Knowledge that Transforms

John Merrick's critique of my 1977 study of real interest rate movements rests on two grounds. The criticism that occupies most of his attention is concerned with whether my model remains internally consistent when either of the two models of inflationary expectations are added to the macro-economic models of the real rate of interest. Merrick finds that each of my macroeconomic models of the real rate has embedded in it a model of inflationary expectations when rational expectations are applied to it, so that my procedure of adding alternative models of inflationary expectations to each macro-economic structure produces a misspecification of the models and constitutes a fundamental flaw in

As others have noted (see articles by Harry Johnson (1971, 1972) and Jaroslav Vanek), the highly mathematical nature of most of the literature integrating growth and trade theory serves to restrict considerably the size of the audience to which explanations of this important subject can be directed.' This paper attempts to widen this audience by framing the analysis of the topic in simple geometric terms that utilize the standard two-country, two-sector (commodity), two-factor model of international trade. Assume that the two commodities produced by the two countries A and B are a capital good K and a consumption good C. The capital good together with a growing labor force L are the two factors of production.2 As is typical for this model, also suppose that the capital good cannot be traded once it is used as a productive factor and that this good is produced in a uniformly laborintensive fashion compared to the consumption good.3 The production function of each good is identical in both countries and subject to constant returns to scale.4 It is further assumed that the growth rate of the labor force is the same in both countries and that each economy saves a constant but different proportion of its income.5 There are two requirements for steadystate equilibrium in such a model: 1) The desired rate of capital accumulation in both countries must equal the exogenously determined rate of growth of the labor force, and 2) The value of exports must equal the value of imports for each of the two countries.6 As the first step in the analysis, it will be shown that over some range of capital-labor (K/L) endowment ratios for each country, there is for each of these endowment ratios some relative price of the capital good in terms of the consumption good (Pk) that will equalize the desired rate of capital accumulation in each country and the common rate of labor force growth. After finding the set of Pk and K/L ratios for each country satisfving this equilibrium condition, the next step will be to select the subset of Pk at which the two countries wish to trade in opposite directions, and determine for each of these Pk the relative size of the countries as measured bv the ratio of their labor supplies that would be needed to equalize the value of exports and imports in each country. Given some actual initial ratio of the size of the two labor forces a ratio that remains constant throughout the growth process, since the rates of labor force growth are equal in the two countries it will then be possible to read off from this schedule of * Professor of economics, University of Wisconsin, Madison. ' The exposition of these authors deals mainly with the case of a small country facing fixed terms of trade whereas the analysis here focuses on the more general case where there are two countries, each of which can affect the terms of trade. 2 For simplicity, depreciation of the capital good is ignored. Some initial supply of K and L in each country is also assumed. 3This assumption concerning factor intensity is made to insure a unique, stable steady-state equilibrium. I Such other standard assumptions of the simple Heckscher-Ohlin-Samuelson model as diminishing marginal productivity and perfect competition are also made. I In each economy, all individuals have the same savings ratio and possess the same quantity of capital. 6 When the desired rate of capital accumulation in a country equals the labor force growth rate, the country's supply of the capital good will generally not equal its demand for this good. However, the trading condition required for equilibrium insures that one country's excess demand for K is matched by the other country's excess supply. Thus, the two requirements can be combined into the more familiar condition that the actutal rate of capital accumulation equal the common growth rate of the labor force.

The U.S. policies toward the USSR in the postwar period have been less friendly than those of our NATO allies. These policies have been, however, a largely understandable reaction to the miliary posture and undemocratic domestic policies of the USSR and to the nature of its economic system. But the situation is changing rapidly. The Gorbachev Reform is already a minor social, political, and economic revolution, and may well turn into a major one. These circumstances require a reassessment of our policies toward the Soviet Union. Some reassessment has already taken place as indicated by our signing the INF Treaty. Nevertheless, the overall tone of our administration is dominated by attitudes of skepticism and show me when hardly a week goes by that the Soviets do not show by saying or doing something that two or three years ago was unthinkable. I think it is important for us to adopt a more positive approach toward the Soviet reform. Our major foreign policy goal over the past forty years has been containment of the Soviet Union. This goal has been enormously expensive to implement, and pursuing it bears much of the responsibility for the difficult economic problems this nation faces today. The relentless pursuit of this goal has been based on the assumption that, while uneasy truces between the two camps might be worked out from time to time, the differences between us are irreconcilable over the long run. Now, for the first time in Soviet history, this assumption may no longer be valid. There is little doubt that Gorbachev genuinely wants to eliminate many of those aspects of the Soviet system that we consider objectionable and to end the cold war. His task will be difficult and good relations with the West would simplify it. Gorbachev's policies are in our interest. The opportunity should not be missed-it may not come again for decades.