TERMS OF TRADE AND WORLD DEMAND

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TERMS OF TRADE AND WORLD DEMAND

• A THEORETICAL EXPLORATIONPRABHAT PATNAIK

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• This paper seeks to put forward the following
  basic argument. If we divide the world economy
  into two segments the core capitalist countries
  and the outlying region or periphery, which
  includes all non-core countries, then a terms of
  trade movement against primary commodities
  produced by the latter has an asymmetric effect
  on world aggregate demand of stimulating demand
  at the core and contracting it in the periphery.
• This argument, namely that an adverse terms of
  trade movement for primary commodities stimulates
  aggregate demand in the core countries, is the
  exact opposite of Arthur Lewis argument that it
  would lower core aggregate demand due to standard
  underconsumptionist reasons.

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• Our argument can be expressed somewhat
  differently. In any single period where
  investment is given, total world investment must
  equal total world savings, which in turn
  determines the total world profits under
  Classical/Kaleckian savings assumptions.
• The distribution of these profits between the
  core capitalists and those in the periphery
  however is determined by the terms of trade of
  primary commodities. (Note we are talking not of
  distribution between profits and primary producer
  incomes, but of profits per se).
• Since profits are a certain share of non-primary
  commodity output, this ipso facto determines such
  outputs in the two segments. And a shift in the
  terms of trade against primary commodities
  expands core output and contracts that of the
  periphery.

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A SIMPLE MODEL

• I assume that there are only two regions, the
  core and the periphery. The core produces, under
  capitalist conditions, a sophisticated
  manufactured good, while the periphery produces a
  primary commodity, entirely through petty
  production, and a simple manufactured good under
  capitalist conditions. The primary commodity is
  used wholly for consumption and not as an input
  for manufacturing.
• The money wage rates of the workers in both
  regions and the money prices of the manufactured
  goods are given.
• All wages are consumed all realized incomes of
  petty producers, i.e. incomes obtained from sales
  of the primary commodity, not incomes in the form
  of additions to stock-holding, are also consumed
  but all profits everywhere are saved.
• This being a single-period model, investments in
  both regions, which I define as excluding
  additions to stock-holding of the primary
  commodity, are assumed to be given government
  expenditures are ignored and trade deficits are
  assumed to be easily financed.

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• I believe that there is evidence to show that
  the core has very low income elasticity of demand
  for the peripherys product, and vice versa. But
  I express these (what I consider) stylized
  facts starkly through the assumption that in the
  single period in question the absolute physical
  magnitude of the simple manufactured good
  demanded in the core is fixed irrespective of the
  core regions income, so that any increase in
  real income at the core is associated exclusively
  with a larger demand for cores own output of the
  sophisticated manufactured good. Likewise in the
  periphery the demand for the sophisticated
  manufactured good is fixed in absolute terms
  irrespective of income and any variation of real
  income simply leads to a variation in the demand
  for the simple manufactured god produced by the
  periphery itself. I thus express low income
  elasticity of demand, starkly, as zero income
  elasticity of demand.
• Likewise I also assume a fixed absolute
  demandboth in the core and in the periphery for
  the primary commodity.
• Finally I assume that all investment expenditure,
  no matter where it is undertaken, is on the
  sophisticated manufactured good.

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• Let us denote the price of the primary commodity
  by p and its output by Q. Let us denote the total
  consumption of the primary commodity in the core
  capitalist countries by A and the total
  consumption of the primary commodity in the
  periphery, by the entire working population,
  including the petty producers themselves, by B. A
  and B are constants in the single period by our
  assumption.
• Let us use the subscripts 1 an 2 respectively for
  the core and the peripheral economies, with
  respect to all variables, viz. prices, labour
  coefficients, money wages, investments and
  outputs of the manufactured goods produced in the
  two regions.
• Let us use the symbol w for money wages, I for
  real investment, O for output, M for the fixed
  absolute physical consumption by core workers of
  the simple manufactured good and N for the fixed
  absolute physical consumption by periphery
  workers and petty producers of the sophisticated
  manufactured good.

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• We then have the following output determining
  equations.
•  
• O1 I1 I2 N (O1.l1.w1 - p.A p2.M)/p1
  (i)
•  
• O2 M O2.l2 w p.(Q- ?S) - p.B- p1.N)/p2
  (ii)
•  
• where ?S, the addition to primary commodity
  stocks, is given by
• ?S Q-A-B (iii)
• and is a function of the primary commodity price
  p,
•  
• ?S f (p), with flt0. (iv)
•  
• These four equations determine the outputs of
  manufactured goods in the two regions, the
  addition to primary commodity stocks ?S, and the
  money price of the primary commodity p, for given
  levels of investment and other parameters like
  labour coefficients, primary good output, money
  wages and prices of manufactured goods, and the
  fixed levels of manufactured goods consumption.

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• In the above the price of the primary commodity
  is determined from within the system as the
  price of the primary commodity declines the
  addition to stock holding increases in
  anticipation of a price appreciation in the
  future (which is a fairly standard assumption
  that Keynes had introduced in the Treatise on
  Money).
• Primary commodity price in other words clears the
  market not through inducing changes in
  consumption but through inducing changes in
  stock-holding.
• Reducing the primary commodity price can be done
  in this case through influencing the function
  f(.) for instance in the case of oil, a decision
  not to curtail the output has the effect of
  reducing f and thereby making p lower than it
  would have been if the decision had been to
  curtail output in future.

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• Let us now see what happens when p is reduced in
  this manner by lowering the function f(.). From
  the first equation a fall in p increases the
  level of manufactured good output in the core
  economies. The mechanism for it is quite
  straightforward. A fall in p means that less
  needs to be spent in the core economy on the
  primary commodity, and hence more purchasing
  power is available for expenditure on
  manufactured goods, which by our assumption goes
  exclusively to sophisticated manufactured goods
  produced within the core itself. Hence the output
  in the core economy increases with a fall in the
  primary commodity price.
• By contrast it is clear from equation 2 that a
  fall in the primary commodity price necessarily
  lowers the output of the manufactured good
  produced within the periphery itself. The reason
  for this again is quite straightforward a fall
  in primary commodity price reduces the purchasing
  power in the hands of the primary producers
  (which, it must be remembered, include in the
  real world the OPEC countries as well), which, by
  assumption reduces the demand for the simple
  manufactured good produced within the periphery.

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• When the primary commodity price falls not only
  will there be a net contraction in the vector of
  physical output and employment in the peripheral
  economy, but its fall in real income will be even
  larger owing to the adverse terms of trade
  effect.
• What is more, its trade balance will necessarily
  deteriorate, since its level of investment would
  have remained unchanged even though its domestic
  savings would have fallen owing to the output
  contraction.
• The significance of this result may be questioned
  on the grounds that there are many primary
  commodities, and not just one. But the primary
  commodities are by and large linked to one
  another as substitutes, either in use or in
  production hence their prices tend to move
  together.

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• It follows that the core countries can pass the
  burden of the crisis to primary producers of the
  periphery, as a way of ridding themselves of the
  crisis. This what old Marxist theory had
  suggested in the 1930s, but wrongly (in the light
  of the Kaleckian-Keynesian revolution). What had
  been wrong at that time however has some validity
  today.
• The fall in the price of oil is a contributory
  factor to the revival of consumer demand in the
  U.S. It is however reducing the demand for a
  range of peripheral products. This explains the
  paradox that when the crisis had begun, it is the
  advanced capitalist countries, especially the
  United States, that were particularly afflicted
  by it, while countries like India and China
  appeared to have escaped its impact. But with the
  passage of time, while the United States appears
  to be coming out of it (though not the other
  advanced capitalist countries), countries like
  India and China are getting deeper into it.

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• But passing on the burden of the crisis is
  unlikely to resolve the crisis for two reasons.
  First, it poses a threat to the financial sector
  oil derivative prices have already fallen which
  constitutes a threat to this sector if the
  deflation gets generalized then the problems
  highlighted by Irving Fisher may materialize
  and, continuous provision of credit to the
  periphery to keep up its demand for core goods is
  unsustainable. V
•  Secondly, the fall in the output in the
  periphery will over time lead to a reduction in
  investment and hence also in demands for the
  sophisticated manufactured goods produced in the
  core economy on the other side the mild recovery
  in the core economy will not immediately give
  rise to much of an increase in investment since
  substantial unutilized capacities still exist
  there. It follows therefore that the recovery is
  likely to be an evanescent one, where the effects
  of contraction elsewhere will drag it down once
  more.

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• Given the fact that the fall in oil prices has
  not led to any recovery in core economies outside
  the U.S. (partly owing to the fact that oil
  consumption is much less important in these
  economies than in the U.S.), if the U.S. recovery
  itself is evanescent, because the negative
  effects of contractions in the rest of the world
  are bound to be felt upon the U.S. economy sooner
  or later, then it seems that world capitalism is
  headed for a serious and prolonged crisis.

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• A deflation of course will make matters worse,
  but even in the absence of a deflation the crisis
  is likely to persist, unless the State once again
  begins to intervene, through fiscal measures, in
  demand management. But this is not as easy as it
  sounds, for it would require a confrontation with
  finance capital.