American Economic Association

Comparative Advantage, Trade, and Payments in a Ricardian Model with a Continuum of Goods
Author(s): R. Dornbusch, S. Fischer and P. A. Samuelson
Source: The American Economic Review, Vol. 67, No. 5 (Dec., 1977), pp. 823-839
Published by: American Economic Association
Stable URL: http://www.jstor.org/stable/1828066
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 ComparativeAdvantage,Trade, and Payments
in a RicardianModel witha ContinuumofGoods -
By R. DORNBUSCH, S. FISCHER, AND P. A. SAMUELSON*
This paper discussesRicardian trade and
paymentstheoryin thecase of a continuum
of goods. The analysisthus extendsthe de-
velopmentof many-commodity, two-coun-
trycomparativeadvantage analysis as pre-
sented,for example, in GottfriedHaberler
(1937), Frank Graham (1923), Paul Samuel-
son (1964), and Frank W. Taussig (1927).
The literatureis historicallyreviewed by
JohnChipman(1965). Perhaps surprisingly,
the continuum assumption simplifiesthe
analysisneatlyin comparison with the dis-
crete many-commoditycase. The distin-
guishingfeatureof the Ricardian approach
emphasizedin this paper is the determina-
tion of the competitivemargin in produc-
tionbetweenimportedand exportedgoods.
The analysisadvances the existingliterature
by formallyshowing preciselyhow tariffs
and transportcosts establish a range of
commoditiesthat are not traded, and how
the price-specieflow mechanism does or
does not give rise to movementsin relative
cost and pricelevels.
The formalreal model is introducedin
Section 1. Its equilibrium determinesthe
relativewage and price structureand the
efficientinternationalspecializationpattern.
Section II considers standard comparative
staticquestions of growth,demand shifts,
technologicalchange,and transfers.Exten-
sions of the model to nontraded goods,
tariffs,and transportcosts are then studied
in Section III. Monetaryconsiderationsare
introducedin Section IV, which examines
the price-specie mechanism under stable
parities,floatingexchangerate regimes,and
also questions of unemployment under
stickymoneywages.
* Massachusetts Institute of Technology. Helpful
comments from Ronald W. Jones are gratefully
acknowledged.Financial support was provided by a
Ford Foundationgrantto Dornbusch,NSF GS-41428
to Fischer,and NSF 75-04053to Samuelson.
823
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I. The Real Model
In thissection we develop the basic real
model and determinethe equilibriumrela-
tivewage and pricestructurealong withthe
efficientgeographic pattern of specializa-
tion. Assumptions about technology are
specifiedin SectionIA. SectionIB deals with
demand. In Section Ic the equilibrium is
constructedand some of its propertiesare
explored. Throughoutthis section we as-
sumezero transportcosts and no otherim-
pedimentsto trade.
A. Technologyand Efficient
GeographicSpecialization
The many-commodityRicardian model
assumes constant unit labor requirements
(a,,..., a,) and (al*,..., a*) forthe n com-
moditiesthatcan be produced in the home
and foreign countries, respectively.The
commoditiesare convenientlyindexed so
that relative unit labor requirementsare
rankedin orderof diminishinghome coun-
trycomparativeadvantage,
al*1a, > ... > ... > Ol*ai > ... > an*la,
wherean asteriskdenotesthe foreigncoun-
try.
In workingwith a continuumof goods,
we similarlyindexcommoditieson an inter-
val, say [0, 1], in accordance with diminish-
ing home countrycomparative advantage.
A commodityz is associated with each
point on the interval,and for each com-
moditythereare unitlabor requirementsin
thetwo countries,a(z) and a*(z), withrela-
tiveunitlabor requirement givenby
(1) A(z) - *(z) A
A'(z) < 0
aa (z)
(z)
The relativeunitlabor requirementfunction
in (1) is by strongassumptioncontinuous
824 THE AMERICAN ECONOMIC REVIEW DECEMBER 1977

and byconstruction(rankingor indexingof The relativeprice of home produced z in

goods), decreasingin z. The functionA (z)
is shownin Figure 1 as the downwardslop-
ingschedule.
Consider now the range of commodities
produceddomesticallyand those produced
abroad, as well as the relativeprice struc-
tureassociated with given wages. For that
purposewe defineas w and w* the domestic
and foreignwages measured in any (com-
mon!) unit. The home country will effi-
cientlyproduce all those commodities for
which domestic unit labor costs are less
than or equal to foreignunit labor costs.
Accordingly,any commodityz will be pro-
duced at home if
(2) a(z)w < a*(z)w*
Thus
(2') w < A (z)
where(3) definesthe parameterw, funda-
mentalto Ricardiananalysis,
(3) w/w*
This is the ratio of our real wage to theirs
(our "double-factoralterms of trade"). It
followsthat fora given relativewage w the
home countrywill efficiently produce the
rangeof commodities
(4) 0 < z < (w)
termsof a commodityz" produced abroad
is by contrast
(7) P(z)/P(z") = wa(z)/w*a*(zP")
= wa(z)1a*(z'');
z < z < z"
In summarizingthe supply part of the
model we note that any specifiedrelative
real wage is associatedwithan efficient geo-
graphicspecializationpatterncharacterized
by theborderlinecommodityz(w) as well as
by a relativeprice structure.(The patternis
"efficient"in thesense that the world is out
on, and not inside, its production-possibil-
ityfrontier.)
B. Demand
On the demand side, the simplest Mill-
Ricardo analysis imposes a strong homo-
theticstructurein the formof J. S. Mill or
Cobb-Douglas demand functionsthat asso-
ciate with each ith commoditya constant
expenditureshare, bi. It furtherassumes
identicaltastesforthe two countriesor uni-
formhomotheticdemand.
By analogy with the many-commodity
case, whichinvolvesbudgetshares
bi*
bi= PiCi/Y bi=
n

where taking(2') withequality definesthe Z bi = I

borderlinecommodityz, forwhich
We thereforeprescribefor the continuum
(5) Z = A-I(w)
case a givenb(z) profile:
A-'( ) being the inversefunctionof A( ). 0
(8) b(z) = P(z)C(z)/Y >
By the same argumentthe foreigncountry
will specialize in the production of com- b(z) = b*(z)
moditiesin therange
fb(z) dz I
(4') (w) < z <
The minimumcost condition determines where Y denotes total income, C demand
thestructureof relativeprices.The relative forand P thepriceof commodityz.
price of a commodityz in terms of any Next we definethe fractionof income
othercommodityz', when both goods are spent(anywhere)on those goods in which
producedin the home country,is equal to thehome countryhas a comparativeadvan-
theratioof home unitlabor costs: tage:
= wa(z)/wa(z')
0
z
(6) P(z)/P(z') b
(9) 0(z) b(z)fdz >
= a(z)/a(z');
z < z, z' < z 0 (z)= b(z) > 0

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VOL. 67 NO. 5 - DORNBUSCH ET AL.: RICARDIAN MODEL
whereagain (0, 2) denotesthe rangeof com-
moditiesforwhichthehome countryenjoys
a comparativeadvantage.Witha fractiont
of each country'sincome, and thereforeof
world income, spent on home produced
goods, it followsthatthefractionof income
spenton foreignproducedcommoditiesis
(9' 1 - 9(z) J b(z) dz
0 < ?<(z) < 1
C. EquilibriumRelativeWages
and Specialization
To derivethe equilibriumrelative wage
and price structureand the associated pat-
tern of efficientgeographic specialization,
we turn next to the condition of market
equilibrium.Consider the home country's
labor market,or equivalentlythe market
for domestically produced commodities.
With z denotingthe hypotheticaldividing
line betweendomesticallyand foreignpro-
duced commodities,equilibriumin the mar-
ket forhome produced goods requiresthat
domestic labor income wL equals world
spendingon domesticallyproducedgoods:
(10) wL = 0(2)(wL + w*L*)
Equation (10) associateswitheach z a value
ofthe relativewage -w/w*such that market
equilibriumobtains.This scheduleis drawn
in Figure 1 as theupward slopinglocus and
is obtainedfrom(10) by rewritingthe equa-
tionin theform:
(10') = Il -D(@)( (L*/L) - B(z;L*/L)
whereit is apparentfrom(9) thatthe sched-
as
ule startsat zero and approaches infinity
z approachesunity.
To interpretthe B( ) schedule we note
that it is entirelya representationof the
demand side; and in that respect it shows
thatif the range of domesticallyproduced
goods were increased at constant relative
wages,demand for domesticlabor (goods)
would increaseas thedividingline is shifted
-at thesame timethat demand forforeign
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825
B(Z; L*/L)
A(z)
0 . I
FIGURE 1
labor (goods) would decline.' A rise in the
domesticrelativewage would then be re-
quired to equate the demand for domestic
labor to theexistingsupply.
An alternativeinterpretationof the B( )
scheduleas the locus of trade balance equi-
libriauses the factthat(10) can be written
in thebalance-of-tradeform:
= 0(2)w*L*
(10") [1 - 0(2)]wL
This statesthatequilibriumin thetrade bal-
ance means importsare equal in value to
exports. On this interpretation,the B( )
scheduleis upward sloping because an in-
crease in the range of commoditieshypo-
theticallyproduced at home at constant
relativewages lowersour importsand raises
our exports.The resultingtrade imbalance
would have to be correctedby an increase
in our relativewage that would raise our
importdemand for goods and reduce our
exports,and thusrestorebalance.
The nextstep is to combine the demand
side of the economy with the condition of
efficientspecialization as represented in
equation (5), whichspecifiesthecompetitive
marginas a functionof the relative wage.
Substituting (5) in (10') yieldsas a solution
the unique relative wage 5, at which the
specialized, is in bal-
world is efficiently
'Throughout this paper we refer to "domestic"
goods as commoditiesproduced in the home country
ratherthan to commoditiesthat are nontraded.The
latterwe call "nontraded"goods.
826 THE AMERICAN ECONOMIC
anced trade,and is at fullemploymentwith
all marketsclearing:
(11) z = A(z) = B(-;L*/L)
The equilibriumrelativewage definedin
(11) is representedin Figure 1 at the inter-
section of the A( ) and B( ) schedules.2
Commodityz denotesthe equilibriumbor-
derlineof comparativeadvantage between
commoditiesproducedand exportedby the
home country(O < z < z), and those com-
moditiesproducedand exportedby the for-
eigncountry(z < z < 1).
Amongthe characteristics of the equilib-
riumwe note that the equilibriumrelative
wages and specializationpatternare deter-
mined by technology,tastes, and relative
size (as measured by the relative labor
force).3The relative price structureasso-
ciated with the equilibriumat point E is
definedby equations (6) and (7) once (11)
has defined the relative wage z and the
equilibriumspecializationpatternz(Z).
The equilibrium levels of production
Q(z) and Q*(z), and employmentin each
industryL(z) and L*(z), can be recovered
fromthe demand structureand unit labor
requirementsonce the comparativeadvan-
tagepatternhas been determined.
We note that with identical homothetic
tastes across countriesand no distortions,
therelativewage Z-is a measureof the well-
2See the Appendix for the relation of the diagram
to previousanalyses.
3The constructionof theB( ) schedule reliesheavily
on the Cobb-Douglas demand structure.If, instead,
demand functionswere identicalacross countriesand
homothetic,an analogous schedule could be con-
structed.In thegeneralhomotheticcase, however,a set
of relativepricesis requiredat each z to calculate the
equivalentof the B( ) schedule;the relativeprices are
those that apply on the A (z) schedule for that value
of z. In this case the independenceof the A ( ) and
B( ) schedulesis obviouslylost. In the generalhomo-
theticcase there is still a unique intersectionof the
A ( ) and B( ) schedules.For more generalnonhomo-
theticdemand structures, it is known that an equilib-
rium exists; but even in the case of two Ricardian
goods theremaybe no unique equilibriumeven though
therewill almost always be a finitenumber of equi-
libria.See Gerard Debreu and Stephen Smale. Exten-
sions of our analysiswithrespectto the demand struc-
tureand thenumberof countriesare developed in un-
publishedworkby CharlesWilson.
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REVIEW DECEMBER 1977
being of the representativeperson-laborer
at home relativeto the well-beingof the
foreignlaborer.
representative
Statics
II. Comparative
The unique real equilibriumin Figure 1
is determinedjointly by tastes,technology,
and relativesize, L*/L. We can now exploit
Figure 1 to examine simple comparative
staticquestions.
A. RelativeSize
Considerfirstthe effectof an increase in
therelativesize of the restof the world. An
increase in L*/L by (10) shiftsthe B( )
tradebalance equilibriumschedule upward
in proportionto the change in relativesize
and must,therefore,raise the equilibrium
relativewage at home and reduce the range
of commoditiesproduced domestically.It
is apparentfromFigure2 thatthe domestic
relativewage increases proportionallyless
thanthedeclinein domesticrelativesize.
The risein equilibriumrelativewages due
to a change in relativesize can be thought
of in the followingmanner. At the initial
equilibrium,theincreasein the foreignrela-
tivelabor forcewould create an excess sup-
ply of labor abroad and an excess demand
forlabor at home-or, correspondingly,a
tradesurplusforthe home country.The re-
sultingincrease in domesticrelativewages
servesto eliminatethe trade surpluswhile
B(z; L*/L)
LU\/
B(z; L*/L)O
I ~~~~A
(z)
Go
0 A
FIGURE 2
VOL. 67 NO. S DORNBUSCH
at the same timeraisingrelativeunit labor
costs at home. The increase in domestic
relativeunit labor costs in turn implies a
loss of comparativeadvantage in marginal
industriesand thus a needed reduction in
therangeof commoditiesproduced domes-
tically.
The welfareimplicationsof the change in
relativesize take the formof an unambigu-
ous improvement in thehome country'sreal
incomeand (under Cobb-Douglas demand)
a reductionin real incomeper head abroad.
We observe, too, that from the definition
of the home country'sshare in world in-
come and (10), we have
(12) =
wL/(wL + w*L*) -()
It is apparent,as notedabove, that a reduc-
tion in domesticrelativesize in raisingthe
domestic relative wage (thereby reducing
therange of commoditiesproduced domes-
tically)must under our Cobb-Douglas de-
mandassumptionslowerthe home country's
sharein totalworld income and spending-
eventhoughour per capita incomerises.
B. TechnicalProgress
To beginwith,we are concernedwiththe
effectsof uniformtechnical progress. By
equation(1), a uniformproportionalreduc-
tionin foreignunit labor requirementsim-
plies a reductionin a*(z) and thereforea
proportionaldownward shiftof the A (z)
schedulein Figure 1. At the initial relative
wage a, the loss of our comparativeadvan-
tage due to a reductionin foreignunit labor
costs will imply a loss of some industries
in the home countryand a corresponding
tradedeficit.The resultinginduced decline
in the equilibriumrelativewage serves to
restoretrade balance equilibrium,and to
offsetin part our decline in comparative
advantage.
.Thenet effectis thereforea reductionin
domestic relative wages, which must fall
rproportionally shortof the decline in rela-
tive unit labor requirementsabroad. The
home country'stermsof tradethereforeim-
prove as can be noted by using (7) for any
two commodities z and z", respectively,
producedat home and abroad:
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ET AL.: RICARDIAN MODEL 827
(13) P(z) - P(z") = co- d*(z") > 0
where a "hat" denotes a proportional
change. Domestic real income increases,as
does foreignreal income.4 The range of
goods produced domesticallydeclines since
domesticlabor, in efficiency units, is now
relativelymorescarce.
An alternativeformof technicalprogress
that can be studied is the international
transferof the least cost technology.Such
transfersreducethediscrepanciesin relative
unitlabor requirements-byloweringthem
for each z in the relativelyless efficient
country-and thereforeflatten the A (z)
schedulein Figure 1. It can be shown that
such harmonization of technology must
benefitthe innovatinglow-wage country,
and that it may reduce real income in the
high-wagecountrywhose technologycomes
to be adopted. In fact,the high-wagecoun-
trymustlose if harmonizationis complete
so thatrelativeunitlabor requirementsnow
become identical across countries and all
our consumer'ssurplus from international
tradevanishes.5
C. DemandShifts
The case witha continuumof commodi-
tiesrequiresa carefuldefinitionof a demand
shift.For our purposes it is sufficientto
ask: What is theeffectof a shiftfromhighz
commoditiestoward low z commodities?It
is apparentfromFigure 2 that such a shift
will cause the trade balance equilibrium
scheduleB( ) to shiftup and to the left.It
followsthat the equilibriumdomestic rela-
4The purchasingpower of foreignlabor income in
termsof domestically producedgoods is w*L*/wa(z) =
L*/a(z)z and in terms of foreigngoods L*/a*(z).
The factthat foreigners'real income per head rises is
guaranteedby our Cobb-Douglas demandassumption.
In the generalhomotheticcase, a balanced reduction
in a* (z) can be immiserizingabroad if the real wage
falls stronglyin terms of all previously imported
goods; however,thebalanced drop in a* (z) in the gen-
eral homotheticcase alwaysincreasesour real wage.
5Complete equilization of unit labor requirements
impliesthat the A( ) schedule is horizontal at the
level w = A (z) = 1. In this case geographic specializa-
tionbecomesindeterminate and inessential.
828 THE AMERICAN ECONOMIC REVIEW DECEMBER 1977

tivewage will rise while the range of com-
moditiesproducedbythehome countryde-
clines. Domestic labor is allocated to a
narrowerrange of commodities that are
consumedwithhigherdensitywhile foreign
labor is spread more thinlyacross a larger
rangeof goods.
Welfarechanges cannot be identifiedin
thisinstancebecause tastesthemselveshave
changed. It is true that domestic relative
income rises along with the relativewage.
Furtherwe note that since Zi rises,the rela-
tive well-beingof home labor to foreign
labor (reckonedat thenew tastes) is greater
than was our laborers' relativewell-being
(reckonedat theold tastes).
D. UnilateralTransfers
Suppose foreigners make a continualuni-
lateraltransferto us. With uniformhomo-
thetictastes'and no impedimentsto trade,
neithercurveis shiftedby the transfersince
we spend the transferexactly as foreigners conditionin (10 ") mustnow be modifiedto:
would have spentit but forthetransfer. The
new equilibriuminvolves a recurringtrade
deficitforus, equal to thetransfer,but there
is no changein thetermsof trade. As Bertil
Ohlin argued against John Maynard
Keynes,here is a case where full equilibra- to income less spendingon all domestically
tion takes place solely as a result of the
spendingtransfers. When we introducenon-
traded goods below, Ohlin's presumption
will be found to requiredetailed qualifica- (15')
tions,as it also would if tastesdifferedgeo-
graphically.
III. ExtensionsoftheRealModel
Extensionsof the real model taken up in
this section concern nontraded goods,
tariffs,and transportcosts. The purpose of
this section is twofold. First we establish cordinglya constructionof equilibriumlike
how the exogenous introductionof non-
tradedgoods qualifiesthe precedinganaly-
sis. Next we turn to a particularspecifica-
tionoftariffs and transportcoststo establish
an equilibriumrange of endogenouslyde-
terminednontradedgoods as part of the
equilibriumsolution of the model. Trans-
fersare thenshownto affecttheequilibrium I - k, a positivefraction.
relativeprice structureand the range of
goods traded.
A. NontradedGoods
To introduce nontraded goods into the
analysiswe assume thata fractionk of in-
come is everywherespenton internationally
traded goods, and a fraction (1 - k) is
spent in each countryon nontraded com-
modities.With b(z) continuingto denote
expendituredensitiesfor traded goods, we
have accordingly
(14) k a b(z) dz < 1
wherez denotes traded goods.6 As before
the fractionof income spent on domesti-
callyexportablecommoditiesis O(z), except
that t now reaches a maximum value of
(1)= k.
Equation (1) remains valid for traded
goods, but the trade balance equilibrium
(15) [1 - 0(z) - (1 - k)]wL
= O(Z)W*L*
sincedomesticspendingon importsis equal
produced goods includingnontradedcom-
modities.Equation (15) can be rewritten as
W= k (!) (L*/L)
wherek is a constant and thereforeinde-
pendentof therelativewage structure.
We note that (15') togetherwith (5) de-
terminesthe equilibriumrelativewage and
efficientgeographic specialization, (Co,z).
Furtherit is apparentthat(15') has exactly
the same propertiesas (10') and that ac-
that in Figure 1 remainsappropriate. The
equilibriumrelativewage again depends on
6We can thinkof the range of nontradedgoods as
another[0, 1] intervalwithcommoditiesdenoted by x
and expenditurefractionson those goods given by
c(x). With these definitionswe have f c(x) dx-

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VOL. 67 NO. 5 DORNBUSCH ET AL.: RICARDIAN MODEL 829

relativesize, technology,and demand con- tive wage increasesand the range of com-
ditions. In this case demand conditions moditiesproduced domesticallyis reduced.
explicitlyinclude the fraction of income The stepsin achievingthis resultare, first,
spenton tradedgoods: thatat the initialrelativewage only a frac-
tion of the transferis spent on importsin
k-- -= A(z) thehome country,whileforeigndemand for
T-
k (z) L domesticgoods similarlydeclinesonly by a
This nicelygeneralizesour previousequilib- fractionof their reduced income. The re-
riumof (11) to handle exogenouslygiven sultingsurplusforthe home countryhas to
nontradedgoods.7 be eliminatedby, second, an increasein the
Two applications of the extendedmodel domesticrelativewage and a corresponding
highlightthe special aspects newly intro- improvementin the home country'sterms
duced by nontradedgoods. Firstconsidera of trade.8
shiftin demand (in each country)toward The analysisof nontradedgoods there-
nontradedgoods. To determinethe effects fore confirmsin a Ricardian model the
on theequilibriumrelativewage we have to "orthodox" presumptionwithrespectto the
establishwhetherthisshiftis at the expense termsof tradeeffects of transfers.9
of highor low z commodities.In the former
case the home country'srelativewage in- B. TransportCosts: Endogenous
creases while in the lattercase it declines. Equilibrium for NontradedGoods
If the shiftin demand in each countryis
uniformso that b(z) is reducedin the same The notionthat transportcosts give rise
proportionforall z in both countries,then to a range of commoditiesthat are non-
therelativewage remainsunchanged. tradedis establishedin the literatureand is
Consider next a transferreceivedby the particularlywell statedby Haberler (1937).
home countryin the amount T measuredin In contrastwith the previous section we
termsof foreignlabor. As is well known, shall now endogenously determine the
and already shown, with identical homo- rangeof nontradedcommoditiesas part of
thetic tastes and no nontraded goods, a the equilibrium.We assume, followingthe
transferleaves the terms of trade unaf- "iceberg" model of Samuelson (1954), that
fected.In the present case, however, the transportcosts take the form of "shrink-
condition for balanced trade, inclusive of age" in transitso that a fractiong(z) of
transfers, becomes: commodityz shipped actually arrives. We
further imposethe assumptionthatg = g(z)
(16) T= (k - )[wL + T] is identical for all commodities and the
[L - T] same forshipmentsin eitherdirection.
or, in equilibrium, The homecountrywillproduce commod-
ities for which domestic unit labor cost
(16')
fallsshort of foreignunit labor costs ad-
= I
=k (TIL) + k ( ) (L*/L) justed forshrinkage,and we modify(2') ac-
cordingly:
It is apparent from(16') that a transfer
(17) wa(z) < (1/g)w*a*(z)
receipt by the home country causes the
trade balance equilibriumschedule in Fig- or w < A(z)/g
ure 1 to shiftupward at each level of z.
Accordingly,theequilibriumdomesticrela- 8At constant relative wages the current account
worsensby [(1 - k -. tY) + = (1 - k)dT which
0IJdT
is less thanthetransfer,
sinceit is equal to the fraction
7Diagrams much like Figures 1 and 2 again apply: of incomespentonI nontradedgoods.
thedescendingA (z) scheduleis as before;and now the 9The pre-Ohlinorthodoxview of Keynes, Taussig,
new risingschedulelooks muchas before.As before,a Jacob Viner and other writersis discussed in Viner
risein L*/L and a balanced drop in a* (z) will raise Z (1937) and Samuelson (1952, 1954). A recenttreatment
and lowerz. withnontradedgoods is Ronald Jones(1975).

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830 THE AMERICAN ECONOMIC
w
A(z)/g
A(z)g
U~~~~ I variablesspecifiedin (20) and the respective
i I \
exportoblesz nontroded z importobles I
FIGURE 3
Similarly the foreign country produces
commoditiesfor which foreignunit labor
cost fallsshortof adjusted unit labor costs
of deliveredimports:
(18) w*a*(z) < (l/g)wa(z)
or A(z)g < w
In Figure 3 we show the adjusted relative
unit labor requirementschedules A (z)/g
and A (z)g. It is apparentfrom(17) and (18)
thatfor any given relativewage the home
countryproduces and exportscommodities
to the left of the A (z)g schedule, both
countriesproduceas nontradedgoods com-
moditiesin the intermediaterange,and the
foreigncountryproduces and exportscom-
moditiesin therangeto therightof A (z)/g.
To determinethe equilibrium relative
wage we turnto the trade balance equilib-
riumconditionin (19)-together with (20)
and (21)-which is modifiedto take account
of the endogenous range of nontraded
goods:
(19) (1 -X)wL = (1 - X*)w*L*
The variable X is the fraction of home
countryincome spent on our domestically
(or home) produced goods-exportables
and nontraded-and X* is the share of
foreigners'incomespenton goods theypro-
duce. Both X and X* are endogenouslyde-
terminedbecause the range of goods pro-
duced in each countrydepends on the rela-
tivewages.
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REVIEW DECEMBER 1977
(20) X(gw) f b(z)dz X'(gw) < 0
X*(W/g) j b(z)dz X*'(W/g)> 0
The dependenceof X( ) and X*( ) on the
derivativesfollowfrom(21) below.
The limits of integrationz and z* are
derived from the conditions for efficient
productionin (17) and (18) by imposing
equalities and so definingthe borderline
commodities.Thus, in Figure 3, z is the
borderline between domestic nontraded
goods and importsfor the home country,
and z* denotes the borderline between
foreignnontraded goods and the home
country'sexports:
(21) z* = A-'(w/g) di*/d(w/g) < 0
z = A-1(gw) df/d(gw) < 0
Of course,equilibriumz and z* are yet to
be determinedby the interactionof tech-
nologyand demandconditions.
From (21) an increasein therelativewage
reducesthe rangeof commoditiesdomesti-
callyproducedand therefore raisesthe frac-
tion of income spent on imports.Abroad
theconverseholds. An increase in the do-
mesticrelativewage increases the range of
goods produced abroad and thereforere-
duces the fractionof income spent on im-
ports.It followsthatwe can solve:
(19') =- 1 - X*(&/g) (L*/L)
1-X(;L*IL,g) d</d& < O
forthe unique equilibriumrelativewage as
a functionof relative size and transport
costs:
(22) F = Fv(L*/L,g)
Because (19')'s right-hand side declinesas X'
rises,a risein L*/L muststillraise 3; a rise
in g can shiftX in eitherdirection,depend-
ingon theB(z) and A (z) profiles.
The equilibrium relative wage in (22),
taken in conjunctionwith (21), determines
theequilibriumgeographicproductionpat-
tern,z and z-*.Since the range of nontraded
VOL. 67 NO. 5 DORNBUSCH ET AL.: RICARDIAN MODEL
goods z* < z < z depends in this formula-
tionon the equilibriumrelativewage, it is
obvious that shiftsin givenparameterswill
shiftthe range of nontraded commodities.
Thus, a transferthat raises the equilibrium
relativewage at home causes previouslyex-
portedcommoditiesto become nontraded,
and previouslynontraded commoditiesto
becomeimportables.
C. Tariffs
We considernextthe case of zero trans-
port cost but where each countrylevies a
uniformtariffon importsat respectiverates
t and t*,withproceedsrebatedin lump sum
form.This case, too, leads to cost barriers
to importing,and to a range of commodi-
tiesthatare not traded,withthe boundaries
definedby:
(23) = A-1
and - A'(w(1 + t*))
From (23) it is apparentthatthepresenceof
in eitheror both countriesmust give
tariffs
riseto nontradedgoods because-in thiscase
The trade balance equilibriumcondition
at internationalpricesbecomes, in place of
(19),
(24) (1 - X)Y/(1 + t) =
(1 - X*)Y*/(1 + t*)
where Y and Y* denote incomes inclusive
of lump sum tariffrebates. Using the fact
thatrebatesare equal to thetariffrate times
thefractionof incomespenton imports,we
arriveat the trade balance equilibriumcon-
ditionin theform:'0
(25) X(1 -*) 1 + t*x* (L*/L)
whereX and X* are functionsof (w,t,t*).
are equal to
rebatesin the homecountry
I0Tariff
R = (I - A) Yt/(l + t). With Y = WL + R we there-
forehave Y = WL(l + t)/(l + At) as.an -expression
forincomeinclusive Fromequations(20)
of transfers.
and (23) we have X = A[w/(1+ t)] and A* =
A*[w(1+ t*)],havingsubstituted insteadof
thetariff
transportcostsas theobstacletotrade.
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831
The implicitrelations(25) can be solved for
theequilibriumrelativewage as a function
structure:
of relativesize and thetariff
Z) = Co(L*/L,t,t*)
(26)
From (26) and (23) it is apparent now
thattherangeof nontradedgoods will be a
functionof both tariffrates. It is readily
shown that an increase in the tariffim-
provestheimposingcountry'srelativewage
and termsof trade. Furthermore,as is well
known,when all countriesbut one are free
traders,then one countrycan always im-
prove its own welfareby imposinga tariff
thatis not too large.
A further questionsuggestedby (26) con-
cerns the effectof a uniformincrease in
world tariffs.Startingfromzero, a small
uniformincreasein tariffs raises the relative
wage of the countrywhose commodities
commandthe largershare in world spend-
ing. This result occurs for two reasons.
First, at the initial relativewage a larger
shareof spendingout of tariffrebates falls
on thegoods of the countrycommandinga
largershare in world demand. Second, the
tariffinduces new nontraded goods and
thereforeincreases net demand for the
borderlinecommodityof thecountrywhose
residentshave the largerincome, or equiv-
alently,thelargersharein worldincome.
If countriesare of equal size as measured
by the share in world income, such a uni-
formtariffincreasehas zero effecton rela-
tivewages,but of course reduceswell-being
in both places. Multilateraltariffincreases,
in thiscase, unnecessarilycreatesome non-
tradedgoods, and artificially raise the rela-
tive price of importablesin terms of do-
mesticallyproduced commodities in each
countryexactlyin proportionto thetariff.
Rates
IV. Money,Wages,andExchange
In thissectionwe extendthediscussionof
theRicardian model to deal withmonetary
aspectsof trade.Specificallywe shall be in-
terestedin the determinationof exchange
ratesin a flexibleratesystem,in the process
of adjustmentto trade imbalance under
fixedrates, and in the role of wage sticki-
832 THE AMERICAN ECONOMIC
ness. The purpose of the extensionis to in-
tegratereal and monetaryaspectsof trade.
A. FlexibleExchangeRates
The barteranalysisof the precedingsec-
tions is readily extended to a world of
flexibleexchange rates and flexiblemoney
wages.Assume a givennominal quantityof
money in each country,M and M*, re-
spectively.Further,in accordance with the
classical QuantityTheory,assume constant
expenditurevelocitiesV and V*.ll A flexible
exchangerate, and our stipulatingthe ab-
sence of nonmonetaryinternationalasset
flows,will assure trade balance equilibrium
and thereforethe equality of income and
spending in each country. The nominal
money supplies and velocities determine
nominalincomein each country:
WL = MV W*L* = M* V*
(27) and
where W and W* (now in capital letters)
denote domesticand foreignmoneywages
in termsof the respectivecurrencies.Fur-
ther,definingthe exchange rate e as the
domestic currency price of foreign ex-
change,theforeignwage measuredin terms
of domesticcurrencyis e W*, and the rela-
tivewage therefore is w W/eW*.
From the determinationof the equilib-
riumreal wage ratiocoby our earlier"real"
relations,we can now findan expressionfor
theequilibriumexchangerates:
(28) e = (1/&I)(W/W*) =
(11F.)(MV/M* V*) (L*/L)
where (27') defines equilibrium money
wages:
(27') W = MV/L
and
W* = M* V*/L*
In this simple structureand with wage
flexibility,we can keep separate the de-
terminants of all equilibriumreal variables
fromall monetaryconsiderations.Mone-
IIThis is a strongassumptionsince it makes spend-
ingindependentof incomeand nonliquidassetsevenin
theshortrun.
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REVIEW DECEMBER 1977
tary changes or velocity changes in one
countrywill be reflectedin equiproportion-
ate changesin pricesin thatcountryand,in
the exchange rate in the fashion of the
neutral-money QuantityTheory. However,
a real disturbance,as (28) shows, definitely
does have repercussionson the nominalex-
change rate as well as on the real equilib-
rium.
Using the results of Section II, we see
thatan increasein the foreignrelativelabor
forcecauses, under flexibleexchange rates
and givenM and M*, a depreciationin the
home country'sexchange rate as does uni-
formtechnicalprogressabroad. A shiftin
real demand toward foreigngoods likewise
leads to a depreciationof the exchangerate
as well as to a reductionin real Z. A rise in
foreigntariffswill also cause our currency
to depreciate. Each of these real shiftsis
assumed to take place while (M, M*) are
unchangedand on the simplifyingproviso
that real income changes leave V and V*
unchanged.
B. Fixed ExchangeRates
In the fixed exchange rates case we as-
sume currenciesare fullyconvertibleat a
paritypegged by the monetaryauthorities.
In theabsence of capital flowsand steriliza-
tionpolicy,a tradeimbalance is reflectedin
monetary flows. In the simplest metal
money model, the world money supply is
redistributedtoward the surpluscountryat
preciselythe rate of the trade surplus. We
assume that the world money supply is
givenand equal to G, measuredin termsof
domesticcurrency.The rate of increase of
thedomesticquantityof moneyis therefore
equal to the reductionin foreignmoney,
valued at thefixedexchangeratee:
(29) M=
whereAl dM/dt.
For a fixed rate world we have to de-
terminein addition to the real variables Co
and z, thelevelsof moneywages W and W*
as well as the equilibriumbalance of pay-
mentsassociated with each short-runequi-
librium.In thelong run the balance of pay-
ments will be zero as money ends up
VOL. 67 NO. 5 DORNBUSCH ET AL.: RICARDIAN MODEL 833

redistributedinternationallyto the point W R'

where income equals spending in each
country.In the shortrun an initialmisallo- G /
cation of money balances implies a dis-
crepancybetweenincomeand spendingand
an associated trade imbalance. To char-
acterizethe preferredrate of adjustmentof
cash balances in thesimplestand mostman-
ageable way, we assume that spending by
each country is proportional to money
//
holdings.'2On the furthersimplifyingas-
sumptionthat velocitiesare equal in each
country,V = V*,13world spendingis equal
to
0 -
(30) VM + eV*M* - VG
FIGURE 4
For thetastesand technologyspecifiedin
Section I, world spendingon domestically
producedgoods is givenby ing from(11) for the equilibriumrelative

(31) VG f b(z)dz t- (w)VG

wage Zi, we can employequations (32) and
(33) to determinemoneywage levels.
The equilibriumdeterminedby equations
z= A-'(w) (32) and (33) can be analyzed in terms of
Figure4. The figureemphasizesthe separa-
In equilibrium, world spending on our tion of real and monetaryaspects of the
goods mustequal the value of our full-em- equilibrium under our assumptions of
ploymentincome WL: tradedgoods only, and no distributionef-
WL = t(w) VG fects.From theratioof (32) and (33) we ob-
(32) tain the equilibriumrelative wage C as a
Equilibriumrequires,too, thatworldspend- functionof tastes and technology solely
ing on foreigngoods equals the value of fromthebartermodel. This equilibriumre-
foreignfull-employment income: lativewage is plottedas the ray OR in Fig-
(33) eW*L* = [1 - (w)]V6 ure4.
The equalityof world income and spend-
Equations (32) and (33) express what ing
would seemto be thejoint determinationof
real and monetaryvariables. But, in fact, (30') WL + eW*L* = VG
we could have taken the shortcutof recog-
nizingthatthe real equilibriumis precisely is shown as the downward sloping straight
thatof thebarteranalysisdeveloped in Sec- line GG, whichis drawn forgiven velocity,
tionI. Dividing (32) by (33) and substitut- world quantityof money,and labor forces.
Point E is the equilibriumwhere relative
pricesand the level of wages and prices are
12Theassumption thatspendingis proportionalto such that all marketsclear. At a level of
cashbalancesis only one of a numberof possible wages and priceshigherthan point E,
specifications.
Conditions forthisexpenditure
function
there
to be optimalare derivedin Dornbuschand Michael would be a world excess supply of goods,
Mussa. In general,expenditure willdependon both and converselyat pointsbelow E.
incomeandcashbalances. Figure 4 immediatelyshows some com-
131nthe long-run equilibrium,higherV than V* parativestatic results.Thus a doubling of
leavesus witha smallershareof the worldmoney
stockthanforeigners, but withnominaland real in- both countries' labor forces, from the
comesharesin thetwo countries thesame as when analysisof the bartermodel, will leave the
V= V*. relative wage unaffectedbut will double

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834 THE AMERICAN ECONOMIC
world output. Given unchanged nominal
spendingVG,wages and priceswill have to
halve. This would be shown by a parallel
shiftof the GG schedulehalfwaytowardthe
origin.A shiftin demand towardthe home
country'soutput by contrastwould rotate
the OR ray to a position like OR' since it
raisesour relativewage. The ensuingmone-
taryadjustmentis then an increase in our
moneywage and money income and a de-
cline in foreignwages, prices, and incomes
(point E').
The real and nominal equilibrium at
point E in Figure 4 is independentof the
short- and long-run distributionof the
worldquantityof money.The independence
of thereal equilibriumderivesfromthe uni-
formhomothetictastes. The independence
of the nominal equilibriumis implied by
identical velocities. What does, however,
depend on the short-rundistributionof
worldmoneyis the transitionperiods' bal-
ance of payments.As in the absorptionap-
proach of Sidney Alexander (1952), we
know this: when goods markets clear, the
trade surplusor balance of paymentsM of
thehome countryis equal to the excess of
incomeoverspending,or:
(34) M= WL- VM
Withthe nominalwage independentof the
of world money,equation (34)
distribution
thereforeimplies that the trade balance
monotonicallyconvergesto equilibriumat
a rateproportionalto the discrepancyfrom
long-runequilibrium:"4
(34') M = V(M - M); M = 0 ()G
The assumptionsof this sectionwere de-
signedto renderinoperativemostof thetra-
ditional mechanismsdiscussed as part of
14Suppose V> V* and our share of the world
moneysupplyis initiallylarger than our equilibrium
share.Then, as we lose M, totalworldnominal income
and nominal GNP falls.Always our share of nominal
world GNP staysthe same under the strongdemand
assumptions.Total world real output never changes
during the transition; only regional consumption
shares change. Therefore,both countries' nominal
priceand wage levels fall in the transition,but such
balanced changes have no real effectson either the
transientor thefinalreal equilibrium.
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REVIEW DECEMBER 1977
the adjustment process: changes in the
terms of trade, in home and/or foreign
pricelevels,in relativepricesof traded and
nontradedgoods (there being none of the
latter),in double factoral terms of trade;
and any discrepanciesin the price of the
same commoditybetween countries. The
featuresof the adjustmentprocess of this
sectionrelyon 1) identical,constantexpen-
diturevelocities,2) uniform-homothetic de-
mand,and 3) the absence of trade impedi-
ments. If velocities were constant but
differedbetween countries, the absolute
levelsof money wages and prices, though
not relativewages or prices,would depend
on theworlddistribution of money.Relaxa-
tion of the uniform-homothetic taste as-
sumptionwould make equilibriumrelative
prices a functionof the distributionsof
spending. Finally, the presence of non-
tradedgoods would,togetherwithRicardo's
technology,provide valid justificationfor
some of the behavior of relativeprices and
pricelevelsfrequentlyassertedin the litera-
ture;this behavioris studiedin more detail
in thenextsection.
C. The Price-SpecieFlow Mechanism
underMore GeneralConditions
We now discuss the adjustmentprocess
to monetary disequilibrium and enquire
intothepriceeffectsassociatedwitha redis-
tributionof the world money supply when
thereare nontraded goods. Common ver-
sions of the Hume price-specieflow mech-
anismusually involvethe argumentthat in
theadjustmentprocess,pricesdecline along
- withthemoneystock in the deficitcountry,
whileboth risein thesurpluscountry.There
is usually,too, an implicationthatthe defi-
cit country'stermsof trade will necessarily
worsenin the adjustmentprocess and in-
deed have to do so iftheadjustmentis to be
successful.
SectionIVB demonstratedthat the redis-
tributionof money associated with mone-
taryimbalance need have no effectson real
variables(production,termsof trade, etc.)
and on nominal variables other than the
money stock and spending. While this is
VOL. 67 NO. 5 DORNBUSCH ET AL.: RICARDIAN MODEL 835

clearlya veryspecial case, it does serve as a ing to nontradedgoods, shiftingsome of

benchmark since it establishes that the our resourcesto theirproductionat the ex-
monetaryadjustmentprocess would be ef- penseof our previousexports.We not only
fectiveevenin a one-commodity world. exportfewertypesof goods, but also import
To approach the traditionalview of the more types, and import more of each
adjustmentprocess more clearly and pro- (& risesand z falls).
vide formalsupportforthat view, we con- During the transition, while the real
sideran extensionto the monetaryrealm of transfercorrespondingto our deficitis tak-
our previous model involving nontraded ing place, our terms of trade are more
goods. We returnto the assumptionthat a favorablethan in the long-runstate. The
fraction(1 - k) of spendingin each coun- newgold raises both theirW* and our W,
tryfalls on nontradedgoods, and accord- butin addition,our W is up relativeto their
inglyequations(32)-and (33) become: W*. Thereforethe price level of goods we
(32') WL = 0 (w) VG + (1 - k)yVG; continue to produce is up relativeto the
price level of goods theycontinue to pro-
yMI G duce. This is true both for our nontraded
(33') eW*L* = [k - O(w)]VG goods and for our exportables.The prices
+ (1 - y)(1 - k)VG of goods we produce rise relative to the
pricesof goods theyproduce in proportion
These hold both in finalequilibrium,and in to thechangein relativewages.
transientequilibriumwhere specie is flow- Thus theprice levels in the two countries
ing. Equations (32') and (33') imply that have been changed differentially by the
the equilibriumrelativewage does depend specie flow and implied real transfer.But
on thedistribution of theworld moneysup- that does not mean that any traded good
ply.Solvingtheseequations forthe equilib- eversells fordifferent prices in two places.
riumrelativewage we have: In fact the divergencein weightedaverage
zi5 (consumer)price levels is due to nontraded
(35) z = d > goods. The price level will rise in the gold-
discoveringcountryrelative to the other
An increase in the home country'sinitial countrythe greater is the share of non-
share in the world money supply y raises tradedgoods in expenditure,1 - k. It is a
our relativewage. bit meaningless to say, "What accom-
Using this extendedframework,we can plishedthe adjustmentis the relativemove-
drawon theanalysisof thetransfer problem mentsof pricelevelsfornontradedgoods in
in SectionII to examinetheadjustmentthat thetwo countries,"since we have seen that
follows an initial distributionof world theadjustmentcan and will be made even
moneybetweenthe two countriesthat dif- when thereare no such nontraded goods.
fersfromthe long-runequilibriumdistribu- It is meaningfulto say, "The factthatpeo-
tion. ple wantto directsome of theirexpenditure
Suppose our M is initiallyexcessive,say to nontradedgoods makes it necessaryfor
froma gold discoveryhere. Assume also resourcesto shiftin and out of themas a re-
that the gold discoveryoccurredwhen the sult of a real transfer,and such resource
worldwas in long-runequilibriumwiththe shiftstake place only because the termsof
previousworld moneystock. As a resultof trade(double-factoraland fortradedgoods)
our excess M, we spend more than our do shiftin theindicatedway."
earnings,incurringa balance-of-payments The adjustmentprocess to a monetary
deficitequal to the rate at which our M is disturbanceis stable in the sense that the
flowingout. In effect,the foreigneconomy systemconvergesto a long-runequilibrium
is making us a real transferto offsetour distributionof moneywith balanced trade.
deficit.As seen earlier,we, the deficitcoun- To appreciate that point, we supplement
try,are devotingsome of our excess spend- equations(32') and (33') with(34) thatcon-

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836 THE AMERICAN ECONOMIC
tinuesto describethe monetaryadjustment
process.We note,however,thatnow W and
W* are endogenous variables whose levels
in the shortrun do depend on the distribu-
tionof the world moneysupply.A redistri-
butionof moneytowardthe home country
would raise our spendingand demand for
goods, and reduceforeignspendingand de-
mand. As before, spending changes for
tradedgoods offseteach other preciselyso
thatthe net effectis an increasein demand
fornontradedgoods at home and a decline
abroad. As a consequence our wages will
rise and foreignwages decline. Therefore,
startingfromfullequilibrium,a redistribu-
tionof moneytowardthehomecountrywill
createa deficitequal to
(36) dM/dM= -V(1 6) 0< <1I
where 6 is the elasticityof our nominal
wages withrespectto thequantityof money
and is less than unity.'5 Equation (36) im-
plies that the price-specieflow mechanism
is stable.
to observein thiscontext
It is interesting
thatthepresenceof nontradedgoods in fact
slowsdownthe adjustmentprocess by com-
parisonwitha world of only traded goods
(contraryto J. Laurence Laughlin's turn.of
thecenturyworries).As we saw before,with
all goods freelytradeable,wages are inde-
pendentof the distributionof money,and
accordingly6 = 0. Furtherwe observethat
thespeed of adjustmentdepends on the re-
lativesize of countries.Thus themore equal
countriesare in terms of size, the slower
tendsto be theadjustmentprocess.
In concludingthis section we note that
nontraded goods (and/or localized de-
mand) are essential to the correctnessof
traditionalinsistencethat the adjustment
process necessarilyentails absolute and re-
I5The value of 6 can be calculated fromequations
(32') and (33') to be
6 (1Y(- k kY) --
k)y(l ) + E
wheree is the elasticityof the share of our traded
goods in world spending,e -tYw/lt > 0. The elas-
ticity6 is evaluated at the long-runequilibriumwhere
y t-/k. If A '(z) fallsslowly,e willbe large.
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REVIEW DECEMBER 1977
lativeprice,wage, and income movements.
They are, of course, in no way essential to
theexistenceof a stable adjustmentprocess,
nor is thereat any time a need for a dis-
crepancyof prices of the same commodity
across countriesin eithercase. 16
A final remarkconcernsthe adjustment
to real disturbancessuch as demand shifts
or technical progress. It is certainlytrue
that whetherthe exchange rate is fixed or
flexible,real adjustmentwill have to take
place and cannotbe avoided by choice of an
exchangerateregime.So long as wages and
pricesare flexible,it is quite false to think
thatfixedparities"put the whole economy
throughthe wringerof adjustment" while
in floatingrate regimes"only the export
and importindustrieshave to make the real
adjustment."It is true,however,that once
we depart from flexiblewages and prices
theremay well be a preferencefor one ex-
changerate regimeover another.The next
sectionis devotedto thatquestion.
D. StickyMoney Wages
The last question we address in this sec-
tion concerns the implications of sticky
money wages. For a given world money
supply, downward stickiness of money
wages implies the possibilityof unemploy-
ment. We assume upward flexibilityin
wages,once fullemploymentis attained.
We start with a fixed exchange rate e.
The relationbetweenwages and the world
quantityof moneyis broughtout in Figure
5. Denote employmentlevels in each coun-
try,as opposed to the labor force, by the
newsymbolsL and L*, respectively;denote
nominalincomesby Y and Y*. The equality
of world income and spending is again
shownby the GG schedule,the equation of
whichnow is
(37) VG = Y + eY* - WL + W*L*
16ThecontinuumRicardian technologyis special in
thattherecan be no rangeofgoods both importedand
produced at home. Therefore,the cross elasticityof
supplybetweennontradedgoods and exportsmust be
greaterthan the zero cross elasticitybetween non-
traded goods and imports.Consequently, a transfer
mustshiftthetermsof trade(forgoods and factors)in
thestatedorthodoxway,favorablyforthereceiver.
VOL. 67 NO. 5 DORNBUSCH
Y
G / R'
\/t
E ~~~R
y~~
Y eY*
0 ET*
FIGURE 5 thesubstitutability in demand and the elas-
where W and W* are the fixed money
wages set at too high sticky levels. The
scheduleis drawnforgivenmoneywages, a
given world quantity of money, and a
peggedparityfore. The ray OR now is pre-
determinedby thegivenstickyrelativewage
i = W/eW*. From equations (32) and (33)
theratioof moneyincomes Y/eY* is just a
functionof the relativewage now givenex-
ogenouslyby rigidmoneywages and the ex-
changerate:
(38) Y/eY* - (WeW*)
'(W)
Point E is the nominal equilibriumwhere
by assumptiontheworldquantityof money
is insufficient
relativeto wage rates to en-
sure full employment.Although that equi-
libriumis one withunemployedlabor, it is
in otherrespects.Specifically,geo-
efficient
graphic specializationfollows comparative
advantageas laid out above, but now labor
employedadjuststo stickywage patternsof
specialization.
EmploymentlevelsLand L* now are de-
terminedby(39)
(39) L-= Y/W, L* -
where Y and Y* are the equilibriumlevels
of nominalincomedeterminedby equations
(37) and (38) or by pointE in Figure5.
Considernow the impact of a foreignin-
creasein moneywages. The effectof the im-
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ET AL.: RICARDIAN MODEL 837
plied reductionin our relativewages and
theresultingincreasein our relativeincome
are shown in Figure 5 by the rotationfrom
OR to OR'.
The new equilibriumis at E' where our
moneyincome and employmenthave risen
while income and employment decline
abroad. Thus an increase in the foreign
wage rate, by moving the terms of trade
against us, shifts comparative advantage
and employmenttowardthe home country.
The extentto whichthehome countrybene-
fitsfromthe adversetermsof trade shiftin
termsof employmentwill depend on both
ticityof the A (z) schedule in Figure 1. We
observe,too, that the move fromE to E'
will bring about a transitorybalance-of-
paymentssurplus.Given theinitialdistribu-
tion of money and hence of -spending,the
foreigndecline in income and the increase
at home impliesthatwe will spend less than
our income and thereforehave a trade sur-
plus. This surpluspersistsuntilmoneyis re-
distributedto match the new levels of in-
come at '.
Next we move to flexibleexchange rates.
Under flexibleratesan increase in the for-
eignmoneywage W*, givenmoneysupplies
in each country,will similarlyhave real re-
percussioneffects on relativepricesand em-
< 0 ploymentat home. Now employmentin
each countryis determinedby money sup-
pliesand prevailingwages:
(39') L = VM/ W; L* - VM*/ W*
Given the employmentlevels thus deter-
mined,we know from the analysis of the
earlierbartermodel that thereis a unique
relativewage at which the trade balance
achievesequilibrium. The higheris M*/ W*,
the higher will be employmentabroad-
and, therefore, the higherwill be our rela-
tivewage a. It is thus apparent that an in-
crease in the foreignmoneywage, W*, will
reduce employmentabroad. Employment
declinesonly in proportionto the increase
in wages and thus declines by less than it
would under fixed exchange rates when
specieis lost abroad.
We saw in the bartermodel thata reduc-
838 THE AMERICAN ECONOMIC
tion in effectiveforeignlabor causes a de-
cline in our relative wage, but that the
decline in our relativewage falls propor-
tionatelyshort of the foreignreductionin
labor. Now, at the initialexchangerate,the
increasein foreignwages reduces our rela-
tivewage and theiremploymentin the same
proportion.The declinein our relativewage
is thereforeexcessive.Domestic goods are
underpricedand the exchange rate appre-
ciatesto partlyoffsetthe gain in cost com-
petitiveness.The net effectis thereforea
declinein our relativewage and an appre-
ciationof our exchangerate (a declinein e)
that falls short of the foreignincrease in
wages. Since our termsof trade unambig-
uouslydeterioratewithoutany compensat-
inggain in employment, it mustbe truethat
welfaredeclinesat home. Abroad, the loss
in employmentis offsetby a gain in the
termsof trade,but theretoo thenet effectis
a loss in welfare under our strong Mill-
Ricardo assumption.
The adjustmentto money wage distur-
bances underfixedand flexiblerates differs
in several respects.Under fixed rates em-
ployment effects are transmitted,while
underflexiblerates theyare bottled up in
the country initiating the disturbance.
Under fixedrates the termsof trade move
one forone withmoneywage, while under
flexible rates exchange rate movements
partlyoffsetincreasesin the foreignmoney
wage rate.
The differencebetweenfixedand flexible
ratesin relationto theadjustmentprocess is
further broughtout by an example of a real
disturbance.Consider a shiftin world de-
mand toward our goods. Under fixedrates
theresultingincreasein our relativeincome
will, from(38), move us in Figure 5 from
E to E'. Employmentrisesat home and falls
abroad. Demand shiftsare fullyreflectedin
employmentchanges. Under flexiblerates,
bycontrast,withgivenwages and money,a
demand shifthas no impact on employ-
ment-as we observefrom(39). At the ini-
tial exchange rate the demand shiftwould
giveriseto an excess demand forour goods
and to an excess supply abroad. Domestic
incomeand employmentwould tend to rise
while falling abroad. The resultingtrade
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All use subject to JSTOR Terms and Conditions
REVIEW DECEMBER 1977
surpluscauses our exchange rate to appre-
ciate untiltheinitialemploymentlevels and
therefore trade balance equilibriumare re-
stored.The demand shiftis fullyabsorbed
by a changein thetermsof tradeand a shift
in competitiveadvantage that restoresde-
mand forforeigngoods and labor.
Real and nominalequilibriaare thus seen
to be uniquely definablein our continuum
model with constant-velocity spending de-
terminants.The differencebetween sticky
and flexiblewage ratesunderfixedexchange
ratesis understandableas the differencebe-
tween(a) havingthe crucial relativewage zi
be imposedin thestickywage case withem-
ploymentshavingthento adjust; or (b) hav-
ingthe fullemploymentsbe imposed and C
having to adjust. Under floatingexchange
rates,stickynominalwages impose employ-
mentlevels in each countryand the crucial
relativewage Z then adjusts to those em-
ploymentlevels.
APPENDIX
HistoricalRemark
Figure 1 seems to be new. G. A. Elliot
(1950) gives a somewhatdifferent diagram,
one that makes explicit the meaning of
Marshall's 1879 "bales" (which,bytheway,
happen to work only in the two-country
constantlabor costs case). In termsof the
presentnotations,Elliottplots forthe U.S.
offercurve the followingsuccessive points
tracedout forall w on the range [0, oo]: on
theverticalaxis is plottedour total real im-
ports valued in foreignlabor units ("our
demand for bales of their labor," so to
speak), namely,
f [P*(z)/w*]C(z)dz = j a*(z)C(z)dz
and on the horizontal axis, our total real
exportsvalued in home labor units ("our
supplyof bales of labor to them"), namely,
rz - C(z)]dz=
J[P(z)/w][Q(z)
L - a(z) C(z)dz
VOL. 67 NO. 5 DORNBUSCH ET AL.: RICARDIAN MODEL 839

It is to be understoodthat2 is a functionof G. A. Elliott,"The Theory of International

w,namelythe inversefunctionA '(w); also
that C(z) are the amounts demanded as a
functionof our real income L and of the
P(z)/ W functiondefinedfor each, namely
min[wa(z), a*(z)]. Because we have a con-
tinuum of goods, we avoid Elliott's
branches of the offercurve that are seg-
mentsof various rays throughthe origin.
The reader will discernby symmetrycon-
siderationshow the' foreignoffercurve is
plotted in the same (L, L*) quadrant, by
varyingw to generatethe respectivecoor-
dinates
rz
a(z)C*(z)dz,
L* a*(z)C*(z)dz P. A. Samuelson,"The TransferProblem and
Our model forces the Elliott-Marshall
diagramto generatea uniquesolutionunder
uniform-homothetic demand. Unlike our
Figure 1, the Elliott diagram can handle
thegeneralcase of nonhomotheticdemands
in the two countries;but then, as is well
known, multiple solutions are possible,
some locallystableand some unstable. The
priceone pays forthisgeneralityis that,as
Edgeworth observed, the Marshallian
curvesare the end products of much im-
plicit theorizing,with much that is inter-
estinghavingtakenplace offstage.
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