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.

In his recent paper, in this Review, Samuel Bowles (1985) argues that involuntary unemployment in a competitive capitalist economy is an outcome of the Marxian notion of conflict between the firm (capitalist) and workers. The purpose of this comment is not to question the Marxian framework, but simply to argue that the model and examples in Bowles, though very interesting, do not in any cogent way reflect class conflict. Let me list the major points made by Bowles in the context of a competitive capitalist economy: 1) involuntary unemployment, leading to reserve army of the unemployed, is a reflection of class conflict; 2) capitalist technology may be profit maximizing but inefficient; and 3) discrimination among identical workers may be profit maximizing. I will focus primarily on the first observation which is the heart of the paper. The other two can be deduced from the first.

Vito Tanzi's comment on my earlier study (1982) is based upon his belief that the Mundell effect alone could not likely account for the ex ante negative real rates observed in his simulations. His suggestion is that Perhaps a Mundell effect, together with a fiscal illusion, provides the best explanation (p. 502). Nowhere did I argue that the Mundell effect was all-encompassing. nominal rate is determined by many factors besides expected (X). My reducedform nominal rate equation includes uncertainty, the current and lagged money stock, and the lagged price level as well as expected as arguments. Thus, at any point in time, the nominal rate will shift with a movement in any of these variables. One way of looking at this is that holding s constant, i will vary with the other predetermined variables so that the real rate changes. Since Tanzi and previous researchers have used partial equilibrium analysis to highlight the relation between 1T and i, we tend to forget that the level of the real rate depends upon all the predetermined variables of the system. To concentrate on the partial derivative of i with respect to sr, we must take as given some initial i, holding constant the other factors influencing i. Tanzi's simulations set the real rate of (r) initially equal to .03. Then by assuming different values for di/d7r and v, he generates implied values for the after-tax real rate (r*). Since the after-tax real rate turns negative at quite low rates of 7r, Tanzi concludes that fiscal illusion is present as interest rates did not adjust for the effect of taxes (p. 502). simple fact that the after-tax real rate turns negative need imply nothing regarding whether or not investors are cognizant of taxes. There is nothing inherently unusual about negative real rates of in the short run during inflationary periods. Clearly, if money can be costlessly stored, the nominal rate of cannot be negative but this in no way rules out negative real rates. a world of incomplete markets, there may be inflationary periods when a negative real rate of is the best that optimizing agents can earn. If there was a suitable asset available that guaranteed a zero return, we would not expect to observe ex ante negative real rates. Benjamin Friedman (1980) emphasizes the limited nature of portfolio substitution possibilities by arguing that if holding goods was a feasible portfolio alternative, then the expected rate of could be viewed as simply the return from holding such real assets. such a case, higher expected would reduce the lenders supply of loans directly via portfolio substitutions from loans (bonds) to real goods. problem with this scenario, as stated by Friedman is: In practice, however, the available opportunities for such portfolio substitutions involving consumption or other real commodities are usually extremely limited; purchasing the Consumer Price Index basket of goods is not a feasible portfolio alternative (p. 34). lack of such a real asset allows market instruments to offer a negative yield. Of course, with no (and costless storage), one could hold money so that we don't expect to observe negative rates in noninflationary periods. Frederic Mishkin provides corroborating evidence in this area as he finds The real rate, whether adjusted or unadjusted for taxes, is negatively correlated with inflation (1981, p. 191, emphasis added) and The real rate appears to have been positive in the 1950s and 1960s but has since turned negative in the midand late-1970s (p. 192). Regarding Tanzi's simulations, I do not believe that they correctly assess the path of the real rate following an exogenous change in inflationary expectations (nw). A major theme of my earlier paper was the emphasis *Arizona State University. I thank Don Schlagenhauf, John Schroeter, and Richard L. Smith for helpful discussions.

The comment of John Makin gives me an opportuinitv to elaborate on some of the implications the existence of a second reserve currency might have in the model and the empirical tests. In the model in Part I, we have assumed that there are only two reserve assets, gold and one reserve currency (dollars), and investigated what economic factors might determine the reserve policies of central banks. Of these factors, some characterize the country in question, others characterize the reserve-currency country (United States), and again, others the relation between them. If a second reserve currency (sterling) is introduced into the model, additional variables come into play which reflect the economic position of the second reserve-currency coun try (United Kingdom), its relation to the specific country as well as its relative position to the first reserve-currency country. Thus, if a country can hold pounds in addition to gold and dollars, it might rearrange