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TERMS OF TRADE AND WORLD DEMAND A THEORETICAL EXPLORATION PRABHAT PATNAIK This paper seeks to put forward the following basic argument. If we divide the world economy ... – PowerPoint PPT presentation

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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.

  • 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

  • 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.

  • 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.

  • 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
  • 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.

  • We then have the following output determining
  • O1 I1 I2 N (O1.l1.w1 - p.A p2.M)/p1
  • O2 M O2.l2 w p.(Q- ?S) - p.B- p1.N)/p2
  • 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
  • ?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.

  • 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
  • Primary commodity price in other words clears the
    market not through inducing changes in
    consumption but through inducing changes in
  • 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.

  • 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.

  • 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
  • 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
  • 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

  • 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
  • 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.

  • 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

  • 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.

  • 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.
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