McCalla, Alex F.

Pick, Daniel H.

English

Research Papers in Economics

International Agricultural 
Trade  Research  Consortium 
Do  Macroeconomic  Variables Affect  the Agricultural 
Trade  Sector?  An  Elasticities Analysis 
By 
Daniel  H.  Pick* 
and 
Alex  F.  McCalla 
Working  Paper  #85-1 
The  International Agricultural  Trade  Research  Consortium is an  informal 
association of  University and  Government  economists  interested in agricultural 
trade.  Its purpose  is  to  foster  interaction,  improve  research capacity and  to 
focus  on  relevant  trade  policy issues.  It is financed  by  USDA--ERS  and  FAS--, 
Agriculture  Canada  and  the  participating institutions. 
The  IATRC  Working  Paper  series  provides  members  an  opportunity  to circulate 
their work  at  the  advanced  draft  stage  through  limited distribution within  the 
research and  analysis  community.  The  IATRC  takes  no  political positions  or 
responsibility for  the accuracy  of  the data or validity of  the  conclusions 
presented by  working  paper authors.  Further,  policy  recommendations  and 
opinions  expressed by  the authors  do  not  necessarily reflect  those  of  the 
IATRC. 
This  is a  working  paper  which  should  not  be  quoted  without  the  author(s) 
permission. 
*The  authors  are  Post  Graduate  Research Agricultural Economist  and  Professor, 
Department  of  Agricultural  Economics,  University of  California,  Davis. 
Correspondence  should be  addressed  to  the  senior author  at  the  following 
address: 
University of  California,  Davis 
Department  of  Agricultural Economics 
Davis,  California  95616 
November  11,  1985 University of  California,  Davis 
Department  of  Agricultural Economics 
Do  Macroeconomic  Variables  Affect  the 
Agricultural Trade  Sector?  An  Elasticities Analysis 
by 
Daniel  H.  Pick 
and 
Alex  F.  McCalla 
November  1985 Introduction 
The  linkages  of  macroeconomy  and  the agricultural sector has  been a 
popular  topic  in  the  literature in recent  years.  Schuh  (1974)  was  the first 
to  argue  that  the  over valuation of  the  exchange  rate  had  a  large negative 
effect on agricultural exports.  Since  then,  many  researchers  have 
investigated  the effects  on  trade  of macroeconomic  variables  such  as  the 
exchange  rate,  the money  supply,  and  the  interest rate.  The  results of  these 
studies are  sometimes  in conflict.  The  differences in the  results often 
emerge  from  the  model  specification.  This  paper  presents  some  alternative 
possible model  specifications of macroeconomic variables,  and  discusses  their 
implications.  A new  model  is  then  presented which  shows  that  the effects of  a 
change  in the  level of  the money  supply  and  the interest rate on agricultural 
trade is ambiguous.  Furthermore,  it can be  shown  that  the effect of  exchange 
rate appreciation or depreciation which will follow changes  in the money 
supply  and  interest rates,  on  agricultural  trade will also be  ambiguous. 
Existing Model  Specifications 
Most  studies  isolate a  single macroeconomic  variable in their model,  and 
test its effect on  the  trade  flow.  Such  is the  case in the Longmire  and  Morey 
study,  where  an  exchange  rate variable was  inserted in the model  to  test its 
impact  on  international trade.  A change  in the  exchange  rate will shift  the 
excess  demand  function,  and  thus  an appreciation of  the  exchange  rate will 
decrease world  prices  and  the quantity traded.  Chambers  (1981)  demonstrated 
the effect of  the  interest rate on  agricultural  trade  flow.  By  inserting an 
interest rate variable in the  domestic  supply  function,  a  change  in the 
interest rate will shift  the  domestic  supply  function,  thus  shifting the 
excess  supply  function.  An  increase in the interest rate will decrease  the 2 
supply,  as  the cost  of borrowing  to  the  farmers  increases,  and  the  excess 
supply  function will shift  to  the left thus  reducing  the  quantity traded  and 
increase  the  trade  price. 
Paggi  (1984)1  tried to  test  the effect of  the  money  supply  on 
agricultural exports.  However,  the results  could not  support  the hypothesis 
of  increased  trade as  a  result of  an  increase in the  level of  the money 
supply. 
All  the  above  models  affect  the  trade sector,  since  each  one  tests  the 
effect of  individual macro  variables  in the  trade sector.  However,  when 
combining  the effect of  the money  supply  and  the interest rate,  the  outcome  is 
ambiguous.  This  is demonstrated  in  the model  in the  next  section. 
The  Money  Supply  and  the  Interest Rate 
One  cannot  assume  that  a  rise or  drop  in the interest rate will occur  as 
an  independent  event.  Macroeconomic  theory  indicates  that  interest rates 
respond  to  changes  in the level of  the money  supply.  Thus,  causality runs  as 
follows: 
•  MS  +  t  i  +  t  ER 
One  might  assume  that  there  is a  very  short-run adjustment  period between 
the  changes  in the money  supply and  the interest rate,  but  the  response  of  the 
exchange  rate might  be  lagged. 
This  paper  attempts  to  show  that  changes  in the money  supply  and  the 
resulting change  in the  interest rate affect the  quantity  traded  and  trade 
prices  in opposite ways.  Therefore,  one  cannot  determine ~ priori the final 
effect of  increase  or  decrease  in the money  supply  on  the agricultural  trade 
sector.  Quantity  traded  and  prices may  increase or decrease  depending  on  the 
relative elasticities (price  and  income),  and  the appropriate shifts in the 3 
demand  and  supply  schedules.  This  paper  demonstrates  why  some  studies  had 
difficulties in relating agricultural exports  to  the  levels  of  the money 
supply. 
To  show  the  ambiguity  of  the effects of  changes  in the money  supply on 
the  trade  sectors,  the  three panel  diagram in Figure  1  will be helpful. 
Panel  (a)  represents  the  domestic  country,  panel  (b)  the  trade sector,  and 
panel  (c)  the  foreign country. 
The  first step is  to  show  the effect of  a  decrease in the  level of  the 
money  supply.  A decrease  in the money  supply is deflationary,  since people 
have  less money  to  spend.  The  domestic  demand  falls  from  D to D'  causing  a 
shift to  the  right of  the  excess  supply  function in the  trade  sector  from  ES 
to ES'.  This  increases  the  quantity  traded  and  reduces  the  trading price  to 
Q'  and  P',  respectively. 
The  decrease  in the  level of  the money  supply will be  followed  by  an 
increase in the interest rate.  The  increase in the interest will shift the 
domestic  supply  schedule  to  the  left from  S  to  Sf'  as  the  cost  to  the  farmer 
of borrowing  money  for  production will increase.  The  effect on  the  trade 
sector is a  shift of  the  excess  supply  function back  to  the left from  ES'  to 
ES". 
The  ambiguity with  regard  to  the  total effect on  the  trade  sector occurs 
after the  increase in the  interest rate.  There  are  three possible scenarios: 
a)  as  a  result of  the  increase in the  interest rate,  domestic  supply will 
shift far  enough  to offset  the  previous  shift in demand.  This case is 
demonstrated  in Figure  1  where  there is no  effect on  the  trade sector and  the 
excess  supply  function shifts back  to its original curve.  The  effect on  the 
domestic  country will be  less quantity available Qll  < Q o  offered at  the 
original price Pll  z  Po'  b)  In this  scenario  the  supply  schedule shifts such 4 5 
that  the  excess  supply  schedule settles between ES  and  ES'.  The  total impact 
of both  the  decrease in the  money  supply  and  the  increase  in the interest rate 
on  the  trade  sectors will be  to  increase  the quantity  traded  somewhere  between 
QO  and  Q'  and  decrease  the  trading  to between  po  and  P'.  In  the  domestic 
market  price and  quantity both decrease.  c)  In  the  final  case,  the  domestic 
supply will shift in a  more  drastic fashion  than  the shift in demand.  The 
result of  such  a  movement  will be  to shift the  excess  supply  to  the left of 
the original excess  supply function  ES.  The  outcome  of  such a  shift is  to 
reduce  the quantity  traded beyond  QO  and  increase  the  trading  price above  po. 
In the  domestic  market,  the  quantity  traded is below Q11,  and  the price 
increases  above  Po.  One  must  realize  that  the extent of  the shifts in 
quantities and  prices will be  determined exclusively by  the relative price 
elasticities of  the  demand  and  supply and  the  income  elasticity. 
Effects  in Term  of Elasticities 
To  show  the  ambiguity in  the  results,  a  model  very similar  to  the  one  set 
by  Chambers  (1981)  is used.  The  difference lies in the specification of  the 
interest rate not  as  an  independent variable but rather as  a  function of  the 
money  supply.  The  money  supply will appear also in the  domestic  demand 
function via  income.  Expansion of  the money  supply is inflationary as 
consumer's  income  rises,  thus  inducing  them  to  spend  more,  and  shifting the 
domestic  demand  schedule upward.  The  money  supply will also affect  the 
domestic  supply  through  the  interest rate effect.  As  the  money  supply 
changes,  it affects  the  interest rate,  which  in turn affects  the cost of 
borrowing  to  the  farmers,  thus  shifting to  the left the  domestic  supply 
function. 6 
Let  D(P,  Y(m»  be  the  domestic  demand  where  P  is domestic  price,  Y is 
income,  and  m is domestic  money  supply.  Notice  that  the money  supply m is not 
the  only variable which  affects  income,  but  for  our analysis it is  the 
variable interest.  Let  S(P,  r(m»  be  the  domestic  supply  function where 
r  represents  the  domestic  interest rate.  Let  an asterisk denote  the  foreign 
country.  We  assume  that  the  domestic  price is related  to  the  foreign  price 
via the  exchange  rate,  P*=eP,  where  e  denotes  the  exchange rate.  The  domestic 
excess  demand  function  is: 
ED(P,  Y(m),  r(m»  = D(P,  Y(m»  - S(P,  r(m». 
The  trade equilibrium condition,  therefore is: 
(1)  ED(P,  Y(m),  r(m»  + ED*  (P*,  Y*(m*),  r*(m*»  = O. 
Assuming  the  exchange  rate is  fixed  and  partially differentiating with 
respect  to  the money  supply,  we  obtain  the  following  expression 
(2)  OE  OP  +  OE  Or  + oE  oY  + oE*  op*  OP  _  0 
OF  Om  Or Om  Oy Om  0piiC or  Om  -
Rearranging  (2)  in elasticities  form: 
(3) 
where  €ij is the elasticity of  j  with  respect  to i.  Since  in this case  the 
exchange  rate is fixed,  the  only macroeconomic  variables which  enter  the  above 
expression are  the money  supply  and  the  interest rate.  €my  is the  income 
elasticity with  respect  to  the money  supply,  €my  is the  interest rate 
elasticity with respect  to  the money  supply,  and  eyE  is the domestic  excess 
demand  elasticity with  respect  to  the  interest rate.  The  denominator  is the 7 
same  as  Chambers,  and  is negative.  However,  the  sign of  the  numerator is 
undetermined  since it captures  the effects of  the money  supply  on both  the 
domestic  demand  and  the  domestic  supply.  As  EmP  is the price elasticity with 
respect  to  the money  supply,  under  the  three  scenarios described before,  the 
domestic  prices might  decrease,  stay the  same,  or increase.  In the  trading 
sector, it is impossible  to  determine  whether  the  new  excess  supply function 
will lie to  the left, right or  remain  the  same  as  the old excess  supply 
function. 
The  Exchange  Rate Effect 
"In the above  model,  changes  in the money  supply level and  the interest 
rate were  considered.  The  third effect which  one  might  consider  in the model 
is the  exchange  rate.  As  the  level of  the money  supply decreases,  the 
interest rate increases.  These  shifts will cause capital inflow and 
appreciation of  the  exchange  rate. 
The  appreciation of  the  exchange  rate will shift the  excess  demand 
function  (in Figure  1)  to  the left, decreasing both  the price and  the quantity 
traded.  However,  when  combining  the  previous  shifts of  the domestic  supply 
and  demand  as  the results of  the  changes  in the monetary base  and  the interest 
rate,  the  results are  not  always  clear. 
Again,  three possible cases  can be  analyzed.  Assuming  there is  some 
fixed shift in the  excess  demand  function  as  the result of  the appreciation of 
the  exchange  rate,  (1)  The  shifts in domestic  demand  and  supply are equal.  In 
this case it is clear that both quantity  traded  and  the price will decrease  in 
the  trade sector.  (2)  The  shift in the  domestic  demand  function  exceeds  the 
shift in the domestic  supply  function.  In this case it is clear that  the 
price in the  trade  sector will decrease.  However,  the quantity  traded might 8 
increase or  decrease  depending  on  the  difference in the shifts,  and  (3)  The 
shift in the  domestic  demand  function  is smaller  than  the shift in the 
domestic  supply  function.  This  case  implies  a  drop  in the quantity traded, 
but  ambiguous  results with respect  to  the  traded price as it might  increase or 
decrease  depending  the magnitude  of  the  domestic  shifts. 
One  must  be careful in interpreting these cases.  It is very unlikely 
that  an  exchange  rate appreciation resulting  from  a  decrease  in the money 
supply  and  an  increase in the  domestic  interest rate, will increase  the 
quantity traded.  It takes  large shift in the  domestic  demand  and  small shift 
in the  domestic  supply to cause  an  increase in the  trade  flow,  as  described in 
Case  (b)  on  page  3. 
Effects of  Exchange  Rate in Elasticities Form 
The  algebraic derivations of  the  impact  of  a  flexible  exchange  rate,  we 
use  the  same  model  as before with  the  exception that  the  exchange  rate is a 
function  of  the  relative domestic-and  foreign  interest rates: 
e  - e(r(m)/r*(m*» 
Using  this notation in (1),  and  partially differentiating with respect  to  the 
money  supply,  we  obtain: 
(4) 
Rearranging  (4)  in elasticities form  we  derive at: 
(5  ) 9 
The  above  term is complicated,  but it captures all the macro  variables effects 
at once,  as  the causality flows  from  the money  supply  to  the interest rate and 
then on  to  the  exchange  rate. 
Under  the third case in the  previous  section where  the shift in the 
domestic  demand  function is smaller  than  the shift in the  domestic  supply 
function,  the  sign of  EeP  is unknown.  However,  under  the  second  case where 
the shift in domestic  demand  exceeds  the shift in the domestic  supply 
function,  the  sign of  EeP  is known,  but  the overall effect  on  the quantity 
traded is unknown. 
Conclusion 
In the  above  paper  a  new  model  specification was  presented which is 
unique  in the  way  all three macroeconomic  variables were  used.  When 
considering all the  consequences  of  a  change  in the money  supply (i.e., change 
in the interest rate and  exchange  rate),  the results might be  ambiguous. 
When  analyzing  the effect of  each macroeconomic  variable  on  the 
agricultural trade  flow,  the  outcome  is known  and  clear.  However,  when 
combining  the  impacts  of all three variables  together,  the  outcome  is not 
necessarily known. 
It was  the  intention of  this paper  to alert other researchers about  the 
possible outcomes  of  using different model  specifications.  When  considering 
only  the effect of  the money  supply  on  the  trade sector,  the  outcome  might be 
deceiving  as  there are other macro  variables which  should be  considered as  the 
above  model  has  suggested. 
mlr  11/5/85 JS-6 10 
REFERENCES 
Chambers,  Robert  G.  "Interrelationships between Monetary  Instruments  and 
Agricultural  Commodity  Trade."  Amer •  .::!.:..  Agr.  Econ.  63(1981):934-41-
Longmire,  Jim  and  Art  Morey.  "Strong Dollar Dampens  Demand  for  U.S.  Farm 
Exports."  U.S.D.A.,  Economic  Research  Service,  Foreign Agricultural 
Economic  Report No.  193,  1983. 
Paggi,  M.  "A  Note  on  Changes  in Monetary Variables,  Exports  of 
U.S.  Agricultural Commodities,  and  Granger Causality."  Unpublished 
Paper,  1984. 
Schuh,  Edward  G.  "The  Exchange  Rate  and  U.S.  Agriculture."  Amer •  .::!.:.. ~ 
Econ.  56(1974):1-13. .0 
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Do Macroeconomic Variables Affect the Agricultural Trade Sector? An Elasticities Analysis

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