I guess this is one of those nostalgic periods on PEN-L when old
debates come back for a second run. Tom W. wonders how it can be
that, in one context, I claim that absolute advantage does not
rule because exchange rates need not adjust to balance the current
account, and in another I claim that the neoclassical aggregate
demand curve cannot be based on trade substitution effects because
exchange rates *will* adjust. Sounds bad for the home team.
Here is how I would reply: I would imagine nominal exchange rates
to be determined by a function over such variables as demand &
supply on the current account, demand and supply on the capital
account, safe haven effects, real interest rate differential
effects, speculative factors -- AND differences in rates of
inflation. Since D&S on the current account is only one small
part of this story, I would not expect exchange rates to settle in
the manner hypothesized by comparative advantage. But a ceteris
paribus argument can be made that, holding the other factors
fixed, price level changes alone *should* induce such offsetting
movements. The only reason they wouldn't (in principle) would be
if there were a logical connection between the rate of inflation
and one or more of the arguments being held constant. Well, you
might make a case for changes in the safe haven or speculative
effects, but (a) that is not what is generally considered by
neoclassical economists! and (b) even so, I can't see why the
relationship would necessarily be predictable, certainly not at
all initial levels of inflation. Moreover, it is also necessary
in this case to look at possible price level changes in trading
partners. Here the question would be whether the shocks driving
up prices in one country are national or international in scope.
Wait--there's more. Even if all of the preceding were wrong and
increases in inflation did entail corresponding decreases in the
real exchange rate, there is still the small matter of the J-
curve. For the first quarter or so after the price spike we would
expect the current account to improve; it would be at least six
quarters before the balance fell. I know we compress (or better,
deny) historical time somewhat whenever we contemplate movement
along a curve (Joan Robinson), but isn't this stretching things a
bit?
Peter Dorman
