Houck, James P.

English

Research Papers in Economics

INFLATION AND INTERNATIONAL  TRADE
James P. Houck
Professor, Department  of Agricultural and
Applied Economics, University of Minnesota
International  trade and trade policy are difficult enough to under-
stand  when  price  levels  remain  relatively  constant.  But when rapid
or chronic  inflation  are  added,  most  of  us  find  that whatever  grip
we have  on  economic  principles begins  to  slip away.  This  is because
general  price inflation reflects  changes in the level and distribution of
real  income  within  countries  and  across  national  boundaries.  Infla-
tion  also tends to  change  currency  exchange rates  and international
balance of payments accounts.
This  paper  examines  briefly  some  of the  major ways  in  which
inflation can influence trade among nations.
Inflation  is  a  sustained  increase  in  the  general  price  level  of a
national  economy  measured  either  at  the  retail  or  wholesale  level.
The  annual  rate  of  change  in  this  price  level,  commonly  expressed
in index numbers, is the inflation rate.
Constant Inflation Rates
First  imagine  a curious  world  in which  all trading nations display
rapid but equal inflation rates. No changes occur anywhere in relative
prices-all  conceivable  price  and cost ratios stay  constant  over time.
Since  currency  exchange  rates are  really  price  relatives, no exchange
rates  would  change  in  response  to  this  inflation.  Thus,  no  price-
induced  changes  in imports,  exports,  interest  rates,  capital  flows,  or
balance of payments would occur.
Such a world would be uninteresting from our point of view unless
this  constant  international  inflation  rate  were  accompanied  by un-
equal rates  of change  in  real income.  These could emerge because of
differential  rates  of growth  in  real  output across  international  bor-
ders.  Unequal  changes in real income  could  induce  changes  in com-
modity trade and  foreign  exchange through demand shifts, but these
would  not be inflation phenomena  as  such. Now  consider the more
relevant  case  involving  differential  inflation rates occurring from one
trading nation to another.
57Differential Inflation and Fixed Exchange  Rates
For whatever  underlying  reasons,  imagine  that at least two  major
trading nations  display  substantially  different  internal inflation rates
affecting  prices  of both traded  and  non-traded  goods.  If the rate  of
exchange  of  one  nation's  currency  for  that  of  the  other  is  fixed,
relative  prices  across  the border  would be changing at a rate equal to
the  difference  between  the  two  inflation  rates.  For example,  if the
U.S.  inflation rate  is  10  percent  and  the  West  German rate  is  7 per-
cent,  then relative  prices  for  U.S.  goods  would  be  rising by  3  per-
cent per  year  in terms  of German  currency.  Similarly, relative  prices
for  German  goods  in  U.S.  currency  would  be  falling  at  3  percent
per year.
With  fixed  exchange  rates,  the exports  of the rapidly-inflating  na-
tion  would  tend  to  dwindle,  and  their  imports  would  tend to rise.
In  our  example,  this  adjustment  would  dampen  inflation  in  the
United  States  and  heighten  it  in  Germany  if  large  balance  of pay-
ments  surpluses  and  deficits  are  not  allowed  to  accumulate  and  if
trade is responsive  to price change.
This  theoretically-tight,  international  linkage  of economic activity
and price  levels  is  a major advantage  seen  by  supporters  of the gold
standard  and other types of fixed exchange rates.  They favor the au-
tomatic  external  discipline  on economic  activity and inflation which
such  schemes  provide.  With  fixed  currency  exchange  rates,  inflation
is clearly an export  commodity.
How  easily  and  rapidly  inflation  can  move  from nation  to nation
under fixed  exchange  rates depends  upon the importance  of trade in
total economic  activity  and the degree to which  exports and imports
respond to international  price differences.  The more important trade
is  and the more  responsive  demand  and supply  are  to price changes,
the more readily inflation will surge from one country to another.
Differential Inflation and Flexible  Exchange  Rates
Completely  fixed  exchange  rates are  one  polar extreme.  Is there a
link between inflation and trade at the other extreme where exchange
rates are  fully  flexible?  Here  we  can  turn to the venerable  "purchas-
ing power parity"  doctrine  of economic  theory  which  dates back to
the  work  of  the  Swedish  economist  Gustav  Cassel  at  the  end  of
World  War  I.  This  principle  shows  relationships  that  should  exist
among freely-determined,  equilibrium  currency  exchange rates when
two  or  more  nations  display  different  rates  of  internal  price infla-
tion and their international  payments are  in balance.
It  is  beyond  the  scope  of this  paper  to trace  the history  of this
principle  or  to  provide  a rigorous  discussion  of its  derivation.  The
basic relationship  can be stated as follows for any pair of nations.
(1)  rt = ro(Plt/P2t)
58where  Pit  is  nation  #l's  price  level  in  period  t  (relative  to  some
base);  P2t  is  nation #2's  price  level  in period t  (relative to the same
base);  ro  is the base-period exchange rate expressed as the number of
units of nation #l's currency  that a single unit of #2's currency will
buy; and rt is the equilibrium exchange rate for period t.  In terms of
annual  rates of change, the purchasing-power  parity relation of equa-
tion (1)  can be written
(2)  r* = P  -P2
where  r*  is  the  annual  rate  of  change  in the  equilibrium exchange
rate;  P*  and  P2  are the  annual  inflation rates  in nations  #1  and  #2
respectively.
Since  currency  exchange  rates are really price relatives of one unit
of  money  in  terms  of  another,  they  can  be  linked  to  differential
inflation  rates in the same way as the other price relatives. Returning
to our previous  example,  compare  the United  States, with  a  10 per-
cent  inflation  rate,  to  West  Germany,  with  a  7 percent  rate.  Under
the  purchasing  power  parity  principle,  the number  of dollars that a
given  amount of  German  marks  will  buy on  world  money  markets
should  increase  at  approximately  3  percent  annually.  Similarly,  the
number  of marks  obtainable  per dollar will deteriorate  at 3  percent
annually.
The  next  step  in  this  line  of  reasoning  is  to  consider  the  trade
impacts  of flexible  exchange  rate adjustments  occurring  in response
to  inflation.  Fully-adjusting  currency  exchange  makets  would  com-
pletely  neutralize  the changes  in relative  prices  implied  by differen-
tial inflation  rates.  Hence, the purchasing power parity doctrine with
flexible  exchange  rates teaches  that we  should  expect  no systematic
international  trade  changes  to  flow  from differential  inflation  rates
themselves.
However,  if a time  lag exists  in the rate at which exchange values
adjust  in response  to differential  inflation, then the nation with the
more  rapid  inflation  will  find  its  exports  slipping  and  its  imports
rising.  Because  the  value  of  its  currency  will  not  be  falling  fast
enough  to  maintain  equal  commodity  price  relatives.  So  the  net
impact  that  price  inflation  itself  has  on  international  trade  hinges
upon  where  actual  currency  exchange  markets  fit  between  the
polar extremes of fixity and full flexibility.
The Current Situation
For  the  last  10-15  years,  the  world's  trading  nations  have  been
edging  away  from  fixed  rates  toward  more  flexible,  market-deter-
mined  exchange  rates.  Governments  still intervene  heavily  in money
markets  to influence  currency  values, and currencies of some nations
are still welded together in fixed-value blocks.
59So  on  one  hand,  it  is  a  mistake  to  view  today's  exchange  rates
as  being determined  in  a fully-flexible  system. Yet the relative values
of major reserve currencies and currencies of many important trading
nations  are  now  more  free  to  change  in  response  to market  forces
than at any other time in this century.
Experts  in this field  agree that currency  exchange  rates are  influ-
enced  in  today's  world  by  factors  other  than  price  level  changes.
Government  intervention  in  exchange  markets  occurs  continually.
Private  currency  speculation  doubtless  disturbs  basic  trends  in  ex-
change  rates.  International  flows  of  financial  capital  and  govern-
mental  manipulation  of  interest  rates  powerfully  affect  exchange
rates in ways quite distinct from traditional transactions in goods and
services.  Differential  rates  of  price  inflation  among  and  between
traded and non-traded goods within a major trading nation  can affect
exchange  rates.  These  factors,  operating in both the short and long
run,  can  override  and  obscure  the  linkages  between  inflation  and
exchange  rates  suggested  by  the  purchasing  power  parity  theory.
A recent econometric  study by Charles  Freedman,  Bank of Cana-
da,  focused  on  the  exchange  rate  between  the  U.S.  dollar  and  the
Canadian  dollar.  He  found that about 85-90 percent of the quarterly
fluctuation  in  this  exchange  rate  between  1971  and  1977  can  be
attributed  to changes  in the following  factors, listed here in order of
their statistical importance:
1. Ninety-day interest rate differential between Canada and U.S.
for commercial paper.
2. Price index ratio  of export goods to import goods.
3. Business  cycle  position  of Canada  relative  to  U.S.  (Canadian
minus U.S. unemployment rates).
4. Inflation differential between  U.S. and Canada.
5. Net long-term capital flows into Canada relative to GNP.
Note that the inflation  differential  was  only  one  of many  factors
at work on this particular exchange rate-and not the most important
in  this  period.  However,  there  are  at least two  broader  studies  (one
by  Yeager  of the University  of Virginia  in 1958,  and one by Meyers
of  the  University  of  Minnesota  in  1977)  which  suggest  that,  for
earlier  historical  periods  and  for  several  nations taken  together,  the
purchasing  power parity  hypothesis  could  not  be  rejected  as  a  de-
terminant of equilibrium exchange rates.
Table  1 summarizes  recent inflation rates for several major trading
nations.  It  is  clear  from  these  data  that differential  inflation  is  oc-
curring  among  trader  nations.  If  the  purchasing  power  parity  rela-
tionship were dominant in exchange markets, we would expect to see
the U.S.  dollar appreciating  with respect to the currencies of France,
Italy,  and  the  United  Kingdom  but  depreciating  with  respect  to
Japan  and Germany. The U.S.-Canada exchange rate should be about
constant.  Table  2  illustrates the mixed  nature of the actual situation
over the 1976-79 period.
60Table 1. Average Annual Rates of Consumer Price Inflation for Selected Nations,
1976  through Mid-Year 1979
Annual inflation rate
Country  (1976-79)
(percent)
United States  6.3
Canada  6.1
Japan  4.9
France  8.5
Germany, Fed. Rep.  3.4
Italy  13.8
United Kingdom  11.3
A  dominant  link between  differential inflation and exchange rates
would  be reflected  in similar  signs  (both plus  or both minus) on the
rates  of  change  in  exchange  rates and  prices.  Such  a relation,  from
the U.S.  viewpoint,  does occur  with respect to Japan  and Germany,
two of our major trading partners.  Opposite signs occur for the other
nations.  Even  with  Japan  and  Germany,  widely  different  values  of
the  change  in  exchange  rates  and  the  inflation  differentials  occur.
This indicates  that in recent months  and years the purchasing power
parity relation has been heavily  obscured by other factors. In general,
these  forces  tend to  push  down  the  U.S.  dollar's  value  relative  to
some  other  important  currencies.  Many  observers  feel  that  inter-
national  capital  flows,  changes  in reserve  asset holding behavior, and
government interventions  are largely responsible.
Table  2.  Exchange  Rate Changes  and  Inflation  Rate  Differentials  for Selected
Countries,  1976-79
Average annual  inflation  Average annual rate of
rate differential  above (+)  change in U.S. dollar's
or below  (-)  the  value relative to the
Country  United States  foreign currency
(percent)
Canada  -0.2  +  5.6
Japan  -1.4  -12.3
France  +2.2  - 3.0
Germany,  Fed. Rep.  -2.9  -11.9
Italy  +7.5  - 0.4
United Kingdom  +5.0  - 5.7
61Another View  of the Purchasing Power Parity Relation
The  traditional  purchasing  power  parity  theory  implies  that  the
dominant  flow  of causation  is from price levels to currency exchange
rates.  It  is  probably  at least as correct to argue that in today's highly
interdependent  world  inflation  rates  and  exchange  rates  are  mutual-
ly determined.  Many governments  attempt to alter inflation rates and
exchange  values  via  economic  policy  maneuvers,  including  direct
market intervention.
To illustrate, consider a simple rearrangement  of equation  (2)
(3)  P=  r* + P*
1  2
It is  suggested  that the inflation  rate for one nation is affected  by
the  inflation  rate  in  another  nation  and  the  rate  of  change  in  the
currency  exchange  rate.  Policymakers  in  one  nation  probably  have
little  or  nothing  to  say  about  the  inflation  rate  in  another  nation,
but  they  can  do  something  about  the exchange  value  of their own
currency.  They  can  "overvalue"  it  by using foreign  exchange  hold-
ings to buy their own currency and thereby support its price. Or they
can  "undervalue"  it by acquiring  foreign  exchange through  price de-
pressing  disposals of their own currency.
Nations which exert central control over all foreign currency trans-
actions  can  overvalue  or undervalue  their own  money  by simple  ad-
ministrative  decisions.  In either  case,  the inflation rate in one nation
can be influenced if the theoretical relation holds in practice.
For instance,  downward  pressure on inflation rates can be achieved
by  holding  down  the  annual  rate  of  change  in the  exchange  rate-
by  overvaluing  the  currency  of  a  nation.  This  will  dampen  exports
and  encourage  imports.  On  the  other  hand,  if  the  currency  of  a
nation  is  systematically  undervalued,  upward pressure will be applied
to  its  inflation  rate  as  its exports  appear  cheaper  on world  markets
and  as its imports become relatively more expensive.  Looking at mat-
ters this  way  gives us  some insight  into why policymakers  in nations
with  high  rates  of inflation  tend to overvalue  their currencies  by re-
sisting  devaluation  at  least  partly  on  the grounds  that it would  add
further  fuel  to  domestic  inflationary  fires.  And  resulting  balance
of payments problems are less obvious.
Concluding Comments
As unsatisfactory  as our economic  theory is about the root causes
and  cures  of chronic  inflation,  we  know  that  it  is  not a "natural"
phenomenon  like  the force  of gravity  or the evolution  of plant and
animal  species.  Moreover,  inflation does not proceed equally through-
out an economy  as  we  have  assumed  here.  Particular  changes  in real
or monetary  factors  push  up specific  prices,  wages,  or interest rates.
These  specific  changes  spread  and ripple  across an economy through
62the processes  of private  and public substitution, negotiation, and ad-
ministrative  reaction.  Over  time,  the  net  result  of these  differing
actions and reactions is the inflation rate.
Inflation,  therefore,  is  not something  as fundamental  or inherent
to human  society  as,  say,  the speed  of light is to the physical world.
Inflation,  as  a general economic phenomenon,  is comprehensible  and
manageable  only  to the extent that its underlying  forces  are  identi-
fiable  and  subject  to  control.  Thus,  the  major  way  that  general
inflation  affects  international  trade  is  through  its relation  with  cur-
rency  exchange  rates.  Changing  currency  values  alter  relative  prices
and  costs to  simulate  or dampen  international  transactions  in  goods
and services.
To dig  beneath these  general  tendencies  requires  that we  identify
and analyze the forces which underlie and drive modern international
inflation.  These  include  the  systematic  escalation  of  energy  prices,
intermittent raw  material shortages  and  inventory  speculation,  fiscal
and  monetary  actions  by various  governments,  rising  real incomes,
non-competitive  markets,  and  people's  expectations  about  future
inflation. Each is  clearly the subject of another paper.
63

INFLATION AND INTERNATIONAL TRADE

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