at Z2 .
It is also possible to assess the height of the new TT schedule
2 1
relative to TT , at Z . Suppose that, in Figure IV(16), given p ,
U r
the level of aggregate nominal expenditure was increased, so that the
2 2
budget line moved outward from --- — — to the line b b , so that 1 PNT PF
Z2 Z2 PF
--- — — , bb and Engel (--- , e) share a common point of intersection.
PNF PF NF
It is clear that the chosen point on such a budget line (ie. that common point of intersection), when valued at the original or base period prices, p and p ^ , would represent a volume of expenditure
2
equal to Z . It is also clear that, provided that farm and non-farm commodities are net substitutes in expenditure, the level of Z at
Nr
2
that chosen point would be greater than Z . Therefore, given the NF
2
new relative prices, a volume of expenditure equal to Z would now be associated with a higher level of demand for non-farm traded goods, and hence with a weaker current account. Therefore, the new TT
2 0
schedule, at Z , would lie above TT . Of course, a similar con clusion would hold for all levels of Z, ie. a pure substitution effect away from farm commodities would increase the demand for non farm and hence non-farm traded goods, resulting in a weaker current account.
It is interesting to recall that, in Model I, the decline in farm production also resulted in an upward (or leftward) movement of the TT schedule. However, in that case, the mechanism at work was the decline in the volume and value of farm exports, so that the state of the current account was weaker at each level of Z. That contrasts with the present case, where the volume and value of farm exports are constant, but where relative prices change in the
domestic economy. Of course, there is no presumption that the extent of the upward movement of the TT schedule in Models I and II would necessarily be equivalent.
To summarize our discussion of the movement of the TT schedule from TT°, following the rise in p from p ° to p \ we have seen that:
r r r
the new TT schedule would lie above TT^ for all levels of Z;
3
the height of the new TT schedule at Z will be greater than,
0 2
equal to or less than the height of TT at Z , depending on whether the demand for farm commodities is own price elastic, unit elastic or inelastic, respectively.
We are now in a position to combine our analyses of the move ments in the IS curves with the above analysis of the movement in
the TT schedule. Consider first the case where the demand for farm commodities is own price elastic.
F i g u r e IV(17) Sector I
In Figure IV(17), IS °, ISy 2 , ISY 3 , ISZ°, ISZ2 and ISZ3 are as described previously. TT*3 represents the original position of the
TT schedule, and TT3 represents its new position. Note that, as required, TT3 lies above TT3*, and the height of TT3 at Z3 is greater
than the height of TT*3 at Z2 .
The leftward movement of the IS curves from IS ^ and IS,^*3 to ISy 2
2
and ISZ would be associated with a decline in the interest rate from
0 2
r to r , and as drawn, a balance of payments deficit sufficient to
0 2
move LM to the left from LM to LM . However, the leftward movement
2 3 2 3
of the IS curves from ISy to ISy , and from ISZ to IS would be associated with an increase in the interest rate in this case, from
2 3 0 1
r to r , as TT moves from TT to TT . In order to be consistent with the higher level of r and balance of payments equilibrium, the
2 3
LM curve would need to move further to the left, from LM to LM . However, the rise in p^ would itself raise the demand for money
2
balances, thus moving LM to the left from LM even with a given nominal money stock. Therefore, it is unclear whether the estab-
3
lishment of LM would require a temporary period of balance of payments deficits, or whether a period of surpluses would be required.
2
Also note that the rise in r, from r , raises the possibility that the new, higher level of r could, in fact, lie above r3* -
3 0
for example, in Figure IV(17), r > r . However, this is, of course, an empirical question.
3 3
We know that, from ISy and IS , the IS curves may move either to the left or to the right in order to establish a new Keynesian
equilibrium in the non-traded goods sector. If the movements are to the left then:
those movements would be associated with deficits in the balance of payments (unless the movement of IS^ was signifi
cantly greater than that of IS^). There is a strong pre sumption, therefore, that the overall impact of the shock in the farm sector on the balance of payments would be to create deficits during the period of adjustment to a new Keynesian and balance of payments equilibrium;
3
the interest rate would decline from r . However, as it is
3 0
possible that r > r , it remains possible that, in the new Keynesian and balance of payments equilibrium, r could lie above r^. Therefore, as in Model I , there is considerable uncertainty as to the impact of the shock in the farm sector on r .
3 3
If IS^ and IS^ move to the right from IS^ and IS^ then: - unless the rightward movement of IS^ was significantly
greater that that of IS^, the movements would be associated with balance of payments surpluses. In other words, the shock in the farm sector is likely to have a smaller deleter ious effect on the balance of payments in this case than in the above case where the IS curves moved to the left. It is also suggestive of the possibility that the overall impact of the shock in the farm sector on the balance of payments could be favourable ;
3
the interest rate, r, would increase from r , so that, even
3 0
if r < r , it remains possible that r could eventually rise above r^. Also, of course, as TT"*" lies above TT^, it is clear that, should IS^ move sufficiently to the right to return it to, or to the right of IS^0 , then it is unambig uous that balance of payments equilibrium would require a level of r above r .
The analysis of the cases where the demand for farm commodities is unit own price elastic and own price inelastic follows along the same lines as the above, and leads to very similar conclusions. Our earlier discussion of the nature of the movements in the TT schedule, however, allows us to be a little more concrete about the level of the interest rate in the new Keynesian and balance of payments equil ibrium relative to the original interest rate, r^. In Figure IV(17), in the case of a unit own price elasticity, we know that the height
1 3 0 2
of TT at Z would have been the same as the height of TT at Z .
2 3
Therefore, the leftward movement of IS^ from IS^ to IS^ , and of IS^
2 3
from IS^ to IS^ would not have required a change in the level of 2
the interest rate, from r , in order to maintain balance of payments equilibrium. Then, if the new Keynesian equilibrium required further
3 3
leftward movements of the IS curves from IS^ and IS^ , it is clear
2 2 0
that r would fall below r . As r < r , it follows that, in this case, the new Keynesian and balance of payments equilibrium would have been associated with a level of r below r^.
In the case where the demand for farm commodities is own price
1 3
inelastic, we know that, in Figure IV(17), the height of TT at Z
0 2
would have been less than the height of TT at Z . Therefore, the
2 3 2
leftward movement of IS^ from IS^ to IS , and of IS^ from IS^ to
3 . 2
IS^ would require a fall in the interest rate, from r , in order to maintain balance of payments equilibrium. Then, if a further left ward movement of the IS curves was to occur as the economy moved
towards a new Keynesian equilibrium in the non-traded goods sector, 2 0 the interest rate would fall even further. Again, as r < r , it follows that, in the new Keynesian and balance of payments equil ibrium, the interest rate would be less than r^.