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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*
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824 THE AMERICAN ECONOMIC REVIEW DECEMBER 1977
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VOL. 67 NO. 5 - DORNBUSCH ET AL.: RICARDIAN MODEL 825
C. EquilibriumRelativeWages 0 . I
and Specialization FIGURE 1
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826 THE AMERICAN ECONOMIC REVIEW DECEMBER 1977
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VOL. 67 NO. S DORNBUSCH ET AL.: RICARDIAN MODEL 827
at the same timeraisingrelativeunit labor (13) P(z) - P(z") = co- d*(z") > 0
costs at home. The increase in domestic
relativeunit labor costs in turn implies a where a "hat" denotes a proportional
loss of comparativeadvantage in marginal change. Domestic real income increases,as
industriesand thus a needed reduction in does foreignreal income.4 The range of
therangeof commoditiesproduced domes- goods produced domesticallydeclines since
tically. domesticlabor, in efficiency units, is now
The welfareimplicationsof the change in relativelymorescarce.
relativesize take the formof an unambigu- An alternativeformof technicalprogress
ous improvement in thehome country'sreal that can be studied is the international
incomeand (under Cobb-Douglas demand) transferof the least cost technology.Such
a reductionin real incomeper head abroad. transfersreducethediscrepanciesin relative
We observe, too, that from the definition unitlabor requirements-byloweringthem
of the home country'sshare in world in- for each z in the relativelyless efficient
come and (10), we have country-and thereforeflatten the A (z)
(12) =
wL/(wL + w*L*) -() schedulein Figure 1. It can be shown that
such harmonization of technology must
It is apparent,as notedabove, that a reduc- benefitthe innovatinglow-wage country,
tion in domesticrelativesize in raisingthe and that it may reduce real income in the
domestic relative wage (thereby reducing high-wagecountrywhose technologycomes
therange of commoditiesproduced domes- to be adopted. In fact,the high-wagecoun-
tically)must under our Cobb-Douglas de- trymustlose if harmonizationis complete
mandassumptionslowerthe home country's so thatrelativeunitlabor requirementsnow
sharein totalworld income and spending- become identical across countries and all
eventhoughour per capita incomerises. our consumer'ssurplus from international
tradevanishes.5
B. TechnicalProgress
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828 THE AMERICAN ECONOMIC REVIEW DECEMBER 1977
tivewage will rise while the range of com- relativeprice structureand the range of
moditiesproducedbythehome countryde- goods traded.
clines. Domestic labor is allocated to a
narrowerrange of commodities that are A. NontradedGoods
consumedwithhigherdensitywhile foreign
labor is spread more thinlyacross a larger To introduce nontraded goods into the
rangeof goods. analysiswe assume thata fractionk of in-
Welfarechanges cannot be identifiedin come is everywherespenton internationally
thisinstancebecause tastesthemselveshave traded goods, and a fraction (1 - k) is
changed. It is true that domestic relative spent in each countryon nontraded com-
income rises along with the relativewage. modities.With b(z) continuingto denote
Furtherwe note that since Zi rises,the rela- expendituredensitiesfor traded goods, we
tive well-beingof home labor to foreign have accordingly
labor (reckonedat thenew tastes) is greater
than was our laborers' relativewell-being (14) k a b(z) dz < 1
(reckonedat theold tastes).
wherez denotes traded goods.6 As before
D. UnilateralTransfers the fractionof income spent on domesti-
callyexportablecommoditiesis O(z), except
Suppose foreigners make a continualuni- that t now reaches a maximum value of
lateraltransferto us. With uniformhomo- (1)= k.
thetictastes'and no impedimentsto trade, Equation (1) remains valid for traded
neithercurveis shiftedby the transfersince goods, but the trade balance equilibrium
we spend the transferexactly as foreigners conditionin (10 ") mustnow be modifiedto:
would have spentit but forthetransfer. The
new equilibriuminvolves a recurringtrade (15) [1 - 0(z) - (1 - k)]wL
deficitforus, equal to thetransfer,but there = O(Z)W*L*
is no changein thetermsof trade. As Bertil
Ohlin argued against John Maynard sincedomesticspendingon importsis equal
Keynes,here is a case where full equilibra- to income less spendingon all domestically
tion takes place solely as a result of the produced goods includingnontradedcom-
spendingtransfers. When we introducenon- modities.Equation (15) can be rewritten as
traded goods below, Ohlin's presumption
will be found to requiredetailed qualifica- (15') W= k (!) (L*/L)
tions,as it also would if tastesdifferedgeo-
graphically.
wherek is a constant and thereforeinde-
pendentof therelativewage structure.
III. ExtensionsoftheRealModel We note that (15') togetherwith (5) de-
terminesthe equilibriumrelativewage and
Extensionsof the real model taken up in efficientgeographic specialization, (Co,z).
this section concern nontraded goods, Furtherit is apparentthat(15') has exactly
tariffs,and transportcosts. The purpose of the same propertiesas (10') and that ac-
this section is twofold. First we establish cordinglya constructionof equilibriumlike
how the exogenous introductionof non- that in Figure 1 remainsappropriate. The
tradedgoods qualifiesthe precedinganaly- equilibriumrelativewage again depends on
sis. Next we turn to a particularspecifica-
tionoftariffs and transportcoststo establish 6We can thinkof the range of nontradedgoods as
an equilibriumrange of endogenouslyde- another[0, 1] intervalwithcommoditiesdenoted by x
terminednontradedgoods as part of the and expenditurefractionson those goods given by
equilibriumsolution of the model. Trans- c(x). With these definitionswe have f c(x) dx-
fersare thenshownto affecttheequilibrium I - k, a positivefraction.
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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 REVIEW DECEMBER 1977
w
(20) X(gw) f b(z)dz X'(gw) < 0
A(z)/g
A(z)g
X*(W/g) j b(z)dz X*'(W/g)> 0
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VOL. 67 NO. 5 DORNBUSCH ET AL.: RICARDIAN MODEL 831
goods z* < z < z depends in this formula- The implicitrelations(25) can be solved for
tionon the equilibriumrelativewage, it is theequilibriumrelativewage as a function
obvious that shiftsin givenparameterswill structure:
of relativesize and thetariff
shiftthe range of nontraded commodities. Z) = Co(L*/L,t,t*)
(26)
Thus, a transferthat raises the equilibrium
relativewage at home causes previouslyex- From (26) and (23) it is apparent now
portedcommoditiesto become nontraded, thattherangeof nontradedgoods will be a
and previouslynontraded commoditiesto functionof both tariffrates. It is readily
becomeimportables. shown that an increase in the tariffim-
provestheimposingcountry'srelativewage
C. Tariffs and termsof trade. Furthermore,as is well
We considernextthe case of zero trans- known,when all countriesbut one are free
port cost but where each countrylevies a traders,then one countrycan always im-
uniformtariffon importsat respectiverates prove its own welfareby imposinga tariff
t and t*,withproceedsrebatedin lump sum thatis not too large.
form.This case, too, leads to cost barriers A further questionsuggestedby (26) con-
to importing,and to a range of commodi- cerns the effectof a uniformincrease in
tiesthatare not traded,withthe boundaries world tariffs.Startingfromzero, a small
definedby: uniformincreasein tariffs raises the relative
wage of the countrywhose commodities
(23) = A-1 commandthe largershare in world spend-
ing. This result occurs for two reasons.
and - A'(w(1 + t*)) First, at the initial relativewage a larger
shareof spendingout of tariffrebates falls
From (23) it is apparentthatthepresenceof on thegoods of the countrycommandinga
in eitheror both countriesmust give
tariffs largershare in world demand. Second, the
riseto nontradedgoods because-in thiscase tariffinduces new nontraded goods and
thereforeincreases net demand for the
The trade balance equilibriumcondition borderlinecommodityof thecountrywhose
at internationalpricesbecomes, in place of residentshave the largerincome, or equiv-
(19), alently,thelargersharein worldincome.
(24) (1 - X)Y/(1 + t) = If countriesare of equal size as measured
by the share in world income, such a uni-
(1 - X*)Y*/(1 + t*) formtariffincreasehas zero effecton rela-
where Y and Y* denote incomes inclusive tivewages,but of course reduceswell-being
of lump sum tariffrebates. Using the fact in both places. Multilateraltariffincreases,
thatrebatesare equal to thetariffrate times in thiscase, unnecessarilycreatesome non-
thefractionof incomespenton imports,we tradedgoods, and artificially raise the rela-
arriveat the trade balance equilibriumcon- tive price of importablesin terms of do-
ditionin theform:'0 mesticallyproduced commodities in each
countryexactlyin proportionto thetariff.
(25) X(1 -*) 1 + t*x* (L*/L)
Rates
IV. Money,Wages,andExchange
whereX and X* are functionsof (w,t,t*).
In thissectionwe extendthediscussionof
are equal to
rebatesin the homecountry
I0Tariff theRicardian model to deal withmonetary
R = (I - A) Yt/(l + t). With Y = WL + R we there- aspectsof trade.Specificallywe shall be in-
forehave Y = WL(l + t)/(l + At) as.an -expression terestedin the determinationof exchange
forincomeinclusive Fromequations(20)
of transfers.
and (23) we have X = A[w/(1+ t)] and A* =
ratesin a flexibleratesystem,in the process
A*[w(1+ t*)],havingsubstituted insteadof
thetariff of adjustmentto trade imbalance under
transportcostsas theobstacletotrade. fixedrates, and in the role of wage sticki-
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832 THE AMERICAN ECONOMIC REVIEW DECEMBER 1977
ness. The purpose of the extensionis to in- tary changes or velocity changes in one
tegratereal and monetaryaspectsof trade. countrywill be reflectedin equiproportion-
ate changesin pricesin thatcountryand,in
A. FlexibleExchangeRates the exchange rate in the fashion of the
neutral-money QuantityTheory. However,
The barteranalysisof the precedingsec- a real disturbance,as (28) shows, definitely
tions is readily extended to a world of does have repercussionson the nominalex-
flexibleexchange rates and flexiblemoney change rate as well as on the real equilib-
wages.Assume a givennominal quantityof rium.
money in each country,M and M*, re- Using the results of Section II, we see
spectively.Further,in accordance with the thatan increasein the foreignrelativelabor
classical QuantityTheory,assume constant forcecauses, under flexibleexchange rates
expenditurevelocitiesV and V*.ll A flexible and givenM and M*, a depreciationin the
exchangerate, and our stipulatingthe ab- home country'sexchange rate as does uni-
sence of nonmonetaryinternationalasset formtechnicalprogressabroad. A shiftin
flows,will assure trade balance equilibrium real demand toward foreigngoods likewise
and thereforethe equality of income and leads to a depreciationof the exchangerate
spending in each country. The nominal as well as to a reductionin real Z. A rise in
money supplies and velocities determine foreigntariffswill also cause our currency
nominalincomein each country: to depreciate. Each of these real shiftsis
WL = MV W*L* = M* V* assumed to take place while (M, M*) are
(27) and
unchangedand on the simplifyingproviso
where W and W* (now in capital letters) that real income changes leave V and V*
denote domesticand foreignmoneywages unchanged.
in termsof the respectivecurrencies.Fur-
ther,definingthe exchange rate e as the B. Fixed ExchangeRates
domestic currency price of foreign ex-
change,theforeignwage measuredin terms In the fixed exchange rates case we as-
of domesticcurrencyis e W*, and the rela- sume currenciesare fullyconvertibleat a
tivewage therefore is w W/eW*. paritypegged by the monetaryauthorities.
From the determinationof the equilib- In theabsence of capital flowsand steriliza-
riumreal wage ratiocoby our earlier"real" tionpolicy,a tradeimbalance is reflectedin
relations,we can now findan expressionfor monetary flows. In the simplest metal
theequilibriumexchangerates: money model, the world money supply is
redistributedtoward the surpluscountryat
(28) e = (1/&I)(W/W*) = preciselythe rate of the trade surplus. We
assume that the world money supply is
(11F.)(MV/M* V*) (L*/L) givenand equal to G, measuredin termsof
where (27') defines equilibrium money domesticcurrency.The rate of increase of
wages: thedomesticquantityof moneyis therefore
(27') W = MV/L equal to the reductionin foreignmoney,
valued at thefixedexchangeratee:
and
W* = M* V*/L* (29) M=
whereAl dM/dt.
In this simple structureand with wage For a fixed rate world we have to de-
flexibility,we can keep separate the de- terminein addition to the real variables Co
terminants of all equilibriumreal variables and z, thelevelsof moneywages W and W*
fromall monetaryconsiderations.Mone- as well as the equilibriumbalance of pay-
IIThis is a strongassumptionsince it makes spend- mentsassociated with each short-runequi-
ingindependentof incomeand nonliquidassetsevenin librium.In thelong run the balance of pay-
theshortrun. ments will be zero as money ends up
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VOL. 67 NO. 5 DORNBUSCH ET AL.: RICARDIAN MODEL 833
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834 THE AMERICAN ECONOMIC REVIEW DECEMBER 1977
world output. Given unchanged nominal the adjustment process: changes in the
spendingVG,wages and priceswill have to terms of trade, in home and/or foreign
halve. This would be shown by a parallel pricelevels,in relativepricesof traded and
shiftof the GG schedulehalfwaytowardthe nontradedgoods (there being none of the
origin.A shiftin demand towardthe home latter),in double factoral terms of trade;
country'soutput by contrastwould rotate and any discrepanciesin the price of the
the OR ray to a position like OR' since it same commoditybetween countries. The
raisesour relativewage. The ensuingmone- featuresof the adjustmentprocess of this
taryadjustmentis then an increase in our sectionrelyon 1) identical,constantexpen-
moneywage and money income and a de- diturevelocities,2) uniform-homothetic de-
cline in foreignwages, prices, and incomes mand,and 3) the absence of trade impedi-
(point E'). ments. If velocities were constant but
The real and nominal equilibrium at differedbetween countries, the absolute
point E in Figure 4 is independentof the levelsof money wages and prices, though
short- and long-run distributionof the not relativewages or prices,would depend
worldquantityof money.The independence on theworlddistribution of money.Relaxa-
of thereal equilibriumderivesfromthe uni- tion of the uniform-homothetic taste as-
formhomothetictastes. The independence sumptionwould make equilibriumrelative
of the nominal equilibriumis implied by prices a functionof the distributionsof
identical velocities. What does, however, spending. Finally, the presence of non-
depend on the short-rundistributionof tradedgoods would,togetherwithRicardo's
worldmoneyis the transitionperiods' bal- technology,provide valid justificationfor
ance of payments.As in the absorptionap- some of the behavior of relativeprices and
proach of Sidney Alexander (1952), we pricelevelsfrequentlyassertedin the litera-
know this: when goods markets clear, the ture;this behavioris studiedin more detail
trade surplusor balance of paymentsM of in thenextsection.
thehome countryis equal to the excess of
incomeoverspending,or: C. The Price-SpecieFlow Mechanism
underMore GeneralConditions
(34) M= WL- VM
Withthe nominalwage independentof the We now discuss the adjustmentprocess
of world money,equation (34)
distribution to monetary disequilibrium and enquire
thereforeimplies that the trade balance intothepriceeffectsassociatedwitha redis-
monotonicallyconvergesto equilibriumat tributionof the world money supply when
a rateproportionalto the discrepancyfrom thereare nontraded goods. Common ver-
long-runequilibrium:"4 sions of the Hume price-specieflow mech-
anismusually involvethe argumentthat in
(34') M = V(M - M); M = 0 ()G
theadjustmentprocess,pricesdecline along
The assumptionsof this sectionwere de- - withthemoneystock in the deficitcountry,
signedto renderinoperativemostof thetra- whileboth risein thesurpluscountry.There
ditional mechanismsdiscussed as part of is usually,too, an implicationthatthe defi-
cit country'stermsof trade will necessarily
14Suppose V> V* and our share of the world worsenin the adjustmentprocess and in-
moneysupplyis initiallylarger than our equilibrium
share.Then, as we lose M, totalworldnominal income
deed have to do so iftheadjustmentis to be
and nominal GNP falls.Always our share of nominal successful.
world GNP staysthe same under the strongdemand SectionIVB demonstratedthat the redis-
assumptions.Total world real output never changes tributionof money associated with mone-
during the transition; only regional consumption taryimbalance need have no effectson real
shares change. Therefore,both countries' nominal
priceand wage levels fall in the transition,but such variables(production,termsof trade, etc.)
balanced changes have no real effectson either the and on nominal variables other than the
transientor thefinalreal equilibrium. money stock and spending. While this is
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VOL. 67 NO. 5 DORNBUSCH ET AL.: RICARDIAN MODEL 835
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836 THE AMERICAN ECONOMIC REVIEW DECEMBER 1977
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VOL. 67 NO. 5 DORNBUSCH ET AL.: RICARDIAN MODEL 837
Y
G / R' plied reductionin our relativewages and
theresultingincreasein our relativeincome
are shown in Figure 5 by the rotationfrom
\/t OR to OR'.
The new equilibriumis at E' where our
E ~~~R moneyincome and employmenthave risen
y~~ 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-
Y eY* fitsfromthe adversetermsof trade shiftin
0 ET* termsof employmentwill depend on both
FIGURE 5 thesubstitutability in demand and the elas-
ticityof the A (z) schedule in Figure 1. We
observe,too, that the move fromE to E'
where W and W* are the fixed money will bring about a transitorybalance-of-
wages set at too high sticky levels. The paymentssurplus.Given theinitialdistribu-
scheduleis drawnforgivenmoneywages, a tion of money and hence of -spending,the
given world quantity of money, and a foreigndecline in income and the increase
peggedparityfore. The ray OR now is pre- at home impliesthatwe will spend less than
determinedby thegivenstickyrelativewage our income and thereforehave a trade sur-
i = W/eW*. From equations (32) and (33) plus. This surpluspersistsuntilmoneyis re-
theratioof moneyincomes Y/eY* is just a distributedto match the new levels of in-
functionof the relativewage now givenex- come at '.
ogenouslyby rigidmoneywages and the ex- Next we move to flexibleexchange rates.
changerate: Under flexibleratesan increase in the for-
eignmoneywage W*, givenmoneysupplies
(38) Y/eY* - (WeW*) in each country,will similarlyhave real re-
percussioneffects on relativepricesand em-
'(W) < 0 ploymentat home. Now employmentin
each countryis determinedby money sup-
Point E is the nominal equilibriumwhere pliesand prevailingwages:
by assumptiontheworldquantityof money
is insufficient
relativeto wage rates to en- (39') L = VM/ W; L* - VM*/ W*
sure full employment.Although that equi-
libriumis one withunemployedlabor, it is Given the employmentlevels thus deter-
in otherrespects.Specifically,geo-
efficient mined,we know from the analysis of the
graphic specializationfollows comparative earlierbartermodel that thereis a unique
advantageas laid out above, but now labor relativewage at which the trade balance
employedadjuststo stickywage patternsof achievesequilibrium. The higheris M*/ W*,
specialization. the higher will be employmentabroad-
EmploymentlevelsLand L* now are de- and, therefore, the higherwill be our rela-
terminedby(39) tivewage a. It is thus apparent that an in-
crease in the foreignmoneywage, W*, will
(39) L-= Y/W, L* -
reduce employmentabroad. Employment
where Y and Y* are the equilibriumlevels declinesonly in proportionto the increase
of nominalincomedeterminedby equations in wages and thus declines by less than it
(37) and (38) or by pointE in Figure5. would under fixed exchange rates when
Considernow the impact of a foreignin- specieis lost abroad.
creasein moneywages. The effectof the im- We saw in the bartermodel thata reduc-
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838 THE AMERICAN ECONOMIC REVIEW DECEMBER 1977
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VOL. 67 NO. 5 DORNBUSCH ET AL.: RICARDIAN MODEL 839
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