: A receives all proceeds from exporting to B.
2. Tariffs but no transport costs: Under Classical approach, we assume tariffs are redistributed and spent by B. As such proportions of expenditure change on exports is greater than marginal propensity to spend on exports.
3. Transfer costs but no tariffs: Transfer costs are receipts for A. Hence transport costs are an indirect demand for goods. So proportion of expenditure change on exports is greater than marginal propensities to spend on exports.
What does classical approach mean for countries involved? Let’s assume transfer undereffected if – when both A and B have an increase in income - A has greater spending power.
In case 1, free Trade A and B pay same prices. For Classical theory to hold, if both countries have similar “tastes” for goods, the country with the higher income per head produces more “luxurious” goods for export i.e. goods differ in degree of necessity.
Where tariffs and transport costs exist, goods are cheaper in the exporting country. For classical approach to hold, a country must favour its’ exports over imports and country with lower income per head must produce necessary goods.
What about indirect consumption?
For the case of tariffs but no transport costs, we assume indirect consumption of tariffs is same as direct so classical approach holds.
Where we have both transport costs and free trade, if transport costs are added fully to imported goods, then consumers are more likely to purchase similar home produced goods. And vice versa.
Additional factors to consider?
1. Varying the home production of similar imported good? Not relevant as it’s the price ratio that’s the crucial factor here.
2. Non-traded goods? Is a factor as demand for such goods changes total demand for imports/exports.
More countries? Is a factor since balance of trade between A and B are no longer
eual or opposite









II. The Keynesian Transfer Problem

Assumptions:
- economy consists of a perfectly elastic supply of labour and commodities at a fixed wage and price level so that output, income and employment are determined by aggregate demand (AD)
- exchange rates & interest rates are fixed by monetary policy
- international capital movements are independent of national income.

Multiplier Equations: (for country A and B)
- these equations relate changes in national income and balance of payments to changes in demand
- all marginal propensities are positive to guarantee stability in the system

Notation:
· Ya,b total change in national income
· Ba total change in country A’s balance of payments
· Ia,b change in demand for country’s own output
· Ma,b change in demand for each other’s output
· T change in capital movements from A to B
· ca,b marginal propensity to spend on domestic output
· ma,b marginal propensity to spend on imports
· sa,b marginal propensity to save in each country

Equations:
Ya = Ia + caYa + Mb + mbYb
Yb = Ib + cbYb + Ma + maYa
Ba = Mb + mbYb - Ma - maYa - T

Keynesian Problem:
Unlike the classical (real) case we do not assume that aggregate expenditure of A and B will change equal to the amount expensed on financing and disposal of the transfer. Any such changes in expenditure will have multiplier effects on the balance of trade between A and B. The problem therefore is whether the transferor’s balance of payments worsens or improves as a direct result of the transfer.
Solution:
To solve this problem we simply substitute for the change in demand in the multiplier equations with the proportion of the transfer whereby demand for domestic and foreign goods is reduced in A and increased in B (or vice versa).
We will work with the change in demand for imports and the saving associated with the transfer since the transfer must alter demand for domestic goods and imports or the accumulation of assets through saving.


m` change in demand for imports (as a proportion of amount transferred)
s` change in saving (as a proportion of amount transferred)
quations:
Ya = 1 / sa (Ba + s`a T)
Yb = - 1 / sb (Ba + s`b T)
Ba = (m`a + m`b - ma / sa (s`a) - mb / sb (s`b) – 1) X (sasb / Δ) T

where Δ = sasb + samb + sbma

From these equations we concur that the transfer will be undereffected or overeffected where m`a + m`b (sum of proportions of transfer by which expenditure on imports is altered by financing and disposal of transfer) is less than or greater than

ma / sa (s`a) + mb / sb (s`b) + 1
This criterion allows the transfer to be either undereffected or overeffected according to the scales of various parameters. The behaviour of income therefore, is determined by whether the transfer is undereffected or overeffected.
Generally, there seems to be less reason in the Keynesian model than in the classical model to identify the direct effects of the transfer on demand with those of any other economic change.
III – Application of transfer theory

Transfer theory applied in the analysis of:
Reparation payments
International flows of long term capital.
Also more importantly in overcoming any Balance of Payment (BOP) disequilibrium through either automatic mechanisms of adjustment or planned government policies.

Both the floating and fixed rate regimes are "automatic" free-market mechanisms for international payments. With a "clean" floating rate, a monetary authority sets a monetary policy, but has no exchange-rate policy—the exchange rate you might say is on autopilot. In effect, the monetary base is determined domestically by a monetary authority. In other words, when a central bank purchases bonds or bills and increases its net domestic assets, the monetary base increases and vice versa. Whereas, with a fixed rate, a monetary authority sets the exchange rate, but has no monetary policy—monetary policy is on autopilot. In consequence, under a fixed-rate regime, the monetary base is determined by the balance of payments. In other words, when a country's official net foreign reserves increase, its monetary base increases and vice versa. With both of these free-market exchange-rate mechanisms, there cannot be conflicts between exchange-rate and monetary policies, and balance-of-payments crises cannot occur. Market forces automatically rebalance financial flows and avert balance-of-payments crises.

Government policies are important in overcoming the above mentioned imbalance. For example the UK government might intervenr to raise or lower the value of sterling. This can be done through short term interest rates: usually raising them attracts investors into buying sterling while lowering encourages selling. Another option is to utilize its foreign currency reserves to push up its value or at least hold it steady.

BOP imbalance occurs due to some form of transfer from the surplus to deficit country. This can be solved by creating a transfer of equal amount in opposite direction.
For example, with ‘full employment’ in deficit country, deterioration in terms of trade will be less (or improvement greater) the more deflation of expenditure in deficit country and inflation of expenditure in surplus country is spent on imports as opposed to on exportable goods. Terms of trade refers to the purchasing power of a country’s exports in terms of the imports it buys; it indicates how much of goods and services one country can buy from abroad with the goods and services it sells abroad. The terms of trade shift whenever a country’s exports will buy more or fewer imports. An improvement in the terms of trade occurs when export prices rise relative to import prices.

In the Keynesian transfer analysis:
With a positive Marginal prop to save (MPS) in both countries changes in income taxation adequate to yield change in budget surpluses or deficits equal to original BOP deficits will not solve the disequilibrium issue. However changes in government expenditure of this amount may do so. This example involves adjustments to aggregate income and expenditure.
A more important application looks at effects of changes in relative price levels on the BOP’s. Change by deflation or inflation of domestic currency prices of fixed exchange rates or by alteration of exchange rate.
Problem formulated in terms of
Effects of devaluation on trade balance
Stability of foreign exchange markets

The Central theoretical problem
Conditions under which a relative reduction in export prices would tend to improve a countries trade balance?

Volume of exports determined by demand from abroad which in turn depends on the state of importing country, price of exports which are dependant on inflation and exchange rate and finally the quality of products.

Look at the exchange stability problem in terms of transfer theory. We assume that trade is balanced and no barriers exist.
What happens in terms of country A if there is a reduction in the price of A’s exportables relative to B?
Transfer from A to B = in amount to the increase in the cost of A’s initial volume of exports.
And in terms of B to the reduction in the costs of B’s initial volume of imports.
With initial balance and small price change these two transfers are approximately equal.
Transfer is ‘financed’ and ‘disposed of’ through effects of the relative price change which will have income and substitution effects on the demands of the countries for their own and each others goods.
The income effect – real income falls as prices increase
The substitution effect – price change that causes the consumer to substitute away from the comparatively more expensive one.
Price change will affect two countries aggregate expenditure and expenditure on imports.
Exchange stability problem takes into account whether effects of price change on expenditure will be sufficient to effect the transfer implicit in the price change itself.
With regard to classical case All income is spent insuring that transfer is accompanied by equal change in the two countries expenditure.
Transfer will be over or under-effected or market stable or unstable according to whether sum of the proportion of the transfer by which two countries expenditure on imports change is greater or less than unity.
Unit elasticity describes a supply or demand curve which is perfectly responsive to change in price. That is quantity supplied or demanded changes according to the same percentage as the change in price.
These proportions, equal to the price of demand for imports of the countries so that the market is stable depend on whether the sum of these elasticities is greater or less than unity. Transfer analysis leads to stable or unstable dependant on whether elasticities greater of less than
1+ S’a (ma / Sa) + S’b (mb / Sb)
Sa - marginal propensity to save
m – marginal propensity to import
S’a – proportion of transfer by which saving from pre-transfer level of income is reduced in A by increase in price of A’s imports.
S’b – proportion of transfer by which saving from pre-transfer level of income is increased in B by decrease in the price of B’s imports.
S’s above represent the consequence of a fall in the price of imports on saving or increase in the price of imports on expenditure from initial income divided by initial value of imports.
When elasticity is less than unity (inelastic demand) higher prices bring larger outlays.
When elasticity is greater than unity (elastic demand) higher prices bring smaller outlays.
Laursen and Metzler – highlight that in the short run of the cycle, a rising proportion of real income is saved to the conclusion that an increase in price of imports would increase expenditure thus making critical sum of elasticities import demand greater than unity.
Harberger looks at effect of an increase in imports prices on savings. He assumed that saving is measured in exports goods and depends on real income only, and that changes in prices inducing no substitution between Savings and Consumption.
Therefore it can be deduced that the criteria of exchange stability becomes whether sum of elasticities of import demand is greater or less than 1 plus the sum of Marginal propensity to import.
Assumptions of this criticized for a number of reasons.
Day, Savings and Imports might be substitutes (as imports may be consumer durables yielding flow of satisfaction comparable to interest on saving)
Pearce, shows Day overlooks effects of change in price of Imports on real value of interest.
Spraos, shows MPS from a change in real income due to change in real income due to change in Import prices is likely to be substantially greater than MPS from change in output at constant prices.
Spraos and Pearce, show Harberger implies presence of money illusion since they ignore effects of an increase in price of Imports in reducing value of saving.

If substitution effects between imports and savings and Pigou’s effect of import prices on savings are ignored then Harberger analysis on assumption that real rather than money saving depends on real income to yield
S’ = (Average propensity to save / 1-APS) X ( €s -1)
$s is income elasticity of demand for real saving. I – APS is the equivalent of the average propensity to consume.
The above formula proposes that the effect of a fall in the price of imports on saving = (APS / APS) X (Income elasticity of demand for real saving – 1)
This alteration reconciles Harberger’s and Metzler and Laursen’s approach. It also confirms the workings below in deducing the effect of devaluation on expenditure from the relationship between the savings ratio (MPS) and income.
Average propensity to save = Savings / Volume of domestic Output.
(Savings here is equivalent to Volume of domestic output minus Consumption at home and abroad.)

However it assumes that imports are demanded for consumption only. If some imports are required for investment as would be reasonable and investment expenditure is fixed in real terms a fall in import prices affects money saving both by increasing consumers real income and by reducing the cost of investment imports.
The preceding result is than changed to
S’ = mc (APS / 1-APS)($s – 1) + mi
Mc and Mi are proportions of the original volume of imports devoted to consumption and investment, respectively. Even though the assumption that the critical value of the sum of the elasticities of import demand is greater than unity implies a slightly unrealistic assumption about the behavior of the savings ratio this last result can be supported by the introduction of investment imports.