Knowledge that Transforms

We study the full equilibrium dynamics of a two-country world economy with a floating exchange rate, traded and nontraded goods, and explicit modeling of the use of money. The resulting exchange rate equation depends on several details of the economic structure, such as the supply structure and propensities to spend on various goods. Although real exchange rate movements have the usual association with the current account, the ordinary exchange rate may appreciate or depreciate when there are deficits on current account even when the quantities of money do not change. Deviations from purchasing-power parity and the Fisher equation are shown to be the rule rather than the exception.

This paper shows that, in the absence of a complete set of risk markets, prices provide incorrect signals for guiding production decisions. Even if all individuals have rational expectations concerning the distribution of prices which will prevail on the market next period, the market allocation is, in general, not a constrained Pareto optimum. Essentially the only conditions under which, for all technologies, the market equilibrium is a constrained Pareto optimum are those in which risk markets are redundant. We derive the necessary and sufficient conditions for redundancy of risk markets, which turn out to be extremely restrictive.

In this paper we study the determinants of intersectoral factor mobility. Mobility is the outgrowth of a prior investment decision. In particular, we focus on the human capital (i.e., training) decisions of workers. Uncertainty isa critical feature in such training decisions. The acquisition of general (vs. specific) skills allows a worker to select the more favorable sector after uncertainty is resolved. Thus general training has option value, which is enhanced by increases in risk. General training is a form of self-insurance. We study the impact of conventional insurance opportunities on training decisions. We find that the availabilty of income insurance does not necessarily imply less mobile workers.

The use of the compensation principle in cost-benefit analysis as a means of separating the efficiency and distributional effects of a project is theoretically suspect for a number of reasons. One difficulty is the lack of a necessary and sufficient criterion for determining that a compensation test is passed in an economy where consumers' and producers' prices are not the same. For this paper we establish such a criterion for projects that are small in the differential sense. The criterion requires the calculation of a set of "shadow prices" which is a weighted average of the consumers' and producers' price vectors.

The paradoxical aspect of the Giffen Paradox is the inability of demand theory to explain why Giffen goods are apparently so rare. The resolution of the paradox arises from the distinction between the shape of market demand curves and the sequence of equilibrium prices that will be observed in markets in which quantity supplied changes. The sense in which the Giffen case is "unlikely" to occur is that the probability of identifying a Giffen good is less than the probability that such a good exists.

Effects on renters' welfare of changes in local government spending are examined in a multijurisdiction model. In equilibrium each income class chooses the jurisdiction whose combination of local public output and housing price maximizes utility. Comparative-static analysis of this equilibrium is used to show how inequality in local public expenditure benefits low-income residents. If low-income residents are observed to choose jurisdictions with low levels of per capita public expenditure, then they may be worse off by outside aid which increases local public expenditure in their jurisdictions. The advantages of inequality in the local public sector also exist when a program of tax base equalization is introduced.