International Trade Theory Capital Knowledge Economic Structure Money and Prices Over Time

Wei-Bin Zhang
1
International
Trade Theory
Capital, Knowledge,
Economic Structure, Money,
and Prices over Time
1 23
International Trade Theory
Capital, Knowledge, Economic Structure,

Money, and Prices over Time
Wei-Bin Zhang
International Trade Theory

Capital, Knowledge, Economic Structure,
Money, and Prices over Time
Professor Wei-Bin Zhang
Ritsumeikan Asia Pacific University
Jumonjibaru, Beppu-Shi, Oita-ken, 874-8577
Japan
[email protected]
ISBN 978-3-540-78264-3 e-ISBN 978-3-540-78265-0

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Preface
The development of international trade theory has created a wide array of

different theories, concepts and results. Nevertheless, trade theory has been
split between partial and conflicting representations of international eco-
nomic interactions. Diverse trade models have co-existed but not in a
structured relationship with each other. Economic students are introduced
to international economic interactions with severally incompatible theories
in the same course. In order to overcome incoherence among multiple
theories, we need a general theoretical framework in a unified manner to
draw together all of the disparate branches of trade theory into a single or-
ganized system of knowledge.
This book provides a powerful – but easy to operate - engine of analysis
that sheds light not only on trade theory per se, but on many other dimen-
sions that interact with trade, including inequality, saving propensities,
education, research policy, and knowledge. Building and analyzing various
tractable and flexible models within a compact whole, the book helps the
reader to visualize economic life as an endless succession of physical capi-
tal accumulation, human capital accumulation, innovation wrought by
competition, monopoly and government intervention. The book starts with
the traditional static trade theories. Then, it develops dynamic models with
capital and knowledge under perfect competition and/or monopolistic
competition. The uniqueness of the book is about modeling trade dynam-
ics. We differ from the traditional trade theories in that we introduce a
novel economic mechanism to determine consumers’ decision on con-
sumption and savings. Through this novel approach, the book attempts to
construct an international trade theory which integrates economic growth,
monetary, and value theories by a general-equilibrium analysis of the com-
modity and bonds markets over time and space. Economic dynamic theory
has been dominated by the two – the Solow and Ramsey – analytical frame-
works in the last five decades. The two modeling frameworks have co-existed
in “harmony” mainly because one cannot effectively replace the other. The
Solow model is empirically friendly and easy to analyze but lacks sound be-
havioral mechanism. The Ramsey framework is neither theoretically sound
nor empirically supported, even though it has recently become the dominant
framework in economic dynamics. Moreover, a model based on the Ramsey
VI Preface
approach tends to become analytically intractable when economic issues re-

lated heterogeneous households, or multiple sectors, or urban structure, inter-
regional, or international interactions are introduced. The novel utility
maximization approach helps us to solve the problem that there is no pro-
found rational decision mechanism for consumers in the Solow model and
avoids the complication that the Ramsey growth theory brings about.
Through numerous examples, this book demonstrates that the novel utility
functions help us to analytically study many trade problems in a consistent
manner.
This book studies trade issues in a comprehensive manner. It is largely
based on Zhang’s previous book (Zhang, 2000). This book differs from the
previous one in many important aspects, providing more general results,
simulating many models and introducing traditional trade theories and the
new trade theory more comprehensively.
I would like to thank Editors Wetzel-Vandai Katharina and Christiane
Beisel at Springer for effective co-operation. I completed this book at the
Ritsumeikan Asia Pacific University, Japan. I am grateful to the univer-
sity’s research environment.
Wei-Bin Zhang
APU, February 2008
Contents
Preface v
1 International Trade and Trade Theory 1

1.1 A Brief Introduction to International Trade Theory 2
1.2 The Purpose and the Structure of the Book 15
2 Classical International Trade Theories 23

2.1 Adam Smith and Absolute Advantage 24
2.2 The Ricardian Trade Theory 25
2.3 The 2 × 2 × 2 Trade Model and the Core Theorems in
Trade Theory 33
2.4 The Dual Approach to the Two-Good, Two-Factor Model 42
2.5 The Heckscher-Ohlin Theory 45
2.6 The Neoclassical Trade Theory 52
2.7 A General Two-Country Two-Good Two-Factor Trade
Model 56
2.8 Public Goods and International Trade 63
2.9 Concluding Remarks 71
Appendix 73
A.2.1 A Ricardian Model with a Continuum of Goods 73
3 Trade with Imperfect Competition 77

3.1 A Trade Model with Monopolistic Competition 78
3.2 The Ricardian Theory with Monopolistic Competition 82
3.3 The Heckscher-Ohlin Theory with Monopolistic
Competition 85
3.4 Oligopoly and Intraindustry Trade 90
3.5 Trade Pattern and Variable Returns to Scale 95
3.6 Transboundary Pollution and Trade 103
4 Trade with Factor Mobility 107

4.1 A Two-Good, Three-Factor Model with Capital Mobility 108
4.2 Variable Returns to Scale and Immiserizing Growth 117
VIII Contents
4.3 A Trade Model with Emigration 125

4.4 Human Capital Mobility and Chamberlinian
Agglomeration 129
4.5 Trade and Factor Mobility 133
5 Money, Exchange Rate, and Trade 135

5.1 Measurement and Accounting Relations of Economies 136
5.2 The IS-LM Analysis for an Open Economy 140
5.3 A Gold Standard Model 161
5.4 Exchange Rates and the Terms of Trade in a
Two-Country Model 163
5.5 On Money and Trade 173
6 Growth of Small Open-Economies with Capital

Accumulation 175
6.1 The One-Sector Growth (OSG) Model of a Closed Economy 178
6.2 The Ramsey Growth Model and the OSG Approach 185
6.3 A Small Open Economy with Capital Accumulation 192
6.4 Growth and Agglomeration of a Small-Open
Multi-Regional Economy 203
6.5 On the Alternative Utility Function 227
Appendix 229
A.6.1 Growth of a Small Overlapping-Generations
Economy 229
A.6.2 Habits and Current Account Dynamics 231
A.6.3 Proving Lemma 6.4.1 234
A.6.4 The Keynesian Consumption Function and the OSG
Approach 235
A.6.5 The Solow Growth Model and the OSG Approach 238
7 One-Sector Global Growth Models with Capital

Accumulation 241
7.1 A Growth Model with Trade Between North and South 243
7.2 A Two-Country Trade Model with Capital Accumulation 245
7.3 A Multi-Country Growth Model with Labor Supply and
Capital 255
8 Growth, Trade Patten and Structure 285

8.1 Oniki-Uzawa’s Trade Model with Capital Accumulation 286
8.2 Economic Structure, Trade and Capital Accumulation 296
8.3 Trade and Growth with Non-Traded Services 305
Contents IX
Appendix 314
A.8.1 Capital Accumulation and Services in a
Multi-Country Economy 314
A.8.2 A Two-Country Model of Optimal Growth 319
9 Growth and Trade with Capital and Knowledge 323

9.1 A National Growth Model 326
9.2 Trade and Growth with Learning-by-Doing and Research 338
9.3 Conclusions 368
Appendix 369
A.9.2.1 Proving Lemma 9.2.2 369
10 Trade Dynamics with Innovation and Monopolistic

Competition 373
10.1 Comparative Advantage with Endogenous Technological
Change 375
10.2 Intellectual Property Rights (IPRs) and Trade 381
10.3 Trade Costs and Trade Patterns 388
10.4 Growth and Innovation of a Small Open Country 391
10.5 Growth and Trade with Externalities 395
10.6 On Innovation and Monopolistic Competition 398
Appendix 399
A.10.1 Variety of Consumer Goods and Growth 399
A.10.2 The Schumpeterian Creative Destruction 403
A.10.3 Growth with Improvements in Quality of Products 407
11 Growth, Money and Trade 417

11.1 A Monetary Growth Model for a Small Open Economy 419
11.2 A Small Open-Country Economy with the MIUF
Approach 421
11.3 A Small Open-Country Economy with the CIA Approach 429
11.4 A Multi-Country Growth Model with the MIUF Approach 438
11.5 A Heterogeneous Households Model with the CIA
Approach 446
11.6 Global Economy with Money, Capital, and Knowledge 467
Appendix 470
A.11 A Monetary Growth Model of a Small Open
Economy with the Ramsey Approach 470
X Contents
12 Trade Patterns and Dynamics 475
References 483
Index 507
1 International Trade and Trade Theory
In recent years, global economy has experienced a tremendous increase in

the international movements of factors and goods, with international trade
and factor flows growing much more rapidly than output.1 One can hardly
find a family that does not hold something produced by foreign countries
even in a developing economy like mainland China. All the people around
the world are enjoying global services such as international sport games
and global supermodels. Globalization is bringing the world together in
consumption of services, goods, brand names, as well as knowledge. Evi-
dently, a comprehensive international trade theory is essential not only for
professional economists but also for any people who want to understand
mechanisms of globalization and relations among nations. Trade theory is
supposed to provide insights into mechanisms of international trades and
determinants of trade patterns, and interactions of trade and economic
growth. For instance, one may ask what are the long-term implications of
sustained United States current account deficits and Japanese current ac-
count surpluses. Do the both economies lose or benefit from the unbal-
anced trade? If not, who benefits, and who loses? How can the government
budgets for R&D and education affect national growth and international
trade patterns? What are the economic mechanisms that determine interest
rates, trade balances, and exchange rates? One may also ask about how in-
creasing global capital market integration affects the nature and interna-
tional business cycles. Will free trade bring the per capita incomes of de-
veloping countries to converge to the levels of developed economies? Is it
possible that free trade harms all the countries? The purpose of this book is
to provide a coherent and comprehensive analytical framework to address
basic issues of international trade.
1 See, for instance, Faini (2005).

2 1 International Trade and Trade Theory
1.1 A Brief Introduction to International Trade Theory
Mercantilism was the mean stream of economics throughout the 16th to the
18th century.2 Belief in mercantilism began to fade in the late 18th century.
The word comes from the Latin word “mercari”, which means “to run a
trade”. Mercantilism holds that the prosperity of a nation is dependent on
its supply of capital,3 and the global volume of capital is not changed ac-
cording to international trade. Capital can be increased mainly through a
positive balance of trade with other nations. Hence, national wealth and
power are best served by encouraging exports and collecting precious met-
als in return. To govern the national economy properly, the government
should advance these goals by adopting protectionist policy. The so-called
mercantile system is based on the idea that exports should be encouraged,
imports discouraged through the use of tariffs. Different mercantilists were
concerned with different ideas without a unified framework. Nevertheless,
a common viewpoint is that international trade is considered as a zero-sum
game, where a gain by one nation results in a loss of another. Hence, any
system of policies that benefit one nation would of course harm the other.4
By the late eighteenth century, classical economists such as David
Hume and Adam Smith began to criticize mercantilism. In his Political
Discourses (1752), David Hume attached the mercantilist idea that a nation
could continue to accumulate specie without any repercussions to its inter-
national competitive position. He reasoned that as the nation experienced
trade surplus and accumulated more gold, money supply should be in-
creased. The increase of money supply would result in rises in prices and
wages. The increases in prices and wages would increase imports and re-
duce exports.5 Hence, the competitiveness of the country with a surplus
would be reduced. Hume hence argued that it is impossible to continue to
maintain a positive balance of trade in the long run. In The Wealth of Na-
tion, Adam Smith refuted the idea that the wealth of a nation is measured
2 Mercantilism as a whole cannot be considered a unified theory of economics. It
did not present a scheme for the ideal economy, as Adam Smith did for classical eco-
nomics.
3 It should be noted that “capital” in this theory is represented by bullion (gold
or silver) held by the state. Today, we measure the wealth of nation by human,
man-made, and natural resources.
4 Although Adam Smith supported that mercantilism advocated for strict controls
over the economy, mercantilist domestic policy is actually fragmented than its trade
policy.
5 Hume assumed that changes in the money supply would affect prices rather
than output and employment.

by the amount of treasury. He held that a nation’s wealth was reflected in

its productive capacity, not in its holdings of precious metals. He criticized
the doctrine by demonstrating that free trade benefits both parties. Rather
than a zero-sum game, Smith argued that international trade is a positive-
sum game. He also argued that division of labor and specification in pro-
duction results in economies of scale, which improves efficiency and
growth.
Adam Smith (1776) held that a country could gain from free trade. He
pointed out that if one country has an absolute advantage over the other in
one production and the other country has an absolute advantage over the
first in another production, both countries gain from trading. But Smith
failed to create a convincing economic theory of international trade. It is
generally agreed that David Ricardo is the creator of the classical theory of
international trade. The theories of comparative advantage and the gains
from trade are usually connected with his name, even though many con-
crete ideas about trade existed before his Principles (Ricardo, 1817). In
this theory the crucial variable used to explain international trade patterns
is technology. The theory holds that a difference in comparative costs of
production is the necessary condition for the existence of international
trade. But this difference reflects a difference in techniques of production.
According to this theory, technological differences between countries de-
termine international division of labor and consumption and trade patterns.
It holds that trade is beneficial to all participating countries.
The Ricardian theory failed to determine the terms of trade, even though
it can be used to determine the limits in which the terms of trade must lie.
It was recognized long ago that in order to determine the terms of trade, it
is necessary to build trade theory which not only takes account of the pro-
ductive side but also the demand side.6 The neoclassical theory holds that
the determinants of trade patterns are to be found simultaneously in the
differences between the technologies, the factor endowments, and the
tastes of different countries.7 Preference accounts for the existence of in-
ternational trade even if technologies and factor endowments were com-
pletely identical between countries. The Marshallian offer curve has been
often used to analyze problems such as the existence of equilibrium, the
stability of equilibrium, the gains from trade, optimum tariffs and so on
within static frameworks. Mill introduced the equation of international
demand, according to which the terms of trade are determined so as to
equate the value of exports and the value of imports. He argued: “the ex-
ports and imports between the two countries (or, if we suppose more than
6 See Negishi (1972), Dixit and Norman (1980), and Jones (1979).
7 See Mill (1848) and Marshall (1890).
two, between each country and the world) must in the aggregate pay for
each other, and must therefore be exchanged for one another at such values
as will be compatible with the equation of the international demand” (Mill,
1848: 596). Mill initiated the theory of reciprocal demand which is one of
the earliest examples of general equilibrium analysis in trade theory.
The Ricardian model and Heckscher-Ohlin model are two basic models
of trade and production. They provide the pillars upon which much of pure
theory of international trade rests. The so-called Heckscher-Ohlin model
has been one of the dominant models of comparative advantage in modern
economics. The Heckscher-Ohlin theory emphasizes the differences be-
tween the factor endowments of different countries and differences be-
tween commodities in the intensities with which they use these factors.
The basic model deals with a long-term general equilibrium in which the
two factors are both mobile between sectors and the cause of trade is dif-
ferent countries having different relative factor endowments. This theory
examines the impact of trade on factor use and factor rewards. The theory
is different from the Ricardian model which isolates differences in tech-
nology between countries as the basis for trade. In the Heckscher-Ohlin
theory costs of production are endogenous in the sense that they are differ-
ent in the trade and autarky situations, even when all countries have access
to the same technology for producing each good. This model has been a
main stream of international trade theory. According to Ethier (1974), this
theory has four “core proportions”. In the simple case of two-commodity
and two-country world economy, we have these four propositions (which
are of course held under certain conditions) as follows: (1) factor-price
equalization theorem by Lerner (1952) and Samuelson (1948, 1949), stat-
ing that free trade in final goods alone brings about complete international
equalization of factor prices; (2) Stolper-Samuelson theory by Stolper and
Samuelson (1941), saying that an increase in the relative price of one
commodity raises the real return of the factor used intensively in producing
that commodity and lowers the real return of the other factor; (3) Rybczyn-
ski theorem by Rybczynski (1955), stating that if commodity prices are
held fixed, an increase in the endowment of one factor causes a more than
proportionate increase in the output of the commodity which uses that fac-
tor relatively intensively and an absolute decline in the output of the other
commodity; and (4) Heckscher-Ohlin theorem by Heckscher (1919) and
Ohlin (1933),8 stating that a country tends to have a bias towards produc-
ing and exporting the commodity which uses intensively the factor with
which it is relatively well-endowed.
8 See also Heckscher and Ohlin (1991).

The Heckscher-Ohlin theory provides simple and intuitive insights into

the relationships between commodity prices and factor prices, factor sup-
plies and factor rewards, and factor endowments and the pattern of produc-
tion and trade. Although the Heckscher-Ohlin model was the dominant
framework for analyzing trade in the 1960s, it had neither succeeded in sup-
planting the Ricardian model nor had been replaced by the specific-factor
trade models. Each theory has been refined within ‘small scales’. Each the-
ory is limited to a range of questions. It is argued that as far as general
ideas are concerned, the Heckscher-Ohlin theory may be considered as a
special case of the neoclassical theory mentioned before as it accepts all
the logical promises of neoclassical methodology.9 The Heckscher-Olin
theory may be seen as a special case of the neoclassical trade theory in
which production technology and preferences are internationally identical.
This loss of generality has long been held necessary in order to construct a
clear picture of international trade patterns and division of labor and con-
sumption.
Ricardo’s initial discussion of the concept of comparative advantage is
limited to the case when factors of production are immobile internation-
ally. The Heckscher-Ohlin theory is similarly limited to the study of how
movements of commodities can substitute for international movements of
productive factors. It is obvious that if technologies are everywhere identi-
cal and if production is sufficiently diversified, factor prices become equal-
ized between countries. But if production functions differ between coun-
tries, no presumption as to factor equalization remains. Most of early
contributions to trade theory deal with goods trade only and ignore interna-
tional mobility of factors of production. For a long period of time since Ri-
cardo, the classical mobility assumption had been well accepted. This as-
sumption tells that all final goods are tradable between countries whereas
primary inputs are non-tradable, though they are fully mobile between dif-
ferent sectors of the domestic economy. In reality, this classical assump-
tion is invalid in many circumstances. For instance, many kinds of final
‘goods’, services, are not-trade and capitals are fully mobile between coun-
tries as well as within domestic economies. A great deal of works on trade
theory has been concerned with examining the consequences of departures
from these assumptions. There is an extensive literature on various aspects
of international factor mobility.10
9 See Gandolfo (1994a, 1994b).

10 See Jones and Kenen (1984, 1985), Ethier and Svensson (1986), Bhagwati
(1991), and Wong (1995). It takes a long space to comprehensively review this litera-
ture.
It may be true to say that most of the pure theory of international trade
emerged from Ricardo’s Principles. The further development of the sub-
ject by Mill, Marshall and Edgeworth remained largely within the bounds
set by Ricardo. Since then, there had been much attention focused on the
determination of the terms of trade by reciprocal demand within frame-
works of many goods, countries and factors under various forms of inter-
vention. As mentioned by Findlay (1984), one topic that was almost en-
tirely absent from the pure theory of international trade was any
consideration of the connection between economic growth and interna-
tional trade in classical literature of economic theory. Almost all the trade
models developed before the 1960s are static in the sense that the supplies
of factors of production are given and do not vary over time; the classical
Ricardian theory of comparative advantage and the Heckscher-Ohlin the-
ory are static since labor and capital stocks (or land) are assumed to be
given and constant over time. Although Marshall held that it is important
to study international trade in order to be clear of the causes which deter-
mine the economic progresses of nations, it has only been in the last three
or four decades that trade theory has made some systematical treatment of
endogenous capital accumulation or technological changes in the context
of international economics.
The consideration of endogenous capital or technological change in
trade theory was influenced by development of neoclassical growth theory
with capital accumulation and growth theory with endogenous knowledge.
This order of development of economic theory is reasonable as it is only
after we are able to explain how national economies operate that we can
effectively model international economies. When economists had no com-
pact framework to explain national economies, it is hard to imagine how
international economies could be analyzed comprehensively. A national
economy may be perceived as a special case of the global economy in the
sense that the global economy is national when it consists of identical mul-
tiple national economies. Since there was no compact framework of na-
tional economies with endogenous capital or/and knowledge, it is reason-
able to know that there was no compact framework to analyze economic
growth and international trade.
Trade models with capital movements are originated by MacDougall
(1960) and Kemp (1961), even though these models were limited to static
and one-commodity frameworks. A dynamic model, which takes account
of accumulating capital stocks and of growing population within the Heck-
scher-Ohlin type of model is initially developed by Oniki and Uzawa
(1965) and others, in terms of the two-country, two-good, two-factor
model of trade. The Oniki-Uzawa model is developed within the frame-
work of neoclassical growth theory. The model is primarily concerned
with the process of world capital accumulation and distribution with de-
mands and supplies as fast processes. The two-sector growth model has of-
ten been applied to analyze the interdependence between trade patterns and
economic growth. These models are used to study the dynamics of capital
accumulation and balance of payment accounts. There are different sets of
assumptions made about the structure of trade. For instance, in the trade
models by Oniki and Uzawa (1965) and Johnson (1971) free trade in both
consumption and investment goods are allowed. An alternative specifica-
tion of trade structure in the growth framework allows for the existence of
international financial markets and for free trade in consumption goods
and securities, but not in investment goods.11 This framework emphasizes
the interaction of foreign borrowing, debt service, and domestic capital ac-
cumulation. The two-sector neoclassical growth theory was also applied to
analyze small open economies.12
Eaton (1987) proposed a dynamic two-sector, three-factors model of in-
ternational trade. The dynamic specification of the model is based on
Samuelson’s (1958) overlapping generations model. The dynamic model at
each point of time t proposed by Eaton is identical to the three-factor,
two-commodity model examined in a static context by Jones (1971),
Samuelson (1971) and Mussa (1974). The model tries to extend the Heck-
scher-Ohlin theory to include endowments of factor as endogenous vari-
ables. In this model land and capital serve not only as factors of production
but also as assets which individuals use to transfer income from working
periods to retirement. The model shows that changes in the terms of trade
and in the endowments of fixed factors do not necessarily have the same
effects on factor prices and on the composition of output as they do in a
static framework. Some results obtained from the specific-factors model
about the relationships between commodity prices and factor prices, factor
endowments and factor rewards, and factor endowments and the pattern of
production are not held in the dynamic model. For instance, a permanent
increase in the relative price of one commodity does not necessarily lower
the steady-state income of the factor specific to the industry producing the
other commodity.
Obstfeld (1981) examined the saving behavior of a small economy fac-
ing a certain world real interest rate. Obstfeld proposes a dynamic Heck-
scher-Ohlin model with internationally mobile capital and overlapping
generations of infinitely-lived agents. The model focuses on the effects of
government debt and spending shocks. Devereux and Shi (1991) devel-
oped a trade model which includes intertemporal consumption-savings de-
11 Fischer and Frenkel (1972).

12 See Bardhan (1965), Ryder (1967), and Bruce (1977).
cisions with the use of recursive preferences. These preferences make it

possible to analyze heterogeneity in a representative-agent infinite horizon
model with well-defined steady states. The key factors driving the steady
state are the convergence of national rates of time preference with one an-
other and the monotonical relationship between consumption and the real
interest rate at the steady state. This implies that each country’s share of
total world output depends only on its degree of impatience and not on
country-specific factors. From this model it concludes that if the country is
more patient country, the economy will have a higher steady-state con-
sumption level.
Increasing returns to scale is a characteristic feature of many economic
activities. It may come from population dynamics, knowledge creation and
utilization, and institutional changes. But the history of economic analysis
shows that it is not an easy matter to formally model non-constant returns
to scale within a competitive framework. In fact most of economic theories
are developed under the assumption of constant returns to scale, even
though economists have long ago recognized the significance of increasing
returns to scale in production for determining international trade patterns.
Nonetheless increasing returns had never played a central role in the trade
theory until the recent developments of the new trade theory. The assump-
tion that technology exhibits constant returns to scale had been accepted in
most general equilibrium models. It is analytically difficult to handle with
increasing returns within the framework of perfect competition. Some
years ago Chipman (1965a, 1956b) pointed out two reasons for this omis-
sion. The first reason is that economies of scale tend to be ignored in theo-
retical models not so much on empirical grounds as for the simple reason
that it is difficult to build a trade theory with increasing returns. This is in-
deed a poor reason; but no theoretical trade economist could avoid being
criticized for neglecting one of the principle sources of international trade
simply due to this reason. The second reason given by Chipman is that the
presence of increasing returns in production leads to multiple equilibria.
The existence of multiple trade patterns introduces an intrinsic arbitrari-
ness into the determination of the international pattern of specification and
trade. It is known that if there are multiple equilibria, comparative static
analysis becomes invalid. It should be remarked that what Chipman had
pointed out have been recently overcome by trade economists. Trade
economists have proposed many theoretical trade models with increasing
returns. They have overcome the theoretical difficulties involved in build-
ing such models13 and they have recently accepted the existence of multi-
13 As shown later on, these are also built on very strict assumptions.
ple equilibria and instability as economists had accepted the existence of a

unique equilibrium and stability in the 60s and 70s.
Adam Smith (1776) used the story of the pin factory to illustrate the
idea that the conception of increasing returns to scale is central to the ex-
planation of long-run growth. There is interdependence between the divi-
sion of labor and learning by doing. As skill is increased, the worker will
concentrate on a special task and thus further increase his skill. Smith ex-
amined the relationship between international division of labor and trade.
Marshall was aware of the inevitably changing technological and social
framework within which economies operated. He provided a vision of “or-
ganic growth” of economic systems. He considered individuals to respond
to economic opportunities locally with partial adjustments occurring over
time. Increasing return to scale economies was explicitly treated in his
theoretical framework of partial analysis. He argued that returning to scale
economies was due to technological changes and other social and eco-
nomic factors. Marshall (1890) distinguished between internal and external
scale economies and examined the possibility of multiple equilibria. He
recognized possible technological and organizational sources of increasing
returns to scale that are internal to establishments, business firms and in-
dustries. He noted a number of conditions, including greater possibilities
for specialization in the provision of intermediate inputs, a finer division of
labor, and the more rapid diffusion of innovation among specialized pro-
ducers and workers. Marshall introduced the notion of an “external econ-
omy” to discuss the existence of the equilibrium of a decentralized price
taking economy in the presence of aggregate increasing returns. He noted
that an increase in trade represents a form of external economy when pro-
duction knowledge cannot be kept secret. Marshall’s argument shows that
if knowledge is treated as an endogenous variable in economic growth,
then the system may exhibit multiple equilibria and it is not necessary for
equilibrium to be stable.
Classical trade theory does not neglect technology. Ricardo’s doctrine of
comparative costs presupposed that countries differed from one another in
the productivity of labor in producing commodities. Although the Ricar-
dian theory is not concerned with how technology itself may be affected
by trade, the theory studies the consequence of technological differences
differing between countries. Marshall was concerned with trade and in-
creasing returns. Issues related to gains from trade and other social welfare
were well raised even in the classical tradition. For instance, Marshall dis-
cussed terms of trade effects, arguing that with increasing returns to scale a
country may improve its terms of trade by expanding demand for its im-
ports. Graham (1923) argued that economies of scale may cause a country
to lose from trade. For instance, consider an economy in which there is a
single production factor, labor, and equal prices of both goods. Also sup-
pose that as a result of foreign trade a country shifts labor from the increas-
ing returns to scale industry to the decreasing returns to scale industry.
Then output per man falls in both industries, thereby reducing gross do-
mestic product at constant prices. He held that when a country has a sector
with increasing returns to scale and a sector with decreasing returns to
scale it may lose from trade. He suggested that in this case a tariff is bene-
ficial. Knight (1924) argued that Graham’s analysis of the possible losses
from trade is valid if the economies of scale are external to the firm and in-
ternal to the industry; but it is wrong if the economies of scale are internal
to the firm. Ethier (1979, 1982a, 1982b) explored the conditions under
which Graham’s arguments hold: they depend on the nature of the increas-
ing returns which are either national or international and the pattern of
change in relative prices due to the transition from autarky to trade.
Economists have recognized long time ago that economies of scale pro-
vide an alternative to differences in technology or factor endowments as an
explanation of international trade. But increasing returns as a cause of
trade has received relatively little attention from formal trade theory. Ohlin
(1933) pointed out that economies of scale serve as one explanation of for-
eign trade patterns. Since then, many trade theorists emphasized the role of
monopolistic competition in differentiated products. In particular, there ex-
ist early attempts to extend trade theory on the basis of Chamberlin’s Mo-
nopolistic Competition (Chamberlin, 1933). Explicit general-equilibrium
analysis of trade based on external economies was initiated with Matthews
(1949). Kemp and Negishi (1970) made an important contribution to the
literature, showing that gains from trade are guaranteed if free trade leads
to an expansion (noncontraction) of all increasing returns industries and
nonexpansion of all decreasing returns industries. Eaton and Panagariya
(1979) refined the Kemp-Negishi result. They proved that there are gains
from trade as long as there exists an industry such that all industries with
stronger degree of increasing returns (to weaker decreasing returns) do not
contract in the move to free trade, and all industries with weaker increasing
returns (or stronger decreasing returns) do not expand. In order to take ac-
count the relative importance of increases and decreases in the increasing
returns to scale sectors, Markusen and Melvin (1984) defined a weighted
average rule which applies under the assumption of convex production
possibilities frontier and the absence of factor market distortions. But this
rule is not valid when increasing returns lead to nonconvex production
possibilities. Helpman and Krugman (1985) provided a rule that applies if
aggregate factor usage is fixed between equilibria. Grinols (1992) develop
a rule which applies to more general cases and does not require a convex
production possibility frontier or fixed factor usage between equilibria. He
developed a sufficient condition for gains from trade when some increas-
ing returns industries expand and others contract. His conclusions do not
depend on the restrictions that the production frontier must be convex,
changes must satisfy a pre-specified hierarchical pattern, or that total factor
supplies must be fixed between equilibria.
Krugman (1989, 1990) developed a trade model with a single scarce
factor of production, labor, on the basis of the assumptions that scale
economies are internal to firms and the market structure is one of Cham-
berlian monopolistic competition. His treatment of monopolistic competi-
tion was influenced by the model by Dixit and Stiglitz (1977). He pro-
duced trade between identical economies where comparative advantage is
not the cause of trade, whether that comparative advantage comes from
Ricardian or Heckscher-Ohlin factors. It is shown that trade may be a way
of extending the market and allowing exploitation of scarce economies,
with the effects of trade being similar to industrial, urban, or regional ag-
glomeration. This trade model is better suited to explain intraindustry trade
(i.e., trade in similar products) between advanced countries.
Much of the early attention in the literature of modeling two-way trade
with increasing returns was placed on trade at the final product level,
rather than trade in intermediate products. Ethier (1979, 1982b) empha-
sized that returns to specification and two-way trade in intermediate prod-
ucts imply external returns to scale that spill over between economies. It is
argued that the spillover effects associated with international scale econo-
mies are an immediate result of the global and regional integration of in-
dustries subject to external static or dynamic scale effects. In Francois
(1994), a dual model of trade under international returns economies is de-
veloped and applied to examine foreign investment, labor migration, and
commercial policy. It is demonstrated that spillover effects associated with
international scale economies are an immediate result of global and re-
gional integration of industries, and have important implications for com-
mercial policy. As far as economic modeling is concerned, the models with
increasing returns mentioned above were limited to static frameworks.
These works did not provide much indication as to what are the dynamic
effects of international trade on growth, technological progress, and wel-
fare.
Except population and institutions, knowledge is a significant source of
returns to scale economies. Classical economists such as Smith, Marx,
Marshall and Schumpeter, emphasized various aspects of knowledge in
economic dynamics. But there were only a few formal economic models
which deal with interdependence between economic growth and knowl-
edge accumulation before the 1960s. Development of macroeconomics and
theory of international trade are intimately connected. Neoclassical growth
theory has been adopted to study relationships between trade and eco-
nomic growth. But most of trade models with endogenous capital assume
constant returns to scale production functions with inputs of capital and la-
bor. Technological change is assumed to be exogenous or an ad hoc func-
tion of variables that can be analyzed separately from the basic factors of
production function. The neoclassical growth theory developed in the 60s
and 70s was crucially dependent on some exogenous parameters such as
exogenous technological progress and an exogenous saving rate. However,
it has been pointed out that the neoclassical growth theory cannot satisfac-
torily explain many empirical observations such as the diversity in per cap-
ita GNP growth rates across regions or countries. The neoclassical growth
framework failed to provide a satisfactory framework for analyzing long-
run growth. These models conclude that if countries with the same prefer-
ence and technology will converge to identical levels of income and as-
ymptotic growth rates.
In the 70s Arrow’s learning by doing model (Arrow, 1962) and research
models (Uzawa, 1965; Phelps, 1966) initiated a new trend of modeling in-
terdependence between knowledge and economic growth. Although re-
search on human capital (e.g., Becker, 1975) and technological change
(e.g., Robson, 1980; Sato and Tsutui, 1984; Nelson and Winter, 1982)
caused attention from economists, it may be said that growth with endoge-
nous knowledge was not a mainstream of theoretical economics in the 80s.
Since Romer (1986) and Lucas (1988) published their works on knowl-
edge-based growth models, there has been a continuously increasing litera-
ture in the new growth theory. In the new growth theory, knowledge ac-
cumulation plays an important role in generating endogenously determined
and sustained growth, even though most of the recent works in the new
growth theory have neglected physical capital accumulation. Recently
there have been a rapidly increasing number of publications in the theo-
retical economic literature concerning the relationship between knowledge
accumulation and economic development.14
These knowledge-based economic frameworks have been extended to
study small open economies or interactions of multiple countries. Trade
economists have recently developed different trade models in which en-
dogenous growth is generated either by the development of new varieties
of intermediate or final goods or by the improvement of an existing set of
goods with endogenous technologies.15 These studies attempted to formal-
ize equilibrium trade patterns with endogenous technological change and
See Aghion and Howitt (1992), Jensen and Wong (1998), and Maurer (1998).
14
See Grossman and Helpman (1991), Aghion and Howitt (1998), and
15
Grossmann (2001).
monopolistic competition. They often link trade theory with increasing-

returns growth theory. Within such frameworks the dynamic interdepend-
ence between trade patterns, R&D efforts and various economic policies
are well connected. With the development of models with endogenous
long-run growth, economists now have formal techniques with which to
explore the relationship between trade policy and long-run growth either
with knowledge or with capital, but in most of them not both with capital
and knowledge within the same framework.
Traditional trade theories failed to handle with issues of trade with in-
creasing returns in a consistent way not because economists did not recog-
nize the significance of increasing returns, but because free trade based on
increasing returns is difficult to model formally under internationally and
domestically perfect competition. One of the main obstacles to formally
model economies with non-constant returns is the problem of market struc-
ture. It is generally believed that increasing returns are inconsistent with
perfect competition. But before the new trade theory became a dominant
school, trade theorists interested in free economies constructed models
consistent with the assumption of perfect competition. Faced with increas-
ingly significance of endogenous technological changes in affecting trad-
ing patterns among economists, economists have recently produced the
new trade theory. This theory produces many clear and simple mathemati-
cal models and provides insights into international trade based on increas-
ing returns. These models explain trade in the presence of increasing re-
turns and imperfect competition. The new trade theory is influenced by the
developments in the theory of growth with endogenous knowledge and in-
dustrial organization. It highlights the roles of knowledge accumulation
and international dissemination in explaining how trade structure and trade
policy affects rates of growth. Specification and the rationalization at the
immediate product level, along with related effects of trade, market inte-
gration, learning-by-doing, technical innovation, and other external returns
have recently emerged as central issues in the new trade theory.
There are some models which deal with technology transfer via direct
foreign investment in the theoretical literature on growth and international
capital movements.16 For instance, Findlay (1978) built a international
growth model under the assumption about technology transfer that the rate
of technological change in a less developed country will be an increasing
function of the amount of foreign capital operating in the less developed
country and the extent to which the technology in the advanced country
exceeds that in the less developed one. Wang (1990) proposed a dynamic
two-country model to examine the interactions among growth, technologi-
16 See Findlay (1978), Wang (1990), and Wang and Blomström (1992).
cal change, and international capital movements. It includes capital accu-

mulation and treats human capital as a country-specific variable. Perfect
capital mobility links the two countries and human capital plays an impor-
tant role in determining the effective rate of return for physical capital and
affects the direction and magnitude of international capital movements.
Rivera-Batiz and Romer (1991) developed a dynamic model with specifi-
cation driven by R&D. Their model examines the effects of economic in-
tegration, through an increased flow of specified capital goods and of
ideas, on economic growth rates. It demonstrates that to the extent that
economic integration and other commercial policy changes increase the
global resource or activity base over which external economies are gener-
ated, such integration may induce globally positive level and growth ef-
fects. Matsuyama (1991) developed a dynamic model to examine eco-
nomic development under external economies and learning-by-doing
effects. It is shown that free trade may lower the growth rate of low-
income countries while accelerating the rate for high-income countries.
These dynamic models exhibit instabilities and multiple equilibria. Hence,
history as reflected in initial factor allocations, technology choices, and
sectoral efficiency may be critical to the global economic development.
The new trade theory with endogenous knowledge has two main differ-
ences from the traditional trade theory. The first is that it is developed
mainly under the assumption of imperfect competition. Although the sig-
nificance of imperfect competition for the pure theory of international
trade has been recognized and there are a number of macroeconomic mod-
els with imperfect competition as a crucial feature,17 most of these models
are developed within a static framework with fixed factors of production.
Like in the Dixit-Stiglitz model, many of these trade models assume mo-
nopolistic competition in which each good is produced by a separate firm
and labor is the only factor of production. The new trade theory combines
the trade models with imperfect competition and the growth models with
endogenous knowledge. The second main difference between the tradi-
tional trade theory and the new trade theory is that most of the formal
models in the new trade theory omit explicit treatment of physical capital.
The reason for the lack of endogenous physical capital is not that new
trade theorists don’t recognize the significance of physical accumulation.
We mentioned that one of the reasons that traditional trade theorists did
not make formal modeling of trade based on increasing returns is that they
did not have some analytical frameworks to formally examine these issues.
It is due to a similar reason that trade in the presence of possible physical
17 Dixit and Stiglitz (1977), Helpman and Krugman (1985), and Dixon and Rankin
(1994).
capital accumulation is not formally examined in the formal modeling of

the new trade theory with endogenous knowledge. If endogenous physical
capital accumulation is introduced into trade models in the new trade the-
ory, it will be difficult to make models tractable. It is not surprising to
know that the new trade theory omits formal treatment of endogenous
physical capital. This book treats both physical capital accumulation and
knowledge creation and utilization as endogenous variables within the
framework recently proposed by Zhang
1.2 The Purpose and the Structure of the Book
This book is concerned with dynamic relations between international divi-

sion of labor, division of consumption and determination of prices struc-
ture in the global economy. We develop trade theories under two market
structures – perfect and monopolistic competition. The book’s original
contributions are related to modeling dynamic interactions among capital
accumulation, knowledge creation and utilization, economic growth, price
structures and international trade patterns under perfect competition. The
book not only takes account of capital accumulation, but also treats knowl-
edge creation and diffusion, human capital accumulation and education,
institutions, monopoly, population growth, and cultural communications as
endogenous processes of economic evolution. We don’t supplant capital
accumulation as the key process of economic growth but to supplement it
with these processes. Since it is difficult to get explicit solutions of some
of the growth models, we simulate some models. The recent surge of simu-
lations in growth theory has been impelled by current developments in
computer processing, algorithm design, software, and data storage. We
will combine analytical methods and computer simulation.
As far as perfect competition is concerned, the book builds the theory in
a compact theoretical framework with a few concepts. The comparative
advantage of the theory is that it uses only a few concepts and simplified
functional forms and accepts a few assumptions about behavior of con-
sumers, producers and institutional structures, but it achieves rich conclu-
sions. It is conceptually easy to extend and generalize the theory because
of its consistency and simplicity. As far as trade dynamics under perfect
competition is concerned, this book is unique in the sense that it deals with
international trade theory with an alternative approach to consumer behav-
ior proposed by Zhang. In most of the models recently represented in the
three books by Zhang (2005a, 2006a, 2008a), trade issues are examined
not in a systematical way. This book studies trade issues in a comprehen-
sive manner. It is largely based on Zhang’s previous book, A Theory of In-

ternational Trade (Zhang, 2000). But this book differs from the previous
one in many important aspects. The previous one is entirely concentrated
on the analytical framework and models proposed by Zhang. This book in-
troduces different international trade theories18 and simulates some of the
models; while the previous book includes no simulation example.
The book is structured in parallel to the history of development of trade
theory. We are first concerned with static trade theories with exogenous pro-
duction factors, such as population, labor force, capital and knowledge. We
introduce trade theories of perfect competition and monopolistic competition,
respectively, with international factor mobility and immobility. We also in-
troduce the static IS-LM model for open economies to examine how money
and exchange rates interact with the other aspects of economic systems. After
examining static trade theories, we develop dynamic trade theory with en-
dogenous production factors, such as capital and knowledge accumulation.
We introduce trade theories of perfect competition and monopolistic compe-
tition with endogenous capital or/and knowledge on the basis of the analytical
frameworks of static trade theories.
The book is organized as follows. Chapter 2 introduces the basic ideas
and conclusions of classical international trade theories in mathematical
form. Section 2.1 studies Adam Smith’s trade theory with absolute advan-
tage. Although Smith’s ideas about absolute advantage were crucial for the
early development of classical thought for international trade, he failed to
create a convincing economic theory of international trade. Section 2.2 exam-
ines the theories of comparative advantage and the gains from trade. Section
2.3 develops a two-good, two factor model. Different from the common dual
approach to examining perfectly competitive two-factor two-sector model
in the trade literature, we use profit-maximizing approach to demonstrate
the most well-known theorems in the Heckscher-Ohlin trade theory. These
theorems include the factor price insensitivity lemma, Samuelson’ factor
price equalization theorem, Stolper-Samuelson theorem, and Rybczynski’s
theorem. In Sect. 2.4, we illustrate the dual approach for the same eco-
nomic problems as defined in Sect. 2.3. Section 2.5 examines the Heck-
scher-Ohlin theory which emphasizes the differences between the factor
endowments of different countries and differences between commodities
in the intensities with which they use these factors. The basic model deals
with a long-term general equilibrium in which the two factors are both
mobile between sectors and the cause of trade is different countries having
18 Although this book does not integrate Zhang’s approach and the new trade
theory within a single framework, the reader can see that a higher integration is
possible.
different relative factor endowments. The theory is different from the Ri-
cardian model which isolates differences in technology between countries
as the basis for trade. In the Heckscher-Ohlin theory costs of production
are endogenous in the sense that they are different in the trade and autarky
situations, even when all countries have access to the same technology for
producing each good. Section 2.6 introduces the neoclassical theory which
holds that the determinants of trade patterns are to be found simultaneously
in the differences between the technologies, the factor endowments, and
the tastes of different countries. Section 2.7 develops a general equilibrium
model for a two-country two-sector two-factor economy, synthesizing the
models in the previous sectors. Section 2.8 introduces public goods to the
two-sector and two-factor trade model defined in the previous sections.
Section 2.9 concludes the chapter. Appendix 2.1 represents a generaliza-
tion of the Ricardian model to encompass a continuum of goods.
Chapter 3 introduces some basic models of the new trade theory. Sec-
tion 3.1 studies a trade model with monopolistic competition by Krugman.
The Krugman model addresses relations between trade and elements such
as economies of scale, the possibility of product differentiation, and imper-
fect competition. The model is specially effective for providing some in-
sights into the causes of trade between economies with similar factor en-
dowments. The model is based on a monopolistic competitive model
proposed by Dixit and Stiglitz. Section 3.2 introduces the Chamberlinian-
Ricardian model proposed by Kikuchi. Rather than assuming cross-country
technical homogeneity like in the model in Sect. 3.1, the model is con-
cerned with cross-country technical heterogeneity. There are two sectors:
the monopolistically competitive sector and the competitive sector – the
former produces a large variety of differentiated products and the latter
produces a homogeneous good. The homogeneous good is produced under
constant returns to scale. Section 3.3 analyzes the interplay between factor
abundance and agglomeration forces, basing on a model of agglomeration
by Epifani. The model synthesizes the Heckscher-Ohlin theory and the
monopolistic competition. Section 3.4 examines economic mechanism for
the contemporary phenomenon that a large part of international trade is in-
traindustry in character. The section uses a simple model to demonstrate
that although it is costly to export the product from one country to another,
firms in different countries may engage in cross-hauling of an identical
product, making positive profits. Section 3.5 introduces a model of extend-
ing the Heckscher-Ohlin international trade theory to include variable re-
turns to scale. Section 3.6 analyzes the effects of transboundary pollution
on trade and welfare in a general equilibrium.
Chapters 2 and 3 examine traditional trade theories with factor mobility
between sectors with each country but factor immobility between coun-
tries. Looking economic activities around, we observe that the f actor-

immobility assumption is not valid. Chapter 4 examines trade patterns with
internationally mobile factor endowments. We are concerned with capital
and labor mobility. We will show that international capital or/and labor
movement may invalidate some of the f our core theorems developed in
Chap. 2. Section 4.1 studies the validity of the four fundamental trade theo-
rems, the factor equalization theorem, the Rybczynski theorem, the Stolper-
Samuelson theorem, and the Heckscher-Ohlin theorem, in the presence of in-
ternational capital movement. We are still concerned with a model similar to
the 2 × 2 model analyzed in Sect. 2.3. The 2 × 2 model is extended in two
ways. Capital moves freely between countries. Moreover, land is considered
as a production factor. The three-factor model still has two immobile factor
endowments, labor and land. Section 4.2 is concerned with immiserizing
growth. We are concerned with a trade model with international factor mobil-
ity and variable returns to scale. The model of this section is a synthesis of
the trade model with variable returns to scale in Sect. 3.4 and the model with
international capital mobility in Sect. 4.1. Section 4.3 is concerned with a
model of emigration and wage inequality proposed by Marjit and Kar. Rather
than following the dual approach accepted by the authors just referred, I will
use the approach as in the previous sections. The model deals with issues re-
lated to trade and wage inequality for developing economies. Section 4.4 in-
troduces a model with Chamberlinian agglomeration, basing on the core-
periphery model proposed by Krugman. The model studies interactions
among transport costs, increasing returns at the firm level, and supply and
demand linkages. Section 4.5 concludes the chapter on international trade
with global factor mobility.
Chapter 5 introduces money and exchange rates into trade models. Sec-
tion 5.1 first defines the current account balance for closed economies and
for open economies. Open economies can trade in goods and services, bor-
row resources from the rest of world, and lend them abroad. Section 5.2 is
concerned with the IS-LM model for an open economy. The model is also
a standard tool f or analyzing balance-of -payments (BOP) behavior when
exchange rate is fixed. Section 5.3 introduces a classical model of mone-
tary open economy with the gold standard. This model and its various ex-
tensions provide insights into many important monetary issues. The model
deals with the interactions among money, spending and prices in the open
economy with full price flexibility. Section 5.4 introduces a simple mone-
tary model of international trade developed by Ohyama. The model studies
an interaction of monetary and real factors affecting the terms of trade and
governing the adjustment process of current account imbalances under the
system of flexible rates. Section 5.5 concludes the chapter.
International factor mobility has received little attention in the literature

of international trade. This is reflected by the fact that in most books on in-
ternational trade, international trade is considered nearly synonymous to
international trade in goods. Many trade theorems are obtained when only
goods are allowed to move between countries. Chapter 6 studies some
models of small open economies with international capital mobility. As
mentioned before, the main deviation of this book from traditional ap-
proaches in modeling dynamics of international trade is how to model house-
holds’ decision making. Section 6.1 introduces the one-sector growth (OSG)
model of an isolated economy. In the rest of this book, we use the OSG
framework to stand for the one sector growth model developed in this section
and its variation extensions. Section 6.2 examines the Ramsey growth model
(which is the most popular approach in economic growth theory with optimal
foundation) also for a closed economy. As the OSG approach is an alterna-
tive approach to the Ramsey approach, we will also compare the two ap-
proaches. Section 6.3 describes dynamics of a small country economy. An
open economy can import goods and services and borrow resources from the
rest of the world or exports goods and services and lend resources abroad.
For convenience of illustration, assume that there is a single good in the
world economy and the price of the goods is unity. Section 6.4 extends the
model in Sect. 6.3 to a multi-regional economy. The model examines eco-
nomic growth of a multi-regional small open economy in a perfectly com-
petitive economy. The national economy consists of multiple regions and
each region has one production sector and one housing sector. Households
move freely among regions, equalizing utility level among regions by choos-
ing housing, goods and saving. A region’s amenity is endogenous, depending
on the region’s output and population. We explicitly solve the dynamics of
the multi-regional economy. As a concluding remark, Sect. 6.5 discusses the
theoretical basis for the utility function used in Chap. 6. Section A.6.1 intro-
duces a typical model of a small overlapping-generalizations (OLG) econ-
omy, proposed by Galor. Section A.6.2 studies a small country model pro-
posed by Ikeda and Gombi to analyze the equilibrium dynamics of
savings, investment and the current account. Section A.6.3 proves Lemma
6.4.1. Section A.6.4 studies the Keynesian consumption function and exam-
ines its possible relations to the consumption function obtained from the OSG
approach. Section A.6.5 studies the Solow growth model and examines its
possible relations to the OSG growth model.
Chapter 7 analyzes trade issues within the framework of a simple inter-
national macroeconomic growth model with perfect capital mobility. Most
aspects of production sectors in our model are similar to the neoclassical
one-sector growth model. It is assumed that there is only one (durable)
good in the global economy under consideration. Households own assets
of the economy and distribute their incomes to consume and save. Our
model, as far as trade and global growth are concerned, is influenced by
the neoclassical trade theory with capital accumulation. Section 7.1 dis-
cusses the nature of the economic relations between the advanced and less
developed regions of the world economy, or the North and South as it has
become customary to call refer to them. The formal framework, initiated
by Findlay (1980), is a synthesis of Solow-Swan’s neoclassical growth
model (for the North), Lewis’s dual-economic model (for the South), and
Johnson’s trade model as a linkage between the North and the South. Sec-
tion 7.2 builds a dynamic one-commodity and two-country trade model to
examine interdependence between trades and global growth. We analyze
trade issues within the framework of a simple international macroeco-
nomic growth model with perfect capital mobility. Section 7.3 extends the
model in Sect. 7.2, introducing a few new features to the analytical frame-
work. We construct a dynamic one-commodity and multiple-country trade
model to examine interdependence between trade and global growth with
sexual division of labor. The section proposes the multi-country model
with endogenous labor supply, sexual division of labor, and capital accu-
mulation.
Chapter 7 assumes that the world has only one production sector and
produces a single product. Chapter 8 is concerned with dynamic relations
between growth, economic structure and trade patterns in a two-country
world economy. Section 8.1 studies the standard trade model in neoclassical
growth theory proposed by Oniki and Uzawa. The model examines interac-
tions between the process of capital accumulation and the pattern of interna-
tional trade. It is presented in terms of the standard two-country, two-
commodity, two-factor model of international trade. Section 8.2 proposes a
trade model with economic structures and endogenous saving, synthesizing
the Oniki-Uzawa model and the one-sector growth trade model proposed in
Sect. 7.1. Section 8.3 studies a two-country trade model in which economic
product in each country is classified into goods and services. Section 8.4 con-
cludes the chapter. Section A.8.1 extends the two-country model in Sect. 8.3
to any number of countries. Section A.8.2 presents a two-country optimal
model, extending and generalizing the Oniki-Uzawa trade model.
Chapter 9 examines interactions between growth, trade, knowledge
utilization, and creativity within a compact analytical framework. We con-
sider knowledge as an international public good in the sense that all coun-
tries access knowledge and the utilization of knowledge by one country
does not affect that by others. Section 9.1 introduces a growth model with
endogenous human capital accumulation for a national economy. Section 9.2
proposes a multi-country model with capital accumulation and knowledge
creation. This section assumes that knowledge creation is through learning by
doing and research. This section simulates the model to see how the system
moves over time and how the motion of the system is affected when some
parameters are changed. This section is organized as follows. Section 9.2.1
defines the multi-country model with capital accumulation and knowledge
creation. Section 9.2.2 examines the case when all the countries have the
same preference. We show that the motion of the global economy can be ex-
pressed by a two-dimensional differential equations system and we can ex-
plicitly determine the dynamic properties of the global economy. Section
9.2.3 shows that the dynamics of the world economy with J countries can be
described by (J + 1) -dimensional differential equations. As mathematical
analysis of the system is too complicated, we demonstrate some of the dy-
namic properties by simulation when the world economy consists of three
countries. Sections 9.2.4 – 9.2.7 examine respectively effects of changes in
each country’s knowledge utilization efficiency and creativity, research pol-
icy, the propensity to save, and the population. The analytical results in Sec-
tion 9.2.3 are proved in Appendix A.9.1.
The new growth theory has modeled endogenous knowledge accumula-
tion through many channels, including formal education, on-the-job train-
ing, basic scientific research, learning by doing, process innovations, in-
dustrial innovations, and product innovations. The crucial assumption that
leads to sustainable endogenous growth is the existence of increasing re-
turns to scale in economic production under monopolistic competition.
Chapter 10 presents some of the key ideas in the approach in the new trade
theory. Section 10.1 introduces a dynamic, two-country growth model with
trade in which endogenous technical change results from the profit-
maximizing behavior of entrepreneurs. Section 10.2 is concerned with the
role of intellectual property rights (IPRs) in encouraging firms in devel-
oped countries to innovate and in helping developing countries gain access
to knowledge on the global frontier. The section introduces a dynamic
general-equilibrium product-cycle model to analyze the effects of Southern
IPRs on incentives of Northern firms to innovate and to license state-of-
the-art technologies to the South. The quality-ladders model with endoge-
nous innovation and licensing integrates licensing into the theory of en-
dogenous product cycles. Section 10.3 introduces trade costs into North-
South endogenous growth model. The model tries to analyze interactions
among factor endowments, trade costs, production location, and growth.
Section 10.4 introduces a model of growth and innovation of a small econ-
omy. The small country faces perfectly elastic demand in world markets
and trades at exogenously given prices. If the small economy trades on
world capital markets, it does so at an exogenously given rate of interest.
The R&D activities of the small country does not influence the rate of ac-
cumulation of knowledge capital in the world at large. Section 10.5 intro-

duces another important mechanism of economic growth. We introduce a
model of economic growth with externalities by Nishimura and Shimo-
mura. The model introduces sector-specific externalities in the Heckscher-
Ohlin two-country general equilibrium model. Section 10.6 concludes the
chapter. Section A.10.1 introduces growth model with a variety of consumer
products for a national economy. Section A.10.2 introduces the Aghion-
Howitt model of economic growth which explains Schumpeter’s process
of creative destruction. Section A.10.3 studies technological changes
through improving quality of the current products.
Chapter 11 introduces some dynamic trade models with money and ex-
change rates. Section 11.1 introduces Kemp’s monetary two-sector growth
model of an open small economy. The model examines how the rate of
domestic monetary expansion may affect the rate of change of the domes-
tic price level and relative attractiveness of physical assets and money as
repositories for saving, as well as the relative demands for consumption
and investment goods and the relative import-export demands for those
goods. Section 11.2 studies a small-country monetary economy with
money in the utility function (MIUF) approach. Section 11.3 examines a
small-country monetary economy with cash-in-advance (CIA) approach.
Section 11.4 develops a multi-country model with money, based on the
multi-country monetary model proposed by the author and the one-sector
multi-country trade model in Section 7.2. The monetary economic side is
based on the MIUF approach. Section 11.5 develops a monetary growth
model with capital, heterogeneous-households and trade. We extend the
two-country single household trade model in Sect. 8.1 to multi-country,
heterogeneous households growth trade model with money. The monetary
economic side is based on the CIA approach. Section 11.6 concludes the
chapter. Section A.11.1 presents a small open economy operating in a
world of ongoing inflation with the Ramsey approach for household be-
havior.
Chapter 12 points out possible directions for generalizations and exten-
sions of the basic ideas presented in this book.
2 Classical International Trade Theories
This chapter introduces the basic ideas and conclusions of classical inter-
national trade theories in mathematical form. Section 2.1 studies Adam
Smith’s trade theory with absolute advantage. Although Smith’s ideas about
absolute advantage were crucial for the early development of classical
thought for international trade, he failed to create a convincing economic the-
ory of international trade. Section 2.2 examines the theories of comparative
advantage. Ricardo showed that the potential gains from trade are far greater
than Smith envisioned in the concept of absolute advantage. Section 2.3 de-
velops a two-good, two-factor model. Different from the common dual ap-
proach to examining perfectly competitive two-factor two-sector model in the
trade literature, we use profit-maximizing approach to demonstrate the most
well-known theorems in the Heckscher-Ohlin trade theory. These theorems
include the factor price insensitivity lemma, Samuelson’ factor price equali-
zation theorem, Stolper-Samuelson theorem, and Rybczynski’s theorem. In
Sect. 2.4, we illustrate the dual approach for the same economic problems as
defined in Sect. 2.3. Section 2.5 examines the Heckscher-Ohlin theory which
emphasizes differences between the factor endowments of different countries
and differences between commodities in the intensities with which they use
these factors. The basic model deals with a long-term general equilibrium in
which the two factors are both mobile between sectors and the cause of trade
is that different countries have different relative factor endowments. The the-
ory is different from the Ricardian model which isolates differences in tech-
nology between countries as the basis for trade. In the Heckscher-Ohlin the-
ory costs of production are endogenous in the sense that they are different in
the trade and autarky situations, even when all countries have access to the
same technology for producing each good. Section 2.6 introduces the neo-
classical theory which holds that the determinants of trade patterns are to be
found simultaneously in the differences between the technologies, the factor
endowments, and the tastes of different countries. Section 2.7 develops a
general equilibrium model for a two-country two-sector two-factor economy,
synthesizing the models in the previous sectors. Section 2.8 introduces public
goods to the two-sector and two-factor trade model defined in the previous
sections. Section 2.9 concludes the chapter. Appendix 2.1 represents a well-
24 2 Classical International Trade Theories
known generalization of the Ricardian model to encompass a continuum of

goods.
2.1 Adam Smith and Absolute Advantage
Adam Smith (1776) held that for two nations to trade with each other vol-
untarily, both nations must gain. If one nation gained nothing or lost, it
would refuse it. According to Smith, mutually beneficial trade takes place
based on absolute advantage. When one nation is more efficient than (or
has an absolute advantage over) the other nation is producing a second
commodity, then both nations gain by each specializing in the production
of the commodity of its absolute advantage and exchanging part of its out-
put with the other nation for the commodity of its absolute disadvantage.
For instance, Japan is efficient in producing cars but inefficient in produc-
ing computers; on the other hand, the USA is efficient in producing com-
puters but inefficient in cars. Thus, Japan has an absolute advantage over
the USA in producing cars but an absolute disadvantage in producing
computers. The opposite is true for the USA. Under these conditions, ac-
cording to Smith, both nations would benefit if each specified in the pro-
duction of the commodity of its absolute advantage and then traded with
the other nation. Japan would specialize in producing cars and would ex-
change some of the cars for computers produced in the USA. As a result,
both more cars and computers would be produced, and both Japan and the
USA gain. Through free trade, resources are mostly efficiently utilized and
output of both commodities will rise. Smith thus argued that all nations
would gain from free trade and strongly advocated a policy of laissez-faire.
Under free trade, world resources would be utilized mostly efficiently and
world welfare would be maximized.
To explain the concept of absolute advantage, we assume that the world
consists of two countries (for instance, England and Portugal). There are
two commodities (cloth and wine) and a single factor (labor) of produc-
tion. Technologies of the two countries are fixed. Assume that the unit cost
of production of each commodity (expressed in terms of labor) is constant.
Assume that a labor theory of value is employed, that is, goods exchange
for each other at home in proportion to the relative labor time embodied in
them. Let us assume that the unit costs of production of cloth and wine in
terms of labor are respectively 2 and 8 in England;1 while they are re-
spectively 4 and 6 in Portugal. Applying the labor theory of value, we see
1 Units for cloth and wine are, for instance, yard and barrel.
that 1 unit of wine is exchanged for 4 units of cloth in England when Eng-
land does not have trade with Portugal. The ratio is expressed as
1 / 4 units of cloth/per wine . The ratio is the relative quantities of labor re-
quired to produce the goods in England and can be considered as opportu-
nity costs. The ratio is referred to as the price ratio in autarky. Similarly,
2 units of wine is exchanged for 3 units of cloth in Portugal ( 3 / 2 units of
cloth/per wine). England has an absolute advantage in the production of
cloth and Portugal has an absolute advantage in the production of wine be-
cause to produce one unit of cloth needs less amount of labor in England
than in Portugal and to produce one unit of wine needs more amount of la-
bor in England than in Portugal. Adam Smith argued that there should be
mutual benefits for trade because each country has absolute advantage in
producing goods. For instance, if the two countries have free trade and
each country specified in producing the good where it has absolute advan-
tage. In this example, England is specified in producing cloth and Portugal
in producing wine. Also assume that in the international market, one unit
of wine can exchange for 3 units of cloth. In England in open economy
one can obtain one unit of wine with 3 units of cloth, while in the autarky
system one unit of wine requires 4 units of cloth, we see that trade will
benefit England. Similarly, in Portugal in open economy one can obtain
one unit of cloth with 1 / 3 unit of wine instead of 2 / 3 unit of wine as in
autarky system, trade also benefits Portugal. In this example, we fixed the
barter price in open economies with one unit of wine for 3 units of cloth.
It can be seen that mutual gains can occur over a wide range of barter
prices.
2.2 The Ricardian Trade Theory
Although Smith’s ideas about absolute advantage were crucial for the early
development of classical thought for international trade, it is generally
agreed that David Ricardo is the creator of the classical theory of interna-
tional trade, even though many concrete ideas about trade existed before
his Principles (Ricardo, 1817). Ricardo showed that the potential gains
from trade are far greater than Smith envisioned in the concept of absolute
advantage.
The theories of comparative advantage and the gains from trade are usu-
ally connected with Ricardo. In this theory the crucial variable used to ex-
plain international trade patterns is technology. The theory holds that a dif-
ference in comparative costs of production is the necessary condition for
the existence of international trade. But this difference reflects a difference
in techniques of production. According to this theory, technological differ-

ences between countries determine international division of labor and con-
sumption and trade patterns. It holds that trade is beneficial to all partici-
pating countries. This conclusion is against the viewpoint about trade held
by the doctrine of mercantilism. In mercantilism it is argued that the regu-
lation and planning of economic activity are efficient means of fostering
the goals of nation.
In order to illustrate the theory of comparative advantage, we consider
an example constructed by Ricardo. We assume that the world consists of
two countries (for instance, England and Portugal). There are two com-
modities (cloth and wine) and a single factor (labor) of production. Tech-
nologies of the two countries are fixed. Let us assume that the unit cost of
production of each commodity (expressed in terms of labor) is constant.
We consider a case in which each country is superior to the other one in
production of one (and only one) commodity. For instance, England pro-
duces cloth in lower unit cost than Portugal and Portugal makes wine in
lower unit cost than England. In this situation, international exchanges of
commodities will occur under free trade conditions. As argued in Sect. 2.1,
trade benefits both England and Portugal if the former is specified in the
production of cloth and the latter in wine. This case is easy to understand.
The Ricardian theory also shows that even if one country is superior to the
other one in the production of two commodities, free international trade
may still benefit the two countries. We may consider the following exam-
ple to illustrate the point.
Let us assume that the unit costs of production of cloth and wine in
terms of labor are respectively 4 and 8 in England; while they are 6 and
10 in Portugal. That is, England is superior to Portugal in the production
of both commodities. It seems that there is no scope for international trade
since England is superior in everything. But the theory predicts a different
conclusion. It argues that the condition for international trade to take place
is the existence of a difference between the comparative costs. Here, we
define comparative costs as the ratio between the unit costs of the two
commodities in the same countries. In our example comparative costs are
4 / 8 = 0.5 and 6 / 10 = 0.6 in England and Portugal respectively. It is
straightforward to see that England has a relatively greater advantage in
the production of cloth than wine: the ratio of production costs of cloth be-
tween England and Portugal is 4 / 6 ; the ratio of production costs of wine
is 8 / 10 . It can also seen that Portugal has a relatively smaller disadvan-
tage in the production of wine. The Ricardian model predicts that if the
terms of trade are greater than 0.5 and smaller than 0.6 , British cloth will
be exchanged for Portuguese wine to the benefit of both countries. For in-
stance, if we fix the trade terms at 0.55 , which means that 0.55 units of
wine exchanges for one unit of cloth, then in free trade system in England
one unit of cloth exchanges for 0.55 units of wine (rather than 0.5 as in
isolated system) and in Portugal 0.55 (rather than 0.6 ) unit of wine ex-
changes for one unit of cloth. The model thus concludes that international
trade is beneficial to both countries. It is straightforward to show that the
terms of trade must be strictly located between the two comparative costs
(i.e., between 0.5 and 0.6 in our example). It is readily verified that if the
terms of trade were equal to either comparative cost, the concerned coun-
try would have no economic incentive to trade; if the terms of trade were
outside the interval between the comparative costs, then some country will
suffer a loss by engaging in international trade.
We now formally describe the Ricardian model.2 The assumptions of the
Ricardian model are as follows: (1) Each country has a fixed endowment
of resources, and all units of each particular resource are identical; (2) The
economy is characterized of perfect competition; (3) The factors of pro-
duction are perfectly mobile between sectors within a country but immo-
bile between countries;3 (4) There is only one factor of production, labor
and the relative value of a commodity is based solely on its labor content;4
(5) Technology is fixed and different countries may have different levels
of technology; (6) Unit costs of production are constant; (7) Factors of
production are fully employed; (8) There is no trade barrier, such as trans-
portation costs or government-imposed obstacles to economic activity.
First, we consider that the world economy consists of two countries,
called Home and Foreign. Only two goods, wine and cloth, are produced.
The technology of each economy can be summarized by labor productivity
in each country, represented in terms of the unit labor requirement, the
number of hours of labor required to produce a unit of wine or a unit of
cloth. Let aW and aC stand respectively for the unit labor requirements in
wine and cloth production, and QW and QC for levels of production of
wine and cloth in Home. For Foreign, we will use a convenient notation
throughout this book: when we refer some aspect of Foreign, we will use
the same symbol that we use for Home, but with a tilde ~. Correspond-
2 The Ricardian model presented below can be found in standard textbooks on
international economics. This section is referred to Krugman and Obstfeld (2006).
A formal analysis is referred to Borkakoti (1998: Chap. 6).
3 This assumption implies that the prices of factors of production are the same
in different sectors within each country and may differ between countries.
4 The assumption of a single factor of production can be replaced by that any
other inputs are measured in terms of the labor embodied in production or the
other inputs/labor ratio is the same in all industries
~ ~
ingly, we define a~W , a~C , QW and QC for Foreign. Let two countries’ to-
~
tal labor supplies be represented by N and N , respectively. The produc-
tion possibility frontiers of the two sectors in the two countries are given
by
aW QW + aC QC ≤ N ,
~ ~ ~
a~W QW + a~C QC ≤ N .
A production possibility shows the maximum amount of one product that
can be produced once the decision on the amount of production of the
other product has been made. We rewrite the above two inequalities in the
following form
aW QW + aC QC ≤ N , (2.2.1)
where a variable with macron ¯ stand for both Home and Foreign. Figure
2.2.1 shows Home’s production possibility frontier. The absolute value of
slope of the line is equal to the opportunity cost of cloth in terms of wine.5
The slope of the line is equal to aC / aW .
QW
L
aW
absolute value of the line’s slope equals opportunity

cost of cloth in terms of wine
L / aC QC
Fig. 2.2.1. Home’s production possibility frontier
5 The opportunity cost is the units of wine the country has to give up in order to
produce of an extra unit of cloth.

The production possibility frontiers show the combinations of goods

that the economy can produce. To determine what the economy actually
produces, we need to know prices. Let PW and PC stand respectively for
the prices of wine and cloth. As it takes aW hours to produce a unit of
wine, under the assumption of perfect competition the wage per hour is
equal to PW / aW in the wine sector in Home. Similarly, the wage rate of
the cloth sector is PC / aC . For a moment, we are concerned with autarky
system. As labor is freely mobile between the two sectors, both goods will
be produced only when the wage rates equal in the two sectors, that is
PW P
= C.
aW aC
Otherwise, if PW / aW > (<) PC / aC , the economy will specialize in the

production of wine (cloth). As aC / aW is the opportunity cost of cloth in
terms of wine, the economy will specialize in the production of cloth
(wine) if the relative price of cloth, PC / PW , exceeds (is less than) its op-
portunity cost.
To examine trade, we compare the opportunity costs, aC / aW and
aC / a~W . The opportunity cost in country may be greater or less than or
~
equal to the opportunity cost in the other country. First, we are concerned
with the case when the opportunity cost in Home is lower than it is in For-
eign, that is, aC / aW < a~C / a~W , or equivalently
aC aW (2.2.2)
< .
a~C a~W
The requirement means that the ratio of the labor required to produce a
unit of cloth to that required to produce a unit of wine is lower in Home
than it is in Foreign. We say that Home’s relative productivity in cloth is
higher than it is in wine. We also say that Home has a comparative ad-
vance in cloth. As Fig. 2.2.1, we can also draw Foreign’s production pos-
sibility frontier. Since the slope equals the opportunity cost of cloth in
terms of wine, Foreign’s frontier is steeper than Home’s.
It should be noted that the concept of comparative advance involves all
the four parameters, a j , j = W , C . The concept of absolute comparative
advantage used in the previous section is different from the concept of
comparative advance. When one country can produce a unit of good with
less labor than the other country, we say that the former has an absolute
advantage in producing that good. In autarky systems relative prices are
determined by the relative unit labor requirements. But once the possibility
of international trade is allowed, we have to examine how relative prices
are determined. We now examine how supply is determined. First, we
show that if the relative price of cloth is below aC / aW , then there is no
supply of cloth. We have already shown that if PC / PW < aC / aW , Home
will specialize in the production of wine. Similarly, Foreign will specialize
in the production of wine if PC / PW < a~C / a~W . Under (2.2.2), there is no
supply of cloth. When PC / PW = aC / aW , Home will supply any relative
amount of the two goods. We draw the relative supply curve (RS) in Fig.
2.2.2, where the horizontal axis is the relative supply,
( ~
)( ~
)
QC + QC / QW + QW , and the vertical axis is the relative price, PC / PW .
At PC / PW = aC / aW , the supply curve is flat. If PC / PW > aC / aW , Home
specializes in the production of cloth, the output being L / aC . As long as
PC / PW < a~C / a~W , Foreign will specialize in production of wine, the output
~
being L / a~W . We see that if
aC P a~
< C < ~C ,
aW PW aW
( ~
)
the relative output is (L / aC ) / L / a~W . When PC / PW = a~C / a~W , Foreign is
indifferent between producing cloth and wine, resulting in a flat section of
the supply curve. Finally, if PC / PW > a~C / a~W , both Home and Foreign
specialize in production of cloth. The relative supply of cloth becomes in-
finite. In summary, we see that the world relative supply curve consists of
steps with flat sections connected by a vertical section.
The supply curve is plotted in Fig. 2.2.2. The relative demand curve
(RD) is plotted as in Fig. 2.2.2. As the relative price of cloth rises, con-
sumers will tend to purchase less cloth and more wine. The equilibrium
relative price of cloth is determined at the intersection of the RD and RS.
From two different RDs, we have two different equilibrium points, A and
B , as illustrated in Fig. 2.2.2. At equilibrium point A , each country spe-
cializes in production of the good in which it has a comparative advantage:
Home produces cloth and Foreign produces wine. At equilibrium point B ,
Home produces both cloth and wine. Foreign still specializes in producing
wine. Foreign still specializes in producing in the good in which it has a
comparative advantage. We also see that except the case that one of the
two countries does not completely specialize, the relative price in trade
system is somewhere between its autarky levels in the two countries.
PC / PW
a~C
a~W
RS
A
aC RD
B
aW
RD’
L / aC ~
~ QC + QC
L / a~W ~
QW + QW
Fig. 2.2.2. Relative supply and demand curves in the world market
We have demonstrated that countries with different technologies will

specialize in production of different goods. To see that trade benefits the
two countries, consider how Home uses an hour of labor. Home could use
the hour either to produce 1 / aW units of wine or 1 / aC units of cloth. This
cloth could be traded for wine, obtaining (PC / PW ) / aC units of wine. There
will be more wine than the hour could have produced directly as long as
(PC / PW ) / aC > 1 / aW , that is PC / PW / > aC / aW , which holds if both coun-
tries specialize in producing one good. This implies that Home uses more
effectively its labor in trade than in autarky. This is similarly holds for
Foreign. Both countries gain by trade.
One of the attractive features of the Ricardian model is that its modeling
structure allows virtually all the results obtained for the simple two-
commodity and two-country case to be extended to many countries and
many commodities, even though some new features appear in high dimen-
sions.6 For example, when the global economy consists of many commodi-
ties but only two countries, commodities can be ranked by comparative
costs in a chain of decreasing relative labor costs:
6 For instance, Ethier (1974), Chang (1979), Jones and Neary (1985) and Neary
(1985).
a 21 a22 a2 j a (2.2.3)
> > ⋅⋅⋅ > > ⋅ ⋅ ⋅ > 2n ,
a11 a12 a1 j a1n
in which aij is country i ’s labor requirement per unit output in sector j ,

i = 1, 2 , j = 1, 2, ..., n . Demand conditions determine where the chain is
broke. The comparative unit costs ensure that country 1 must export all
commodities to the left of the break and import all those to the right, with
at most one commodity produced in common.
This theory may be represented in different ways. For instance, we may
interpret the theory of comparative costs in terms of optimization. We refer
the following example to Gandolfo (1994a). We consider a simple case in
which the world economy consists of two countries and produces two
commodities. Here, we consider the benefits from international trade in
terms of an increase in the quantity (rather than utility) of goods which can
be obtained from the given amount of labor. Our optimal problem is to
maximize each country’s real income under constraints of the fixed labor
and technology. We use Px and Py to denote the absolute prices of cloth
and wine (expressed in terms of some external unit of measurement, for in-
stance, gold). Under the assumptions of free trade, perfect competition and
zero-transportation cost, the Home price ratio is equal between the two
countries. The exchange ratio of the two goods, Px / Py , is taken as given.
Let x j and y j denote respectively country j ' s outputs of cloth and wine
and N j stand for country j ' s fixed labor force. Country j ' s optimal prob-
lem is defined by
P 
Max Y j =  x x j + y j ,
P 
 y 
subject to
a1 j x j + a2 j y j ≤ N j , x j , y j ≥ 0 , j = 1, 2 , (2.2.4)
in which Y j is country j ' s real national income measured in terms of good

y and a1 j and a2 j are respectively country j ' s unit costs of production of
cloth and wine. The optimal problems defined by (2.2.4) can find an easy
graphic solution. It can be shown that international trade and international
specification occur as the consequence of the maximization of the real na-
tional income of each country.
2.3 The Trade Model and the Core Theorems in Trade Theory 33
The Ricardian model assumes that production costs are independent of

factor prices and the composition of output. The model throws no light on
issues related to the internal distribution of income since it assumes either
a single mobile factor or multiple mobile factors, which are used in equal
proportions in all sectors. From this theory, we can only determine the lim-
its within which the terms of trade must lie. Since it lacks consideration of
demand sides, the theory cannot determine how and at what value the
terms of trade are determined within the limits. This is a serious limitation
of this theory because a trade theory should be able to explain not only the
causes and directions of trade but also to determine the terms of trade.7
2.3 The 2 × 2 × 2 Trade Model and the Core Theorems in

Trade Theory
The Ricardian theory is concerned with technology. The theory has a sin-
gle factor of production. Nevertheless, economic activities involve many
factors. The Heckscher-Ohlin international trade theory is concerned with
factors of production. Before introducing the Heckscher-Ohlin theory in
the next section, we develop a two-good, two-factor model. Different from
the common dual approach to examining perfectly competitive two-factor
two-sector model in the trade literature,8 we use profit-maximizing ap-
proach to demonstrate the most well-known theorems in the Heckscher-
Ohlin trade theory. In Sect. 2.4, we illustrate the dual approach for the
same economic problems.
We are concerned with a single country. Assume that there are two fac-
tors of production, labor and capital. Their total supplies, N and K , are
fixed. The economy produces two goods with the following Cobb-Douglas
production functions9
7 The terms of trade measures the relationship between the price a country re-
ceives for its exports versus the price a country pays for its imports. The higher the
ratio, the more favorable terms of trade are for the country (Sawyer and Sprinkle,
2003: Chap. 2). In general, we need to introduce demand theory to determine the
terms of trade.
8 The dual approach is referred to, for instance, Woodland (1977, 1982), Mussa
(1979), and Dixit and Norman (1980). The geometric approach to the problem is
referred to, for instance, Lerner (1952), Findlay and Grubert (1959), and Gandolfo
(1994a).
9 The specified form is mainly for convenience of analysis. It can be shown that
if the production functions are neoclassical, then the essential conclusions of this
α β
F j = A j K j j N j j , j = 1, 2 , α j , β j > 0 , α j + β j = 1, (2.3.1)
where K j and N j are respectively capital and labor inputs of sector j .

We assume perfect competition in the product markets and factor markets.
We also assume that product prices, denoted by p1 and p2 , are given
exogenously. This assumption is acceptable, for instance, if the country is
open and small. Assume labor and capital are freely mobile between the
two sectors and are immobile internationally. This implies that the wage
and rate of interest are the same in different sectors but may vary between
countries. Let w and r stand for wage and rate of interest respectively.
Profits of the two sectors, π j , are given by
π j = p j F j − wN j − rK j .
The marginal conditions for maximizing profits are given by
α j p j Fj β j p j Fj (2.3.2)
r= , w= .
Kj Nj
The amount of factors employed in each sector is constrained by the en-

dowments found in the economy. These resource constraints are given
K1 + K 2 = K , N1 + N 2 = N . (2.3.3)
It is more realistic to use “ ≤ ” instead of “ = ”. We will use equalities for
simplicity of discussion.
Equations (2.3.2) and (2.3.3) contain 6 variables, N j , K j , w and r ,
and 6 equations for given p j , N and K . We now show that the six vari-
ables can be solved as functions of p j , N and K . First, from Eqs.
(2.3.2), we have
α1 p1 F1 α 2 p2 F2 β1 p1 F1 β 2 p2 F2 (2.3.4)
= , = .
K1 K2 N1 N2
From these relations, we have N1 = αkN 2 , where α ≡ α 2 β1 / α1 β 2 and

k ≡ K1 / K 2 . From N1 = αkN 2 and N1 + N 2 = N , we determine the labor
distribution as a function of the ratio of the two sectors’ capital inputs as
follows
section holds. Some of the discussions in this section are based on Leamer (1984)
and Feenstra (2004: Chap. 1).
αkN N (2.3.5)
N1 = , N2 = .
1 + αk 1 + αk
α β
Substituting F j = A j K j j N j j into β1 p1 F1 / N1 = β 2 p2 F2 / N 2 yields
β1 p1 A1 = β 2 p2 A2 K 2α 2 −α1 N 2β 2 − β1 (kα ) 1 , (2.3.6)

α
where we also use K1 = kK 2 and N1 = αkN 2 . Here we require α1 ≠ α 2 .

From k = K1 / K 2 and K1 + K 2 = K , we have K 2 = K / (1 + k ). Substitut-
ing this equation and N 2 in (2.3.5) into Eq. (2.3.6) yields
1 + αk (2.3.7)
= α0 ,
1+ k
where
1 / (α 2 −α1 )
 β pA  N
α 0 ≡  α1 1 1 1  .

 α β 2 p2 A2  K
We solve the above equation in k as follows

1 − α0 (2.3.8)
k= .
α0 − α
Two goods are produced if k > 0 . This is guaranteed if (1) 1 > α 0 > α or
(2) 1 < α 0 < α . The parameter, α 0 , lies between 1 and α . In the case of
α > 1, that is, α 2 > α1 , we should require
β1 α1 β2 α2
 β1   α1  p A N
α1 −α 2
β   α1  (2.3.9)
    < 2 2  <  1    .
 β2   α2  p1 A1  K   β2   α2 
It is direct to show that under α 2 > α1 , the right-hand side of (2.3.8) is
greater than the left-hand side. Hence, under “proper” combinations of
technological levels,10 relative price and factor endowments, we have a
unique positive solution k > 0 . We can similarly discuss Case (1). In the
rest of this section, we require α 2 > α1 and (2.3.8) to be held. Once we
10 It is difficult to explicitly interpret economic implications of these conditions
as a whole.
solve k , it is straightforward to solve all the other variables. From

k = K1 / K 2 and K1 + K 2 = K , we have
kK K (2.3.10)
K1 = , K2 = .
1+ k 1+ k
The labor distribution is given by Eqs. (2.3.4). As the distributions of
the factor endowments are already determined, it is straightforward for us
to calculate the output levels and factor prices.
As the production functions are neoclassical, the wage and rate of inter-
est are determined as functions of capital intensities, K j / N j . We now
α β
find out the expressions for the capital intensities. Insert F j = A j K j j N j j
in Eqs. (2.3.4)
1 / β1 β 2 / β1 1 / α1 α 2 / α1
K1  α1 pA1   K2  K β A   K2  (2.3.11)
=    , 1 =  2 2    ,
N1  α 2 A2   N2  N1  β1 pA1   N2 
where p ≡ p1 / p2 and we have repeatedly made use of the fact that
α j + β j = 1. We solve Eqs. (2.3.11) as
K1 K (2.3.12)
= a1 p β 0 , 2 = a2 p β 0 ,
N1 N2
in which β 0 ≡ 1 / (β1 − β 2 ) and

β0 β2β0 α 2β0 β0 β1 β 0 α1 β 0
A   β1   α1  A   β1   α1 
a1 ≡  1      , a2 ≡  1      .
 A2   β2   α2   A2   β2   α2 
It is important to note that the capital intensities are independent of N and
K . From marginal conditions (2.3.2) and F1 = A1 K1α1 N1β1 , we have
α1 A1 p2β1β 0 β1 A1a1α1 p1α 2 β 0 (2,3,13)

r= β1 β2β0
, w= α1 β 0
.
a1 p1 p2
We obtain the well-known factor price insensitivity lemma.
Lemma 2.3.1 (Factor Price Insensitivity)

So long as two goods are produced, then each price vector ( p1 , p2 ) corre-
sponds to unique factor prices (w , r ).
This lemma also implies that the factor endowments (N , K ) do not affect
(w , r ). “Factor price insensitivity” is referred to the result that in a two-
by-two economy, with fixed product prices, it is possible that the labor
force or capital has no effects on its factor price. This property does hold
even for the one-sector Ricardian model introduced in Sect. 2.2.
Another direct implication of our analytical results is Samuelson’s fac-

tor price equalization theorem.11
Theorem 2.3.1 (Factor Price Equalization Theorem, Samuelson, 1949)

Suppose that two countries are engaged in free trade, having identical
technologies but different factor endowments. If both countries produce
both goods, then the factor prices (w, r ) are equalized across the coun-
tries.
When trade takes place, then the relative price, p , is the same across the
countries. As the two countries have the identical technologies, that is, α j
and A j are identical across the countries, from Eqs. (2.3.13) we see that
Samuelson’s theorem holds. This theorem says that trade in goods may
equalize factor prices across the countries even when production factors
are immobile. One may consider that trade in goods is a perfect substitute
for trade in factors. It should be remarked that in the Ricardian model, this
result does not hold – equalization of the product price through trade
would not equalize wage rates across countries. In the Ricardian economy,
the labor-abundant country would be paying a lower wage.
Another well-known question in the trade literature is that when product
prices are changed, how the factor prices will be changed. Taking deriva-
tives of Eqs. (2.3.13) with respect to p1 and p2 results in
1 dr β2 1 dw α2
= , =− ,
r dp1 (α 1 − α 2 ) p1 w dp1 (α1 − α 2 ) p1
1 dw α1 1 dr β1 (2.3.14)
= , =− ,
w dp2 (α1 − α 2 ) p2 r dp2 (α1 − α 2 ) p2
11 A general treatment of the subject for any finite dimensional case is referred
to Nishimura (1991).
where we use β 0 = − 1 / (α1 − α 2 ). If α 2 > α1 , an increase in goods 1' s

price will increase the wage rate and reduce the rate of interest, and an in-
crease in goods 2' s price will reduce the wage rate and raise the rate of in-
terest.
We now introduce another important concept. For the two industries, we
say that industry 1 is capital-intensive if12
K1 K 2
> .
N1 N 2
If the inequality is inverse, then industry 1 is labor-intensive. From Eq.
(2.3.12), it is straightforward to show
K1 K 2 a p β0 (2.3.15)
− = (α1 − α 2 ) 2 .
N1 N 2 α 2 β1
We see that the sign of K1 / N1 − K 2 / N 2 is the same as that of α1 − α 2 .
If α 2 > α1 , then industry 1 is labor intensive.
Another important issue is related to changes in the real values, w / p j
and r / p j , in terms of goods. As we have already explicitly solved the
model, it is straightforward to calculate the effects of these changes. From
Eqs. (2.3.14), we have
d (r / p1 ) β1 r d (w / p1 ) α1w (2.3.16)
= < 0, =− > 0.
dp1 (α1 − α 2 ) p1
2
dp1 (α1 − α 2 ) p12
The real rate of interest falls and real wage rises under α 2 > α1 . As the
condition of α 2 > α1 implies that industry 1 is labor intensive, the price of
goods 1 rises the price of the factor that is intensively used and reduces the
price of the other factor. This is the Stolper-Samuelson (1941) Theorem.
Theorem 2.3.2 (Stolper-Samuelson Theorem)

An increase in the relative price of a good will increase the real return to
the factor used intensively in that good, and reduce the real return to the
other factor.
The implies that when product price changes because of changes in, for
instance, export conditions or tariffs, there will be both gainers and losers
due to the change. This implies that trade has distributional consequences
12 Similarly, we say that industry 1 is labor intensive if N1 / K1 > K 2 / N 2 .

within the country, which make some people worse off and some better
off, even though the aggregated result for the national economy is benefi-
cial.
We now examine effects of changes in the endowments. From Eq.
(2.3.8), we have
1 dk − (1 − α )α 0
= > 0,
k dN (1 − α 0 )(α 0 − α )N
1 dk
=
(1 − α )α 0 < 0.
(2.3.17)
k dK (1 − α 0 )(α 0 − α )K
Under α 2 > α1 and 1 < α 0 < α , dk / dN > 0 and dk / dK < 0 . Hence, an

increase in either of the factor endowments reduces the ratio of capital
stocks employed by industry 1 and industry 2 . From Eqs. (2.3.12), we
have
1 dK1 1 dN1 1 dk
= = > 0,
K1 dN N1 dN (1 + k )k dN
1 dK 2 1 dN 2 1 dk
= =− < 0,
K 2 dN N 2 dN (1 + k ) dN
N1 d (N1 / N 2 ) 1 dk N d (N1 / N 2 ) 1 dk
= > 0, 1 = < 0.
N2 dN k dN N2 dK k dK
An increase in either of the factor endowments reduces the ratio of labor
force employed by industry 1 and industry 2 . From Eqs. (2.3.10) and
(2.3.12), we obtain
1 dK1 1 dN1 1
= = < 0,
K1 dK N1 dK (1 − α 0 )K
1 dK 2 1 dN 2 1 dk 1 (2.3.18)
= =− + > 0.
K 2 dK N 2 dK (1 + k ) dK K
We note that changes in the endowments have no effect on the wage and
the rate of interest. From Eqs. (2.3.2), we directly obtain
1 dF1 1 dK1 1 dF2 1 dK 2
= < 0, = > 0,
F1 dK K1 dK F2 dK K 2 dK
1 dF1 1 dK1 1 dF2 1 dK 2 (2.3.19)

= > 0, = < 0.
F1 dN K1 dN F2 dN K 2 dN
We notice that industry 1 is labor intensive and industry 2 is capital inten-
sive. Equations (2.3.19) state another important theorem in the trade the-
ory.
Theorem 2.3.3 (Rybczynski Theorem, 1955)

An increase in a factor endowment will increase the output of the industry
using it intensively, and reduce the output of the other industry.
An often cited example for applying this theorem is the so called “Dutch
Disease”13. It was observed that the discovery of oil off the coast of the
Netherlands had led to an increase in industries making use of this re-
source and a decrease in other traditional export industries. The Rybczyn-
ski theorem predicts that for a small open economy, the increase in the re-
source would encourage the industry which uses the resource intensively
and reduce the other industry, with all the other conditions fixed.
Using our alternative approach to the common dual approach, we have
demonstrated the main conclusions about the standard two-factor too-
goods model for a small economy. As we have explicitly solved the equi-
librium problem with the Cobb-Douglas functions, it is straightforward for
us to prove the factor price insensitivity lemma, Samuelson’ factor price
equalization theorem, Stolper-Samuelson theorem, and Rybczynski’s theo-
rem. In fact, as shown in the literature,14 these theorems hold for general
(neoclassical) production functions. In our approach, we use the neoclassi-
cal production functions: F j = F j (K j , N j ). Marginal conditions for
maximizing profits are given by
[
r = p j f j' (k j ), w = p j f j (k j ) − k j f j' (k j ) ,] (2.3.20)
where
Kj F j (K j , N j )
kj ≡ , f j (k j ) ≡ .
Nj Nj
From p1 f1' (k1 ) = p2 f 2' (k 2 ), we find k 2 as a function k1 , denoted as

k 2 = φ (k1 ). It can be shown φ ' > 0 . From
13 See Corden and Neary (1982) and Jones et al. (1987).

14 For instance, Borkakoti (1998).
[ ] [ ]
p1 f1 (k1 ) − k1 f1' (k1 ) = p1 f 2 (φ (k1 )) − φ (k1 ) f 2' (φ (k1 )) .
This equation contains a single variable. From this equation, we solve k1 .

We see that k 2 , w and r are uniquely determined as functions of k1 . As
k1 is independent of N and K , k 2 , w and r are also independent of the
factor endowments. From Eqs. (2.3.3) and the definitions of k j , we have
the following four equations for the four variables
Kj
N1 + N 2 = N , K1 + K 2 = K , = kj ,
Nj
where k j are already known. We solve the above equations as
K − k2 N kN−K
N1 = , N2 = 1 ,
k1 − k 2 k1 − k 2
K1 =
(K − k 2 N )k1 , K2 =
(k1 N − K )k 2 .
k1 − k 2 k1 − k 2
We thus solved all the variables. It is not difficult to examine the compara-
tive statics results of the model with the neoclassical production functions.
Another important case of the 2× 2 model is that either capital or labor
is specific to the sector so that there is no capital or labor movement. A
common assumption is that capital is specific to the sector but labor can
move freely between the sectors. The rental rates for capital employed by
two sectors may vary. The 2× 2 model with specific-factors is called the
Ricardo-Viner or Jones-Neary model.15 The production functions are now
given by F j (K *j , N j ), where K *j are fixed levels of capital. The marginal
conditions for capital are given by
r j = p j f j' (k j ),
where r j is the rate of interest for capital j . It is straightforward to ana-

lyze behavior of the factor-specific model.16
15 See Viner (1931, 1950), Jones (1971) and Neary (1978a, 1978b).
16 See Wong (1995) and Markusen et al. (1995). The specific-factor model is
extended in two directions. First, Mussa (1974), Mayer (1974a) and Grossman
(1983) regard sector specificity as a short-run phenomenon and in the long run
capital is mobile. Second, the extension is to treat the capital stocks in the two sec-
2.4 The Dual Approach to the Two-Good, Two-Factor

Model
We now illustrate the dual approach commonly used in the literature of in-
ternational economics to examine the equilibrium properties of the two-
good two-sector model in Sect. 2.3.17 This section is based on Feenstra
(2004: Chap. 1).18
The basic assumptions are similar to the assumptions in Sect. 2.3. When
a symbol stands for the same variable, we will not explain it. The neoclas-
sical production functions are y j = F j (K j , N j ), where y j is the output of
good j . The resource constraints are
K1 + K 2 ≤ K , N1 + N 2 ≤ N . (2.4.1)
Maximizing the amount of good 2 , y2 = F2 (K 2 , N 2 ), subject to a given

amount of good 1, y1 = F1 (K1 , N1 ), and the resource constraints (2.4.1),
yields y 2 = h( y1 , K , N ). Under the assumptions of perfect competition,
the economy will maximize gross domestic product (GDP)
G ( p1 , p2 , K , N ) = max p1 y1 + p2 y2 s.t. : y2 = h( y1 , K , N ).
yj ≥ 0
The first-order condition for this problem is

p1 ∂h ∂y
p= =− =− 2.
p2 ∂y1 ∂y1
The economy produces where the relative price is equal to the slope of the
production possibility frontier. The function, G , has some “nice proper-
ties” for analyzing the equilibrium problem. Taking derivatives of this
function with respect to prices yields
tors as two different types of factors. This implies a three-factor, two-sector model
(see, for instance, Batra and Casas, 1976; Ruffin, 1981; Thompson, 1986; and
Wong, 1990).
17 The dual approach has been widely applied in static trade theory. Except this
example, this study does not follow this approach in deriving the classical results
of trade theory.
18 Explanations in detail and geometric illustrations are referred to Feenstra
(2004). We also refer this case to Appleyard and Field (2001).

2.4 The Dual Approach to the Two-Good, Two-Factor Model 43
∂G  ∂y ∂y 
= y j +  p1 1 + p2 2  = yj ,
∂p j  
 ∂p j ∂p j 
where we use the envelope theorem.19
The unit-cost functions which are dual to the production functions,
F j (K j , N j ), are defined by
c j (r , w) = min {rK j + wN j | F j (K j , N j ) ≥ 1}. (2.4.2)

Kj, Nj ≥0
Because of the assumption of constant returns to scale, the unit-costs are

equal to both marginal cost and average costs. The unit-cost functions are
nondecreasing and concave in (r , w). Let us express the optimal solution
of problem (2.4.2) as
c j (r , w) = ra jK (r , w) + wa jN (r , w),
where a jK and a jN are respectively the optimal choice of K j and N j .

They are functions of (r , w). According to the envelope theorem, we have
∂c j ∂c j (2.4.3)
= a jK , = a jN .
∂r ∂w
The zero-profit conditions are represented by
p j = c j (r , w), j = 1, 2 . (2.4.4)
The full employment conditions are now represented by

a1K y1 + a2 K y 2 = K , a1N y1 + a2 N y 2 = N . (2.4.5)
We now have four equations, (2.4.4) and (2.4.5) and four variables,
r , w , y1 and y2 , with four parameters, p1 , p2 , K and N . We are pre-
pared to prove the factor price insensitivity lemma, Samuelson’ factor price
19 The theorem states that when we differentiate a function that has been maxi-
mized with respect to an exogenous variable, then we can ignore the changes in
the endogenous variables in this derivative. In fact, by taking partial derivatives of
y2 = h( y1 , K , N ) with respect to p j and using ∂h / ∂y1 = − p1 / p2 , we obtain
∂y1 ∂y
p1 + p2 2 = 0 .
∂p j ∂p j
equalization theorem, Stolper-Samuelson theorem, and Rybczynski’s theo-

rem.
As c j (r , w) does not contain K and N , from Eqs. (2.4.4) we can
solve the factor prices as unique functions of the product prices under cer-
tain conditions.20 That is, Lemma 2.3.1 holds according to the dual ap-
proach. It is straightforward to see that Samuelson’s factor price equaliza-
tion theorem also holds. To prove the Stolper-Samuelson theorem, we take
total differentiation of Eqs. (2.4.4)
dp j = a jK dr + a jN dw , j = 1, 2 ,
where we use Eqs. (2.4.3). We may rewrite the above equations as

dp j ra jK dr wa jw dw
= + , j = 1, 2 .
pj cj r cj w
Let θ jK ≡ ra jK / c j and θ jN ≡ wa jN / c j respectively denote the cost shares

of capital and labor. Then, the above equations can be expressed as
pˆ j = θ jK rˆ + θ jN wˆ , j = 1, 2 ,
in which a variable with circumflex ^ represents the percentage change of

the variable, for instance, pˆ j = dp j / p j = d ln p j . 21 We solve the two lin-
ear equations in r̂ and ŵ as
rˆ =
(θ1N − θ 2 N ) pˆ 2 − ( pˆ 1 − pˆ 2 )θ 2 N
,
θ1 N − θ 2 N
wˆ =
(θ1K − θ 2 K ) pˆ 1 + ( pˆ 1 − pˆ 2 )θ1K
,
θ1 N − θ 2 N
where we use θ jK + θ jN = 1. For convenience of discussion, assume hence-
forth that industry 1 is labor intensive, that is, L1 / K1 > L2 / K 2 . We have
the following relations
These conditions are that both goods are produced and factor intensity rever-
20
sals do not occur. The latter means that the two zero-profit conditions intersect
only once.
21 Expressing the equation using the cost shares and percentage changes follow
Jones (1965) and is referred to as “Jones’ algebra”.

L1 L
> 2 ⇔ θ1 N > θ 2 N ⇔ θ1 K < θ 2 K .
K1 K 2
Moreover, suppose that the relative price of good 1 increases, so that
ˆp = pˆ 1 − pˆ 2 > 0 . With these assumptions, we have
rˆ < pˆ 2 , wˆ > pˆ 1 > pˆ 2 .

The above inequalities are the contents of the Stolper-Samuelson theo-
rem.
To confirm the Rybczynski theorem, totally differentiate Eqs. (2.4.5)
a1K dy1 + a2 K dy2 = dK ,
a1N dy1 + a2 N dy2 = dN ,
where we use the fact that the wage and rate of interest are independent of
the resource endowments. Rewrite the above equations as
λ1K yˆ1 + λ2 K yˆ 2 = Kˆ , (2.4.6)
λ1N yˆ1 + λ2 N yˆ 2 = Nˆ ,
where λ jK ≡ y j a jK / K = K i / K and λ jN ≡ y j a jN / N = N j / N respectively
denote the fraction of capital and the labor force employed in industry j .
We also have λ jK + λ jN = 1. As industry 1 is labor intensive, we have
λ1N − λ2 N > 0 . First, we examine the case of Nˆ > 0 and Kˆ = 0 . We solve
Eqs. (2.4.6) as
λ2 K Nˆ − λ1K Nˆ (2.4.7)
yˆ1 = > Nˆ , yˆ 2 = < 0.
λ2 K − λ2 N λ2 K − λ2 N
We can similarly examine the case of Nˆ = 0 and Kˆ > 0 . The Rybczynski

theorem is thus proved.
2.5 The Heckscher-Ohlin Theory
The classical distinction introduced by Ricardo and maintained by most of

his followers has factors of production trapped within national boundaries.
Only final commodities can be traded. The Heckscher-Ohlin theory shows
that international trade in commodities could alleviate the discrepancy be-
tween countries in relative factor endowments. This takes places indirectly

when countries export those commodities that use intensively the factors in
relative abundance. In 1933, Ohlin, a Swedish economist, published his re-
nowned Interregional and International Trade. The book built an economic
theory of international trade from earlier work by Heckscher (another Swed-
ish economist, Ohlin’s teacher) and his own doctoral thesis.22 The theory is
now known as the Heckscher-Ohlin model, one of the standard models in the
literature of international economics. Ohlin used the model to derive the so-
called Heckscher-Ohlin theorem, predicting that nations would specialize in
industries most able to utilize their mix of national resources efficiently. Im-
porting commodities that would use domestic scarce factors if they were
produced at home can relieve the relative scarcity of these factors. Hence,
free trade in commodities could serve to equalize factor prices between
countries with the same technology, even though the production inputs do
not have an international market.
The Ricardian model and Heckscher-Ohlin model are two basic models
of trade and production. They provide the pillars upon which much of pure
theory of international trade rests. The so-called Heckscher-Ohlin model
has been one of the dominant models of comparative advantage in modern
economics. The Heckscher-Ohlin theory emphasizes the differences be-
tween the factor endowments of different countries and differences be-
tween commodities in the intensities with which they use these factors.
The basic model deals with a long-term general equilibrium in which the
two factors are both mobile between sectors and the cause of trade is dif-
ferent countries having different relative factor endowments. This theory
deals with the impact of trade on factor use and factor rewards. The theory
is different from the Ricardian model which isolates differences in tech-
nology between countries as the basis for trade. In the Heckscher-Ohlin
theory costs of production are endogenous in the sense that they are differ-
ent in the trade and autarky situations, even when all countries have access
to the same technology for producing each good. This model has been a
main stream of international trade theory. According to Ethier (1974), this
theory has four “core proportions”. In the simple case of two-commodity
and two-country world economy, we have these four propositions as fol-
lows: (1) the factor-price equalization theorem by Lerner (1952) and
Samuelson (1948, 1949), stating that free trade in final goods alone brings
about complete international equalization of factor prices; (2) the Stolper-
Samuelson theory by Stolper and Samuelson (1941), saying that an in-
22 The original 1919 article by Heckscher and the 1924 dissertation by Ohlin
have been translated from Swedish and edited by Flam and Flanders (Heckscher
and Ohlin, 1991).
crease in the relative price of one commodity raises the real return of the
factor used intensively in producing that commodity and lowers the real re-
turn of the other factor; (3) the Rybczynski theorem by Rybczynski (1955),
stating that if commodity prices are held fixed, an increase in the endow-
ment of one factor causes a more than proportionate increase in the output
of the commodity which uses that factor relatively intensively and an abso-
lute decline in the output of the other commodity; and (4) the Heckscher-
Ohlin theorem by Heckscher (1919) and Ohlin (1933), stating that a coun-
try tends to have a bias towards producing and exporting the commodity
which uses intensively the factor with which it is relatively well-endowed.
The previous section has already confirmed the factor price insensitivity
lemma, Samuelson’ factor price equalization theorem, Stolper-Samuelson
theorem, and Rybczynski’s theorem. We now confirm the Heckscher-
Ohlin theorem. The original Heckscher-Ohlin model considers that the
only difference between countries is the relative abundances of capital and
labor. It has two commodities. Since there are two factors of production,
the model is sometimes called the “ 2 × 2 × 2 model.” The Heckscher-Ohlin
theorem holds under, except the assumptions for the two-product two-
factor model developed in Sect. 2.3, the following assumptions: (1) capital
and labor are not available in the same proportion in both countries; (2) the
two goods produced either require relatively more capital or relatively
more labor; (3) transportation costs are neglected; (4) consumers in the
world have the identical and homothetic taste. Like in Sect. 2.2, we call the
two countries as Foreign and Home. We will use the same symbol as in
Sect. 2.3 and the variables for Foreign with a tilde ~. We assume that
~ ~
Home is labor abundant, that is, N / K > N / K . The two countries have
identical technologies. We also assume that good 1 is labor intensive.
Trade is balanced, that is, value of exports being equal to value of imports.
Under these assumptions, the following Heckscher-Ohlin theorem holds.
Theorem 2.5.1 (Heckscher-Ohlin Theorem)

Each country will export the good that uses its abundant factor intensively.
The theorem implies that Home exports good 1 and Foreign exports 2 . In
order to determine trade directions, we need mechanisms to determine
prices of goods. The analytical results in Sect. 2.3 and or the dual theory in
Sect. 2.4 cannot yet determine prices. To determine trade directions, we
further develop the economic model in Sect. 2.3. We now introduce a
utility function to determine prices in autarky. After we determine the
prices in autarky, we can then determine the directions of trade flows. The
consumer’s utility-maximizing problem is described as
Max C1ξ1 C 2ξ 2 , s.t. : p1C1 + p2C 2 = Y ,

where C j is the consumption level of good j , ξ1 and ξ 2 are positive
parameters, and Y is the total income given by
Y = rK + wL .
For simplicity, we require ξ1 + ξ 2 = 1. The optimal solution is given by
p j C j = ξ jY .
As C j = F j , we have
p1 F1 ξ1
= .
p2 F2 ξ 2
Substituting r = α j p j F j / K j into the above equation yields k = ξ , where

we use k = K1 / K 2 and ξ = α1ξ1 / α 2ξ 2 . Substituting Eq. (2.3.8) into the
above equation yields
1 + αξ (2.5.1)
np1/ (α 2 −α1 ) = ,
(ξ + 1)α *
where
1 / (α 2 −α1 )
N  βA 
n ≡ , α * ≡  α1 1 1  .
K α β A 
 2 2 
Equation (2.5.1) determines the relative price in Home. According to the

assumptions that the two countries have the identical technology and pref-
erence, the values of the parameters for Foreign corresponding to α , ξ
and α * are equal to the values of α , ξ and α * . We thus have
np1/ (α 2 −α1 ) = n~~

p1/ (α 2 −α1 ) . (2.5.2)
~ ~
The assumption of N / K > N / K implies n > n~ . For n > n~ and Eq.
(2.5.2) to hold, we should have
p1/ (α 2 −α1 ) < ~
p1/ (α 2 −α1 ) .
The assumption that good 1 is labor intensive implies α 2 > α1 . As

α 2 − α1 > 0 , we have p < ~p , that is
p1 ~
p
< ~1 .
p2 p2
Hence, when the two countries are in autarky, the relative price in Home
is lower than the relative price in Foreign. This implies that when the two
countries start to conduct trade, good 1 is exported to Foreign and good 2
is imported from Foreign. We have thus confirmed the Heckscher-Ohlin
theorem. It should be noted that we do not determine trade volumes. We
will not further examine this model in this section as we will study a more
general trade equilibrium model later on.
The Heckscher-Ohlin model was a break-through because it showed how
comparative advantage might be related to general features of a country’s
capital and labor. Although the theory cannot describe how these features
vary over time, it can be used to provide insights into some simple dy-
namic trade issues. In the light of modern analysis, Ohlin’s original work
was not sophisticated. The original model has been generalized and extended
since the 1930s. Mundell (1957) first developed a geometric exploration of
the model with substitute relationship between factor movements and
commodity trade in a Heckscher-Ohlin setting. Here, by trade in commodi-
ties being a substitute for international mobility of factors we mean that the
volume of trade in commodities is diminished if factors are allowed to see
their highest return in global markets. Mundell analyzed a two-country
economy in which the two countries share the same technologies for pro-
ducing the same two commodities with different factor endowments. Free
trade leads to a trade pattern that the relatively capital-abundant country
exports its relatively capital-intensive commodity, and the return to capital
equalized between countries. Notable contributions were made by Paul
Samuelson, Ronald Jones, and Jaroslav Vanek.23 In the modern literature,
these syntheses are sometimes called the Heckscher-Ohlin-Samuelson (HOS)
model and the Heckscher-Ohlin-Vanek (HOV) model. We now mention a
few basic results from the HOV model.24
The economy of the HOV model consists of C countries (indexed by
i = 1, ... , C ), J industries (indexed by j = 1, ... , J ), and M factors (in-
dexed by κ , l = 1, ... , M ). Assume that technologies and tastes are identi-
cal across countries and factor price equalization prevails under free trade.
23 These developments introduce many real-world considerations into the basic

analytical framework, even though the fundamental role of variable factor propor-
tions in driving international trade remains.
24 The rest of this section is based on Feenstra (2004: Chaps. 2 and 3). Wong
(1997) represents a comprehensive treatment of the subject.

Let a jκ stand for the amount of factor κ needed for one unit of production
[ ]
in industry j , and A ≡ a jκ
T
M ×J
. The matrix is valid for any country. Let
Y i and D i represent respectively the (J ×1) vectors of outputs in each in-
dustry and demands of each good in country i . Country i' s net exports
vector is
T i = Y i − Di .
The factor content of trade is defined as F i ≡ AT i , which is a (M ×1)

vector. Let Fκi and Fli represent respectively the individual positive and
negative components of F i . The HOV model reveals the relation between
the factor content of trade and the endowments of the country. We note
that AY i represents the demand for factors in the country. Let V i = AY i .
Since product prices are equalized across countries, the consumption vec-
tors of all countries must be proportional to each other. Hence, we can ex-
press D i = s i D w , where D w is the world consumption vector and s i is
the share of country i in the world consumption. As trade is balanced, s i
also represents the country’s share in the world GDP. Since world con-
sumption equals world production, we have
AD i = s i AD w = s i AY w = s iV w .
We thus have the following relations
F i ≡ AT i = V i − s iV w . (2.5.3)
This equation represents the content of the HOV theorem. If country i' s
endowment of factor κ relative to the world endowment exceeds its share
of world GDP, that is, Vκi / Vκw > s i , that is, F i > 0 , we say that country i
is abundant in that factor. When we have two factors, capital and labor,
then the following theorem holds.
Theorem 2.5.2 (Leamer, 1980)

Let there be only two production factors, capital and labor. If capital is
abundant relative to labor in country i , then the HOV theorem implied by
Eqs. (2.5.3) means that the capital/labor ratio embodied in production for
country i exceeds the capital/labor ratio embodied in consumption
K i K i − Fκi (2.5.4)
> i ,
Li L − Fli
where K i and Li are respectively the capital and labor endowments for
country i .
This theorem holds for only two product factors. It has become clear
that the results for the 2 × 2 × 2 model are not valid for many countries
with many factors and many products.25 The Heckscher-Ohlin model has
been extended and generalized in many other ways. For instance, Purvis
(1972) proposed a trade model, showing that trade in commodities and
mobility of factors might be complements. By complements, it means that
opening up factor mobility could cause the previous level of international
trade in commodities to rise. In Purvis’ framework, the pattern of trade
might reflect different technologies between countries that happen to be
endowed with the same factor endowment proportions. If the home coun-
try has an absolute technological advantage in producing the labor-
intensive commodity which will be exported in the free trade system, its
wage rate will be higher. Free migration attracts the foreign labor because
of the higher wage. Consequently, free trade expands the volume of ex-
ports. In this case, trade in commodities and factor mobility is comple-
ments. Markusen (1983) synthesized the ideas in the two approaches, con-
cluding that if trade is a refection of endowment differences, commodities
and factors are substitutes, while if trade is prompted by other differences,
they can be compliments. A further examination of these ideas is referred
to Jones (2000). Leontief tried to empirically test the theory, concluding
that the theory is empirically not valid.26 Leontief observed that the United
States had a lot of capital. According to the Heckscher-Ohlin theory, the
United States should export capital-intensive products and import labor-
intensive products. But he found that that it exported products that used
more labor than the products it imported. This observation is known as the
Leontief paradox. From the assumptions made in the Heckscher-Ohlin
theory, it is evident that the assumptions are strict. An early attempt to
solve the paradox was made by Linder in 1961. The Linder hypothesis
emphasizes demand aspects of international trade in contrast to the usual
25 Reviews about the literature on equilibrium trade models with many goods
and many factors is referred to, for instance, Wong (1997) and Feenstra (2004).
26 Many other researches are conducted to test the theory, for instance, Leamer
(1980), Bowen et al. (1987), Trefler (1993, 1995), and Davis and Weinstein
(2001).
supply-oriented theories involving factor endowments. Linder predicted

that nations with similar demands would develop similar industries. These
nations would then trade with each other in similar but differentiated
goods. Batra and Beladi (1990) propose a two-good and two-factor trade
model with unemployment. It is observed that in spite of the presence of
trade, the capital-rich countries have higher wages but lower capital rents
than the labor surplus and/or land-rich countries. This conflicts with the
factor-price equalization theorems of the Heckscher-Ohlin international
trade theory. Also, labor-rich countries usually export either labor-
intensive or land-using commodities. Assuming that wages are institution-
ally fixed, Battra and Beladi demonstrate some phenomena which are not
compatible with what the Heckscher-Ohlin theory predicts.
2.6 The Neoclassical Trade Theory
The Ricardian theory failed to determine the terms of trade, even though it
can be used to determine the limits in which the terms of trade must lie.
The Heckscher-Ohlin theory provides simple and intuitive insights into the
relationships between commodity prices and factor prices, factor supplies
and factor rewards, and factor endowments and the pattern of production
and trade. Although the Heckscher-Ohlin model was the dominant frame-
work for analyzing trade in the 1960s, it had neither succeeded in supplant-
ing the Ricardian model nor had been replaced by the specific-factor trade
models. Each theory has been refined within its own ‘scope’. Each theory is
limited to a range of questions. It is argued that as far as general ideas are
concerned, the Heckscher-Olin theory may be considered as a special case
of the neoclassical theory introduced in this section as it accepts all the
logical promises of neoclassical methodology.27 The Heckscher-Olin the-
ory may be seen as a special case of the neoclassical trade theory in which
production technology and preferences are internationally identical.
It was recognized long ago that in order to determine the terms of trade,
it is necessary to build trade theory which not only takes account of the
productive side but also the demand side.28 The neoclassical theory holds
that the determinants of trade patterns are to be found simultaneously in
the differences between the technologies, the factor endowments, and the
tastes of different countries.29 Preference accounts for the existence of in-
ternational trade even if technologies and factor endowments were com-
27 For instance, Gandolfo (1994a).

28 For instance, Negishi (1972), Dixit and Norman (1980), and Jones (1979).
29 See Mill (1848) and Marshall (1890).
pletely identical between countries. As an illustration of the neoclassical

trade theory, we show how Mill solved the trade equilibrium problem and
how this problem can be solved with help of modern analytical tool. Mill
introduced the equation of international demand, according to which the
terms of trade are determined so as to equate the value of exports and the
value of imports. Mill argued: “the exports and imports between the two
countries (or, if we suppose more than two, between each country and the
world) must in the aggregate pay for each other, and must therefore be ex-
changed for one another at such values as will be compatible with the
equation of the international demand.30” He initiated the theory of recipro-
cal demand which is one of the earliest examples of general equilibrium
analysis in trade theory. In Chap. 18, book 3 of his Principles, he showed
the existence of trade equilibrium, using a simplified model and explicitly
solving equations in the model numerically. He assumed that there exists
only one factor of production and production is subjected to constant re-
turns to scale and requires on the demand side as follows: “Let us therefore
assume, that the influence of cheapness on demand conforms to some sim-
ple law, common to both countries and to both commodities. As the sim-
plest and most convenient, let us suppose that in both countries any given
increase of cheapness produces an exactly proportional increase of con-
sumption; or, in other words, that the value expended in the commodity,
the cost incurred for the sake of obtaining it, is always the same, whether
that cost affords a greater or a smaller quantity of the commodity.31” As a
numerical example, consider that the world economy consists of Germany
and England and the economic system has two goods, cloth and linen. Let
us assume that in Germany 10 yards of cloth was exchanged for 20 yards
of linen and that England wants to sell 1,000,000 yards of cloth to Ger-
many. If Germany wants 800,000 yards of cloth, this is equal to 1,600,000
yards of linen at German exchange ratio. Since German expended value in
cloth is constant, England will receive 1,600,000 yards of linen in ex-
change of 1,000,000 yards of cloth, replacing Germany supply of cloth en-
tirely. Under the assumption mentioned above and some additional re-
quirements, Mill explicitly solved the international exchange ratio of two
commodities in terms of coefficients of production in two countries and by
so doing showed the existence of trade equilibrium. Chipman pointed out
that the case analyzed by Mill can be treated as a problem of non-linear
30 Mill (1848: 596).

31 Mill (1848: 598).
programming and the existence of trade equilibrium can be proved by the

existence theorem of a solution of non-linear programming.32
We now use analytical methods to prove the existence of trade equilib-
rium as shown by Mill.33 This example also illustrates the difference be-
tween the Ricardian theory and the neoclassical theory. Let subscript in-
dexes 1 and 2 represent respectively Germany and England. We denote
the amount of cloth and linen produced by country j respectively y jc and
y jl which are non-negative. If we denote the total amount of cloth (linen)
produced in country j when the country is completely specified in pro-
ducing cloth (linen) by a jc ( a jl ), the possible sets of y jc and y jl are given
by
y jc y jl (2.6.1)
+ ≤ 1, y jc , y jl ≥ 0 , j = 1, 2 .
a jc a jl
The above two equations mean that the demand for labor does not exceed
the supply in each country. We denote respectively the prices of cloth and
linen by pc and pl . At equilibrium country j should choose
( y jc , y jl ) such that the following GDP is maximized
pc
y jc + y jl .
pl
Multiplying (2.6.1) by a jc ( j = 1, 2 ) and adding the two equations, we get
a1c a
yc + y1l + 2 c ≤ ac ,
a1l a2 l
where
yc ≡ y1c + y2 c , ac ≡ a1c + a2 c .
If we assume that Germany has the comparative advantage in linen, i.e.,
a1c / a1l < a2 c / a2 l , from the above inequality we get
yc y a (2.6.2)
+ l ≤ c ,
a1c a1l a1c
32 See Chipman (1965a, 1965b) and Negishi (1972).

33 See Negishi (1972).
where yl ≡ y1l + y2l . Similarly multiplying (2.6.1) by a jl , we get
yc y a (2.6.3)
+ l ≤ l ,
a 2 c a2 l a 2 l
where al ≡ a1l + a2 l . In order to describe the demand, let

xc (≥ 0) , xl ( ≥ 0) and R (≥ 0) respectively stand for the demand for
cloth, demand for linen, and income measured in terms of the factor of
production. Maximizing the following utility
U = xc xl ,
subject to the budget constraint pc xc + pl xl = R yields the demand func-

tions
R R
xc = , xl = ,
2 pc 2 pl
which satisfy Mill’s assumption. Since the two countries have an identical
preference structure but different incomes, we have that country j' s de-
mand for cloth and linen, X jc and X jl , are given by
Rj Rj (2.6.4)
X jc = , X jl = , j = 1, 2 ,
2 pc 2 pl
where R j is country j' s income. Since demands for commodities cannot

exceed supplies at the equilibrium of free international trade, we have
X c ≤ y1c + y 2 c , X l ≤ y1l + y 2l , (2.6.5)
where
X c ≡ X 1c + X 2 c , X l ≡ X 1l + X 2l .
Introduce the world utility function as
U = log X c + log X l .
We maximize this U subject to (2.6.1) and (2.6.5). The Lagrangean is
given by
log X c + log X l + pc ( y1c + y 2 c − X c ) + pl ( y1l + y 2 l − X l )

2  y jc y jl 
+ ∑ wj + − 1 .
 
j =1  a jc a jl 
It is shown that the Lagrangean has a strictly positive saddle point at which
(2.6.1) and (2.6.5) are satisfied with equality at the saddle point. In fact,
this saddle point is an equilibrium of free international trade, with
pc / pl , w1 / pl and w2 / pl respectively satisfying the price of cloth, the
price of factor of production in Germany and in England. Since the world
total income is equal to
pc X c + pl X 1 = w1 + w2 ,
we have R j = w j . By (2.6.4) we get X jc and X jl which is an optimal so-

lution of the problem that country j maximizes its utility subject to its
budget constraint with the given world prices.
2.7 A General Two-Country Two-Good Two-Factor Trade

Model
Section 2.3 examined a two-good two-factor model with fixed prices. Sec-
tion 2.5 determined prices for an autarky economy by studying house-
holds’ utility-maximizing behavior. Section 2.6 showed how the neoclassi-
cal economic trade theory determines trade pattern for a two-country world
with a single factor. This section develops a general equilibrium model for
a two-country two-sector two-factor economy, synthesizing the models in
the previous sectors.34
2.7.1 The General Equilibrium Model
The two countries are called Home and Foreign. Assume that there are two
factors of production, labor and capital. For Foreign, we will use the same
symbol that we use for Home, but with a tilde ~. Home’s and Foreign’s to-
tal supplies of capital and labor are fixed and are denoted respectively by,
34 This section will not analyze pattern of specializations in detail, as we will
examine similar issues in Chap. 7 when dealing with economic structures with
capital accumulation.
2.7 A General Two-Country Two-Good Two-Factor Trade Model 57
~ ~
N and K , N and K . Each economy may produce two goods with the fol-
lowing Cobb-Douglas production functions
α β
F j = A j K j j N j j , j = 1, 2 , α j , β j > 0 , α j + β j = 1, (2.7.1)
where K j and N j are respectively capital and labor inputs of sector j in

Home and Foreign. A variable with macron ¯ stands for both Home and
Foreign. We assume perfect competition in the product markets and factor
markets. Let p j stand for the price of good j . Assume labor and capital
are freely mobile between the two sectors and are immobile internation-
ally. This implies that the wage and rate of interest are the same in differ-
ent sectors but may vary between countries. Let w and r stand for, re-
spectively, wage and rate of interest in Home and Foreign. Marginal
conditions for maximizing profits are given by
r = , w= .
Kj Nj

K1 + K 2 = K , N1 + N 2 = N . (2.7.3)
Each country’s income is given by

Y = rK + w N . (2.7.4)
The consumer’s utility-maximizing problems are described as

Max C1ξ 01 C2ξ 02 , s.t. : p1C1 + p2C2 = Y , ξ 01 , ξ 02 > 0 ,
where C j is the consumption level of good j in Home and Foreign. The

optimal solution is given by
p j C j = ξ jY j , j = 1, 2 , (2.7.5)
where
ξ0 j
ξj ≡ > 0 , j = 1, 2 .
ξ 01 + ξ 02
We now describe trade balances. The total output of world production of
any good is equal its total consumption. That is
~ ~ (2.7.6)
C j + C j = Fj + Fj .
~
Let X j and X j stand for respectively the amount of (net) imports of
good j by Home and Foreign. When the variable is negative (positive),
then the country exports (imports) that good. A country’s consumption
plus its exports is equal to its total product. That is
C j = F j + X j , j = 1, 2 . (2.7.7)
The sum of the net exports for any good in the world is equal to zero, that
is
~ (2.7.8)
X j + X j = 0 , j = 1, 2 .
From Eqs. (2.7.7) and (2.7.8), we directly obtain Eqs. (2.7.6). Hence, two
equations in (2.7.6)-(2.7.8) are redundant.
In terms of value, any country is in trade balance, that is
p1 X 1 + p2 X 2 = 0 .
From these conditions and Eqs. (2.7.8), we have35
~ ~
X 1 = pX 2 , pX 2 = X 1 ,
where p ≡ p1 / p2 .
We now solve the model. We have 26 variables, p1 , p2 , E j , X j , F j ,
N j , K j , w and r , to determine. First, from Eqs. (2.7.2), we have
α1 p1 F1 α 2 p2 F2 β1 p1 F1 β 2 p2 F2 (2.7.9)
= , = .
K1 K2 N1 N2
From these relations, we have N1 = α k N 2 , where α ≡ α 2 β1 / α 1 β 2 and

k ≡ K1 / K 2 . From N1 = α k N 2 and N1 + N 2 = N , we determine the labor
distribution as a function of the ratio of the two sectors’ capital inputs as
follows
α kN N (2.7.10)
N1 = , N2 = .
1 + αk 1 + αk
35 This is also obtainable from Walras’s law.

α β
Substituting F j = A j K j j N j j into β1 p1 F1 / N1 = β 2 p2 F2 / N 2 yields
β1 p1 A1 = β 2 p2 A2 K 2α 2 −α1 N 2β 2 − β1α α1 , (2.7.11)
where we also use N1 = α k N 2 . As in Sect. 2.3, we require α1 ≠ α 2 . From

k = K1 / K 2 and K1 + K 2 = K , we have K 2 = K / 1 + k . Substituting ( )
( )
K 2 = K / 1 + k and N 2 in (2.7.10) into Eq. (2.7.11) yields
1 + αk (2.7.12)
= α 0 pυ ,
1+ k
where
υ
p  βA  N 1
p ≡ 1 , α 0 ≡  α1 1 1  , υ ≡ .
 
p2  α β 2 A2  K α 2 − α1
We solve the above equation in k as follows

1 − α 0 pυ (2.7.13)
k = .
α 0 pυ − α
~
The two goods are produced in Home if k > 0 and in Foreign if k > 0 .
We have k > 0 if (1) 1 > α 0 pυ > α or (2) 1 < α 0 pυ < α . The variables,
α 0 pυ , lies between 1 and α . In the case of α > 1, that is, α 2 > α1 , we
should require36
 β1 
β1
 α1 
α1

α1 −α 2
β 
β2
 α1 
α2 (2.7.14)
A N
    < 2   <  1    .
 β2   α2  pA1  K   β2   α2 
It is direct to show that under α 2 > α1 , the right-hand side of (2.3.8) is
greater than the left-hand side. Hence, under proper combinations of tech-
nological levels, relative price and factor endowments, we have a unique
positive solution k > 0 . In the rest of this section, for simplicity we re-
quire α 2 > α1 in Home and Foreign. We omit the other possibilities of
α~ ≤ α~ and α ≥ α or α~ ≥ α~ and α ≤ α .
2 1 2 1 2 1 2 1
36 The conditions guarantee that both countries produce two goods. If these
conditions are not satisfied, then one or two countries may specialize in producing
a single good.
Once we solve k , it is straightforward to solve all the other variables.

From k = K1 / K 2 and K1 + K 2 = K , we have
kK K (2.7.15)
K1 = , K2 = .
1+ k 1+ k
The labor distribution is given by Eqs. (2.7.10). As the distributions of the
factor endowments are determined as unique functions of the relative
price, we can calculate the output levels and factor prices.
As the production functions are neoclassical, the wage and rate of inter-
est are determined as functions of capital intensities, K j / N j . We now
α βj
find the expressions for the capital intensities. Insert F j = A j K j j N j in
Eqs. (2.7.9)
1 / β1 β 2 / β1 1 / α1
 K2 
α 2 / α1 (2.7.16)
K1  α 1 pA1   K2  K1  β 2 A2 
=    , =    .
N1  α 2 A2   N2  N1  β1 pA1   N2 
We solve Eqs. (2.3.11) as
K1 K (2.7.17)
= a1 pυ , 2 = a2 pυ ,
N1 N2
in which
υ β 2υ α 2υ υ β1υ α1υ
A   β1   α1  A   β1   α1 
a1 ≡  1      , a2 ≡  1      .
 A2   β2   α2   A2   β2   α2 
We note that the capital intensities are independent of N and K . From
marginal conditions (2.7.2) and F1 = A1 K1α1 N1β1 , we have
α1 A1 p2β1υ β1 A1a1α1 p1α 2υ (2.7.18)

r = β1 β 2υ
, w= α1υ
.
a1 p1 p2
From the definitions of Y and the marginal conditions, it is straightfor-

ward to show Y = F1 + F2 . From this equation, Y = r K + w N and
α β
F j = A j K j j N j j , we have
r K + w N = A1 K1α1 N1β1 + A2 K 2α 2 N 2β 2 .
Substituting Eqs. (2.7.18) and (2.7.17) into the above equation yields
 α1 A1 K 
 β + β1 A1a1α1 pυ N  p2 = A1 N1 a1α1 p (α1 + β 2 )υ + A2 N 2 a2α 2 pυ .
 a1 
1
Insert Eqs. (2.7.10) and (2.7.13) in the above equation

(n + b p )p
υ
1 = A1α a1α1 (1 − α 0 pυ ) + (α 0 pυ − α )A2 a2α 2 p , (2.7.19)
where
n≡
(1 − α )α 0α1 A1 K , b ≡ (1 − α )α 0 β1 A1a1α1 .
β1
a1 N
Dividing the two equations in (2.7.19) yields
n + bpυ
Ω( p ) ≡ ~ ~ υ~ −
(1 − α 0 pυ )A1αa1α1 + (α 0 pυ − α )A2 a2α 2 p = 0. (2.7.20)
n + bp (1 − α~0 pυ~ )A~1α~a~1α~1 + (α~0 pυ~ − α~ )A~2 a~2α~2 p
The equation, Ω( p ) = 0 , contains a single variable, p . Once we determine
a meaningful solution of the equation, all the other variables in the system
are uniquely determined as functions of the solution.
Lemma 2.7.1
Assume that α 2 > α1 and α~2 > α~1 . If the equation, Ω( p ) = 0 , has a posi-
tive solution satisfying (2.7.14), then each country produces two goods.
The world trade equilibrium is determined by the following procedure: p
by (2.7.20) → p1 by (2.7.19) → p2 = p1 / p → r and w by (2.7.18) →
Y = r K + w L → C j , j = 1, 2 , by (2.7.5) → k by (3.7.13) → K j by
~
(3.7.15) → N j by (3.7.10) → F j by (3.7.1) → E j = − E j = F j − C j .
It is difficult to interpret the conditions for Ω( p ) = 0 to have meaning-

ful solutions. As the problem is difficult to analyze, we are concerned with
a special case. First, we examine the Heckscher-Ohlin model, in which all
aspects, except the factor endowments, of the two economies are identical.
From the definitions of the parameters and Eq. (2.7.20), the relative price
is determined by
n + bpυ
−
(1 − α 0 pυ )A1αa1α1 + (α 0 pυ − α )A2 a2α 2 p = 0.
n + b pυ (1 − α~0 p )A1αa1 1 + (α~0 p − α )A2 a2 2 p
~ υ α υ α
in which we use n = n~ . From the above equation, we have

 a α + β1a1  αa1α1 A1
p =  2 1  α .
 a2α1 + αβ1a1  a2 A2
2
Further calculating yields

α 1 β1 (2.7.21)
p= > 0.
α 2β2
where we use
a2  β1  α 2  a1α1 A1 β 2
=    , = .
a1  β 2  α 1  a2α 2 A2 β1
If p satisfies (2.7.14), that is

1/υ 1/υ
A  β1 
1+ β1
 α1 
1+α1
 K  A1  β1   α1  
1+ β 2 1+α 2
 1      < <      ,
 A2  β2   α2   N  A2  β 2   α 2  
 
then the problem has a unique equilibrium point and each country pro-
duces two goods. The relative price is not dependent on any production
factor. From Eq. (2.7.19), we get
p1 =
(1 − α 0 pυ )A1αa1α1 + (α 0 pυ − α )A2 a2α 2 p
,
(2.7.22)
n + bpυ
where we use α 0 = a2 N / K . The prices are related to factor endowments.

Following Lemma 2.7.1, we can determine all the other variables. Home’s
net export of good 1 is given by
ξ1Y (2.7.23)
F1 − C1 = F1 − .
p1
From Y = rK + wN and Eqs. (2.7.2), we have
Y α F K β j F1 N
= 1 1 + .
p1 K1 N1
Insert this equation into (2.7.23)
α ξ K β ξ N 
X 1 =  1 1 + 1 1 − 1 F1 .
 K1 N1 
( )
Substituting K1 = k K / 1 + k in (2.7.15) and N1 = α k N / 1 + α k ( ) in
(2.7.10) into the above equation yields
 (α pυ − α ) α1 ξ 2 
X 1 =  0 − ξ1 F1 .
 1 − α 0 p α 2 ξ1 
υ
It is straightforward to solve all the other variables in the system. We see

that different trade patterns may occur in this equilibrium model with het-
erogeneous tastes and technologies. For instance, country 1 may specialize
in production of good 1 and country 2 produce goods 1 and 2 . Although
this is a simple neoclassical trade model with the Cobb-Douglass produc-
tion functions and utility functions, it is difficult to get explicit conclusions
about trade.37
2.8 Public Goods and International Trade
The Ricardian theory is concerned with technology. The Heckscher-Ohlin

international trade theory is mainly concerned with factors of production.
We have used two-sector and two-factor trade models to show the core
trade theorems. This section introduces important determinant, public
goods, of international trade to the two-sector and two-factor trade model
defined in the previous sections. Public goods are incorporated trade theo-
ries in different ways.38 This section is influenced by Abe (1990).39
2.8.1 The Two-Sector Two-Factor Model with Public Input
The world consists of Home and Foreign. As Foreign is similar to Home,

first we are concerned with Home. The economy produces two goods,
37 By examining all possible cases in this simple model, one can obtain many of
the important insights that the traditional international trade theories provide. Add-
ing tariffs and transport costs to the model is conceptually easy and can provide
more insights into reality. In Sect. 2.8, we will introduce public good into the
model, showing how public goods may affect trade pattern.
38 With regard to public economics, see, Auerbach and Feldetein (1990, 1991)
and Jha (1998, 2003). For trade with public sectors, see, for instance, Manning and
McMillan (1979), Tawada and Abe (1984), Okamoto (1985), and Ishikawa
(1988).
39 Abe (1990) applies the cost-minimization approach, while this section uses
profit-maximization approach with the Cobb-Douglas functions.

called good 1 and good 2 . There are two primary factors, labor and capi-
tal, and one pure public intermediate good. The total supplies of capital
and labor, K and N , are fixed. Let G stand for the amount of the public
intermediate good. For firms G is given. The economy produces two
goods with the following Cobb-Douglas production functions
F j = A j G j K j j N j j , j = 1, 2 , ν j ≥ 0 , α j , β j > 0 , α j + β j = 1, (2.8.1)
ν α β

We assume perfect competition in the product markets and factor markets.
We also assume that product prices, denoted by p1 and p2 , are given
exogenously. Marginal conditions for maximizing profits are given by
r= , w= .
Kj Nj
In the rest of this section, we choose p2 =1 and express p = p1 . Public

good is also produced by combining capital and labor. The production
function of the public sector is specify as
α β
G = Ap K p p N p p , α p , β p > 0 , α p + β p = 0 , (2.8.3)
where K p and N p are respectively capital and labor inputs of the public
sector and Ap is the productivity. Assume that the amount of public good
is fixed by the government and the public good production is financed by
the income tax.40 The total cost of the public sector is rK p + wN p . Mini-
mizing the total cost subject to the constraint (2.8.3), we obtain the follow-
ing marginal conditions
βpK p
ω= ,
αpNp
where ω ≡ w / r . From this equation and Eq. (2.8.3), we can express the
optimal levels of K p and N p as functions of r , w and G as follows
This assumption follows Abe (1990). Indeed, there are different ways of fi-
40
nancing public good sector (see Jha, 1998). In a growth model with public good
proposed by Zhang (2005a), tax rates on producers are fixed by the government.
The common approach to determining levels of public goods is to assume that the
government makes decision on tax and/or public goods by maximizing some so-
cial welfare function.
Aα G βp (2.8.4)
Np = αp
, K p = Aβ Gω ,
ω
where
αp βp
 βp  1 αp  1
Aα =   , Aβ =   .
α  Ap β  Ap
 p   p
Let τ stand for the tax rate on the total income, Y = rK + wN . Then
we have
rK p + wN p = τ (rK + wN ).
From this equation and (2.8.4), we can determine the tax rate as a function
of r , w and G
βp
τ 0Gω (2.8.5)
τ = ,
1 + nω
where
 α 
βp
 βp 
αp
 1 N
τ 0 ≡  p  +   , n≡ .
 β p  α   KAp K
   p  
We determine the tax rate as a function of the public good and the wage-
rental ratio. The amount of factors employed in each sector is constrained
by the endowments found in the economy. These resource constraints are
given
K1 + K 2 + K p = K , N1 + N 2 + N p = N . (2,8,6)
The consumer’s utility-maximizing problem is described as

Max C1ξ1 C 2ξ 2 , s.t. : p1C1 + p2 C2 = (1 − τ )Y ,

parameters. For simplicity, we require ξ1 + ξ 2 = 1. The optimal solution is
given by
p j C j = (1 − τ )ξ jY . (2.8.7)
For an isolated economy, we also have C j = F j .

We have thus described the model for Home without trade. We can solve
equilibrium problem of Foreign’s economy in the same way. We now
examine how trade direction is determined.
2.8.2 Equilibrium for an Isolated Economy
First, we will determine equilibrium of an economy in autarky. As

C j = F j , from Eqs. (2.8.7) we have
pF1 ξ1 (2.8.8)
= .
F2 ξ2
Substituting r = α j p j F j / K j into the above equation yields k = ξ ,
where we use k = K1 / K 2 and ξ ≡ α1ξ1 / α 2ξ 2 . From Eqs. (2.8.2), we have
α1 p1 F1 α 2 p2 F2 β1 p1 F1 β 2 p2 F2
= , = .
K1 K2 N1 N2
From these relations, we have
N 1 = αN 2 , (2.8.9)
where we use k = ξ and α ≡ β1ξ1 / β 2ξ 2 . From Eqs. (2.8.2), we also ob-

tain
β1 K 1 (2.8.10)
ω= .
α 1 N1
Insert (2.8.4) in (2.8.6)
 1 β  1 AG (2.8.11)
K1 1 +  = K − Aβ Gω p , N1 1 +  = N − αα p .
 ξ  α ω
We are interested in the case that the both goods are produced, that is,
we should have 0 < K1 < K and 0 < N1 < N . From (2.8.11), we see that
for ω > 0 , the conditions are satisfied if
K β AG (2.8.12)
>ω p > α .
Aβ G N
This implies that the amount of public good should not be too large for
given K and N ; otherwise the problem has no solution or the economy
may specialize in producing a single good.
From Eqs. (2.8.11) and (2.8.10), we obtain
(2.8.13)
Ω(ω ) ≡ ω + (Aβ − α 0 Aα )
G β K
ω p − = 0,
α0 N α0 N
where
α1 (1 + 1 / ξ ) α1ξ1 + α 2ξ 2
α0 ≡ = .
β1 (1 + 1 / α ) β1ξ1 + β 2ξ 2
The equation contains a single variable, ω . In the case of Aβ − α 0 Aα = 0 ,
we solve ω = K / α 0 N . We note that by the definitions of the parameters
we have
Aβ − α 0 Aα =
[(α p ]
− α 1 )ξ1 + (α p − α 2 )ξ 2 Aα
.
(2.8.14)
β p (β1ξ1 + β 2ξ 2 )
We see that the term Aβ − α 0 Aα may be either positive or negative. As it is

difficult to explicitly interpret conclusions, we just assume that Ω(ω ) = 0
has at least one positive solution which satisfies (2.8.12). As
β p G −α p
Ω' = 1 + (Aβ − α 0 Aα ) ω ,
α0 N
we see that if Aβ − α 0 Aα > 0 , then the solution is unique. Once we deter-
mine ω , then we determine all the variables by the following procedure:
K1 and N1 by (2.8.11) → N 2 by (2.8.9) → K 2 by (2.8.8) → N p and K p
by (2.8.4) → τ by (2.8.5) → F j by (2.8.1) → C j by (2.8.8) →
p = αβ 2 F2 / β1 F1 41 → r and w by (2.8.2).
2.8.3 Trade Patterns and Public Good Supplies
Section 2.8.2 solves the equilibrium problem when there is no trade be-
tween the two economies. We cannot solve the problem explicitly without
41 This relation is obtained by Eqs. (2.8.2).

further specifying parameter values.42 For explaining the role of public

goods, we are interested in the situation when the two countries are identi-
cal in all aspects, except that the two countries have different levels of
public goods.
To determine directions of trade, we first determine the relative prices be-
fore trade liberalization. Taking derivatives of Eq. (2.8.13), we have
 β p G −α p  dω β
ω p (2.8.15)
1 + ( Aβ − α A
0 α ) ω  = − ( Aβ − α A
0 α ) .
 α0 N  dG α0 N
In the case of Aβ − α 0 Aα = 0 , dω / dG = 0 . In the case of

Aβ − α 0 Aα > 0 , we have dω / dG < 0 . In the case of Aβ − α 0 Aα < 0 ,
from Eq. (2.8.3) we have
β p G −α p K − (Aβ − α 0 Aα )Gα pω
βp
1 + (Aβ − α 0 Aα ) ω = > 0.
α0 N α 0ωN
Hence, we have dω / dG > 0 . We conclude that the sign of dω / dG is the
opposite to that of Aβ − α 0 Aα . From (2.8.14), we see that the sign of
dω / dG is the same as the sign of the following term
ξ ≡ (α1 − α p )ξ1 + (α 2 − α p )ξ 2 . (2.8.16)
The above discussions are valid for Foreign as well. As the two countries
are identical (except in G 43), we see that in the case of ξ > 0 , if
~ ~
G > (<) G , then ω > (<) ω~ ; and in the case of ξ < 0 , if G > (<) G ,
then ω < (>) ω~ , when the two countries are in isolation.
We now compare p and ~ p . From Eqs. (2.8.1) and (2.8.2), we have
αβ 2 A2 Gν 2 K 2α 2 N 2β 2
p= .
β1 A1Gν1 K1α1 N1β1
Substituting N1 = αN 2 , and k = ξ into the above equation yields
p = AGν 2 −ν1ω α 2 −α1 , (2.8.17)
where we also use Eq. (2.8.10) and
42 As the procedure of determining all the variables are explicitly given, it is
straightforward to simulate various possibilities with computer.

43 The macron is defined as before.
α 2α 2 β 2β 2 A2
A= .
α1α1 β1β1 A1
Taking derivatives of Eq. (2.8.17) with respect to G yields

1 dp ν 2 − ν 1 α 2 − α1 dω
= + .
p dG G ω dG
Insert Eq. (2.8.15) in the above equation
1 dp ν 2 − ν 1 (Aβ − α 0 Aα )(α 2 − α1 )
p dG
=
G
−
[ ]
1 + (Aβ − α 0 Aα )β p Gω p / α 0 N ω p α 0 N
−α α
.
This result is important for determining trade patterns.

The magnitude of υ j represents the degree of spillover of public input
into sector j . If the public good has no effect on the production of sector
j , then ν j = 0 . If the public input is effective in increasing the productiv-
ity of sector j , the parameter value is high. To determine factor intensi-
ties, from k = ξ and N1 = αN 2 , we obtain
K1 α 1 β 2 K 2 (2.8.18)
= ,
N 1 α 2 β1 N 2
where we use the definitions of ξ and α . We say that sector 1 is rela-
tively capital (labor) intensive if K1 / N1 > (<) K 2 / N 2 . From
α j + β j = 1, we see that sector 1 is relatively capital (labor) intensive if
α1 > (<) α 2 . We also define that the public sector is capital (labor) inten-
sive relative to the private sectors if
Kp K1 + K 2 K − K p
> (< ) = .
Np N1 + N 2 N − N p
We see that the public sector is relatively capital (labor) intensive if

Kp K
> (<) .
Np N
From Eqs. (2.8.4), the above inequality is equivalent to

βpK
ω > (<) .
αpN
This states that if the wage-rental ratio is higher (lower) than the ratio
β p K / α p N , then the public sector is relatively capital (labor) intensive.
We now examine trade pattern. First, we are concerned with the situa-
tion when the spillover effects of the public good are the same between the
two sectors, i.e., ν 1 = ν 2 . Then, by Eq. (2.8.17), we have
1 dp (Aβ − α 0 Aα )(α1 − α 2 )
=
[ ]
p dG 1 + (Aβ − α 0 Aα )β p Gω −α p / α 0 N ω α p α 0 N
.
We know that denominator is always positive. Hence, the sign of dp / dG

is the same as that of
[ ]
∆ ≡ (α p − α1 )ξ1 + (α p − α 2 )ξ 2 (α1 − α 2 ).
~
In the case of ∆ > 0 , if G > G , then we have p > ~
p . Home imports
good 1 and exports 2 . According to the above discussions, we have the
following lemma.
Lemma 2.8.1
Assume that the two countries have identical preferences, technology, and
factor endowments, and the spillover effects of the public good are the
same between the two sectors. Then, if ∆ > (<) 0 and Home supplies
more public goods than Foreign, then Home exports (imports) good 2 and
imports (exports) good 1.
The case of ∆ > 0 occurs, for instance, if α p > α1 > α 2 . It can been
seen that with different combinations of α p , ξ j and α j , we have different
patterns of trade. Another extreme case is when α1 = α 2 . We have
1 dp ν 2 − ν 1 (2.8.19)
= .
p dG G
Lemma 2.8.2
factor endowments, and the two (private) sectors have the same factor in-
2.9 Concluding Remarks 71
tensities. Then, if Home supplies more public goods than Foreign and sec-
tor 1' s spillover effect is stronger (weaker) than sector 2' s , then Home
exports (imports) good 1 and imports good 2 .
From Eqs. (2.8.19) and (2.8.14), we can explicitly judge the sign of
dp / dG in the cases when ν 2 −ν 1 and ∆ have the same sign. If ν 2 −ν 1
and ∆ are positive (negative), then dp / dG is positive (negative). Hence,
we have the following lemma.
Lemma 2.8.3
factor endowments and Home supplies more public goods than Foreign. If
ν 2 −ν 1 and ∆ are positive (negative), then Home exports (imports) good
2 and imports (exports) good 1.
If (ν 2 − ν 1 )∆ < 0 , we need further information for judging trade pattern.

Like in Abe (1990),44 We have discussed only the case when the two coun-
tries have identical preferences, technology, and factor endowments. It is
important to examine what will happen when the two countries have dif-
ferent preferences, technology, factor endowments and public policy.45
2.9 Concluding Remarks
Ricardo’s initial discussion of the concept of comparative advantage is

limited to the case when factors of production are immobile internation-
ally. His arguments about gains from trade between England and Portugal
are valid only if English labor and/or Portuguese technology (or climate)
are prevented from moving across national boundaries. The Heckscher-
Ohlin theory is similarly limited to the study of how movements of com-
modities can substitute for international movements of productive factors.
It is obvious that if technologies are everywhere identical and if production
44 Abe applies the dual approach. Although the functional forms in Abe’s
analysis are more general than in this section, as we have explicitly solved the
model with different factor endowments, technology and preferences, we can eas-
ily discuss more issues which may not be easily discussed by the dual approach.
45 We don’t discuss issues related to validity of the core theorems in trade the-
ory. The problems are examined by Altenburg (1992) in a similar framework as

Abe’s.
is sufficiently diversified, factor prices become equalized between coun-

tries. But if production functions differ between countries, no presumption
as to factor equalization remains. Most of early contributions to trade the-
ory deal with goods trade only and ignore international mobility of factors
of production. For a long period of time since Ricardo, the classical mobil-
ity assumption had been well accepted. This assumption states that all final
goods are tradable between countries whereas primary inputs are non-
tradable, though they are fully mobile between different sectors of the
Home economy. In reality, this classical assumption is invalid in many cir-
cumstances. For instance, many kinds of final ‘goods’, services, are not
traded and capitals are fully mobile between countries as well as within
Home economies. A great deal of works on trade theory has been con-
cerned with examining consequences of departures from these assump-
tions. There is an extensive literature on various aspects of international
factor mobility.46 It is also important to introduce transport costs into the
models in this section.47
To end this chapter, we introduce how to analyze effects of, for in-
stance, a tariff on trade.48 As we have already solved the model without
any trade barriers. We can determine trade direction. For instance, we as-
sume that Home imports good 2 and Foreign imports good 1. We assume
that there is no other trade barrier. Let use assume that Home introduces a
tariff at ad valorem rate, τ . Prices of good 2 differ in Home and Foreign.
In Home, the equilibrium price equals (1 + τ ) p2 , where p2 is the price of
good 2 in Foreign. In the tariff income is given by τp2 (F2 − C2 ). This in-
come may be distributed in different ways. We may generally assume that
the government distributes ϕτp2 (F2 − C 2 ) to the households in Home and
the rest to the government expenditure, where the parameter, ϕ , satisfies
0 ≤ ϕ ≤ 1. With these notations, we can correspondingly determine the
equilibrium values of all the variables. After determining the equilibrium
values with the given tariff rate, we can then analyze effects of tariff on the
two economies. As we can explicitly solve the equilibrium problem, it is
not difficult to calculate the effects. Under certain conditions,49 the tariff
See Jones and Kenen (1984), Ethier and Svensson (1986), Bhagwati (1991), and
46
Wong (1995).
47 See Steininger (2001: Chap. 2).
48 A graphical illustration of this case is referred to Bhagwati et al. (1998: Chap.
12).
49 The condition is presumed stability. See, Jones (1961) and Amano (1968) for
the definition of stability.

Appendix 73
tends to worsen the terms of trade in Foreign (that is, p2 / p1 falls) and en-
courage the terms of trade in Home (that is, p1 / ( p2 + p2τ ) rises).50
Appendix
A.2.1 A Ricardian Model with a Continuum of Goods
The single-input version of the Rcardian model has been generalized in

different directions. It is straightforward to extend the model to a two-
factor model with fixed input-output coefficients. We now represent a
well-known generalization of the Ricardian model to encompass a contin-
uum of goods.51 First, we assume that there is no transaction cost.
We index commodities on an interval [0 , 1], in accordance with dimin-
ishing home country comparative advantage.52 A commodity z is associ-
ated with each point on the interval. For each commodity there are unit la-
bor requirements, a(z ) and a~( z ) in Home and Foreign. The requirement
of diminishing home country comparative advantage on the interval is rep-
resented by
a~ (z )
A( z ) ≡ , A' ( z ) < 0 .
a(z )
The relative unit labor requirement function, A( z ), is also assumed to be
continuous. Let w be wages measured in any common unit. Home will
produce all those commodities for which domestic unit costs are less than
or equal to foreign unit costs. This means that any commodity z will be
produced in Home if a(z ) w ≤ a~ (z )w
~ , that is, ω ≤ A( z ), where ω ≡ w / w
~.
For given ω , from equation ω = A( z ), we uniquely determine
50 The well-known Metzler (1949: 7-8) paradox states that a tariff may actually
lower the relative domestic price of the importable.

51 The model below due to Dornbusch et al. (1977). The model is also repre-
sented in Rivera-Batiz and Oliva (2003: Sect. 1.2). See also Wilson (1980), Flam
and Helpman (1987), Stokey (1991), and Matsuyama (2000, 2007). It should be
noted that Dornbusch et al. (1980) propose a model with continuum of goods to ex-
amine Heckscher-Ohlin trade theory.
52 An alternative description is to take an interval [0 , ∞ ]. See Elliot (1950).
z * = φ (ω ). (A.2.1.1)
Hence, for a given relative wage ω , Home and Foreign will respec-
tively efficiently produce the rages of commodities as follows
0 ≤ z ≤ φ (ω ), φ (ω ) ≤ z ≤ 1.
The relative price of a commodity z in terms of any other commodity
z ' , when both goods are produced in Home, is equal to the ratio of home
unit labor cost
p( z ) a(z ) (A.2.1.2)
= , 0 ≤ z ≤ φ (ω ).
p ( z ') a ( z ')
The relative price of a commodity z produced in Home in terms of any
other commodity z" produced in Foreign is given by
p( z ) ωa( z ) (A.2.1.3)
= , 0 ≤ z ≤ φ (ω ), φ (ω ) ≤ z ≤ 1.
p(z") a~ (z")
Assume identical tastes in Home and Foreign and Cobb-Douglas demand
functions that associate with commodity z a constant expenditure, b ( z ).
We should have
~
b(z ) = b (z ), 0 ≤ z ≤ 1, ∫ b(z ) dz = 1.
1
Let Y stand for total income and c( z ) for demand for commodity z .
Then, we have
p( z )c( z ) (A.2.1.4)
b( z ) = .
Y
We define the fraction of income spent on those goods in which Home
has a comparative advantage
φ
dΛ
Λ(φ ) ≡ ∫ b(z ) dz > 0 , = b(φ ) > 0 , 1 > Λ (φ ) ≥ 0 .
0 dφ
The fraction of income spent on commodities produced by Foreign is
1
~ ~
Λ(φ ) ≡ 1 − ∫ b(z ) dz > 0 , 1 > Λ(φ ) ≥ 0 .
φ
Appendix 75
Domestic labor income, wN , should equal the total expenditures of the

two countries on commodities produced by Home, that is,
(
wN = Λ(φ ) wN + w ~N~
)
. Hence, (1 − Λ )wN = Λw
~
~N , which states that im-
ports are equal in value to exports. From this equation, we have
Λ (z * ) N
~ (A.2.1.5)
ω= .
1 − Λ (z * ) N
This function describes behavior of the demand side, while Eq. (A.2.1.1)
shows behavior of the supply side. Equation (A.2.1.5) is illustrated in Fig.
A.2.1.1. The curve starts at zero and rises in z * (to infinity as z * ap-
proaches unity). This equation implies that a proper level of the relative
wage ratio is required to equate the demand for domestic labor to the exist-
ing supply. Equations (A.2.1.1) and (A.2.1.5) contain two variables, ω
and z * . As shown in Fig. A.2.1.1, there is a unique solution to the equa-
tions.
ω
( )
A z*
( )
Λ z* N
~
( )
1− Λ z N
*
z*
Fig. A.2.1.1. Determination of equilibrium
Once we determine the equilibrium value of z * (which is the equilib-

rium borderline of comparative advantage between commodities produced
and exported by Home and Foreign. We determine the ranges of produc-
tion of Home and Foreign as follows 0 ≤ z ≤ z * and z * ≤ z ≤ 1. The rela-
tive price structure is given by Eqs. (A.2.1.2) and (A.2.1.3). The equilib-
~N~
rium levels of production. From Y = wN + w and Eq. (A.2.1.4), we de-
termine c( z ). Let N (z ) stand for the labor force employed for producing
commodity z . Then, the output level of commodity z is equal to
a (z )N ( z ). From c(z ) = a ( z )N ( z ), we determine N (z ).
We have thus determined the equilibrium of the Ricardian economy. We
now examine effects of changes in some parameters. First, we increase the
~
relative size of labor endowments. An increase in N / N shifts the trade
balance equilibrium curve given by (A.2.1.5) upward in proportion to the
change in the relative size. From Fig. A.2.1.2, we see that the equilibrium
ratio of the relative wages rise and reduces the range of commodities pro-
duced in Home. When the labor force is increased, there will initially be a
labor excess in Foreign and an excess demand for labor in Home. The re-
sulting increase in Home’s wages serves to eliminate the trade surplus and
at the same time raise relative unit labor costs in Home. This implies a loss
of comparative advantage of Home. We may similarly examine effects of
technological change (for instance, through a uniform proportional reduc-
tion in a~ ( z ) ).
( )
A z*
( )
Λ z* N
~
( )
1 − Λ z* N
z*
Fig. A.2.1.2. A rise in labor supply in foreign
3 Trade with Imperfect Competition
The Heckscher-Ohlin trade model had dominated work in the pure theory
of international trade before Krugmen and other trade economists devel-
oped new trade theory on the base of the monopolistic competitive model
proposed by Dixit and Stiglitz (1977). The concept of monopolistic com-
petition and modeling frameworks associated with type of imperfect com-
petition have been applied to various problems in macroeconomics, inter-
national and interregional economics, economic growth and development.
Monopolistic competition is characterized as follows:
(i) The products are differentiated. It consists of many buyers and sell-
ers. Unlike perfectly competitive firms, firms are characterized by signifi-
cant product differentiation. Consumers view firms’ products as imperfect
substitutes for each other.
(ii) The number of firms is so large that each firm ignores its strategic
interactions with other firms.
(iii) Entry is unrestricted and takes place until the profits of incumbent
firms are driven down to zero. Any firm can hire the inputs, such as labor
and capital, needed to compete in the market, and they can release these
inputs from employment when they do not need them.
The character of imperfect competition is often emphasized for describ-

ing decentralized allocations in the presence of increasing returns. Its com-
petitive feature allows us to avoid complexity of strategic interactions
among firms (like in oligopoly models). The modeling framework with
monopolistic competition makes it possible to endogenize entry-exit proc-
esses and the range of products supplied in the market through these proc-
esses. In determining their prices in the short term, monopolistic competi-
tors behave much like the differentiated products oligopolists. Taking the
prices of other firms as given, each firm faces a downward-sloping de-
mand curve – the downward sloping is held because of product differentia-
tion. Each firm maximizes its profit at the point at which its marginal
revenue equals marginal cost. In a short-run equilibrium, the price chosen
by a firm may exceed the typical firm’s average cost at the prevailing out-
put level. This situation will attract new entrants into the industry. As firms
78 3 Trade with Imperfect Competition
enter the monopolistically competitive market, a typical firm’s demand

curve shifts. At a long-run equilibrium, a typical firm sets the profit-
maximizing price equal to the average cost, making zero profit.
The purpose of this chapter is to introduce basic models of the new trade
theory. Section 3.1studies a trade model with monopolistic competition by
Krugman. The Krugman model addresses relations between trade and ele-
ments such as economies of scale, the possibility of product differentia-
tion, and imperfect competition. The model is specially effective for pro-
viding some insights into the causes of trade between economies with
similar factor endowments. The model is based on a monopolistic competi-
tive model proposed by Dixit and Stiglitz. Section 3.2 introduces the Cham-
berlinian-Ricardian model proposed by Kikuchi. Rather than assuming cross-
country technical homogeneity like in the model in Sect. 3.1, the model is
concerned with cross-country technical heterogeneity. There are two sectors:
the monopolistically competitive sector and the competitive sector – the for-
mer produces a large variety of differentiated products and the latter produces
a homogeneous good. The homogeneous good is produced under constant re-
turns to scale. Section 3.3 analyzes the interplay between factor abundance
and agglomeration forces, basing on a model of agglomeration by Epifani.
The model synthesizes the Heckscher-Ohlin theory and the monopolistic
competition. Section 3.4 tries to examine economic mechanism for the phe-
nomenon that a large part of international trade is intraindustry in character.
The section uses a simple model to demonstrate that although it is costly to
export the product from one country to another, firms in different countries
may engage in cross-hauling of an identical product, making positive profits.
Section 3.5 introduces a model of extending the Heckscher-Ohlin interna-
tional trade theory to include variable returns to scale. Section 3.6 analyzes
the effects of transboundary pollution on trade and welfare in a general equi-
librium.
3.1 A Trade Model with Monopolistic Competition
This section introduces a trade model with monopolistic competition by

Krugman (1979). The model addresses relations between trade and ele-
ments such as economies of scale, the possibility of product differentia-
tion, and imperfect competition. The model is specially effective for pro-
viding some insights into the causes of trade between economies with
similar factor endowments. It is based on a monopolistic competitive
model proposed by Dixit and Stiglitz. The crucial assumption is the exis-
tence of increasing returns to scale in economic production under monopo-
listic competition. In the Krugman trade model, when two monopolistic

competitive economies are allowed to trade, increasing returns produce trade
and gains from trade even if the economies have identical tastes, technolo-
gies, and factor endowments.
3.1.1 The Model for a closed Economy
We first introduce the model for an isolated economy. There are a large
number of potential goods and they enter a representative household’s util-
ity symmetrically. Assume the utility function takes the following form
U = ∑ ciθ , 1 < θ < 1,
i
where ci is the consumption of good i . The number of goods actually

produced, denoted by I , is sufficiently large. Let pi stand for price of
good i . Then the marginal conditions of maximizing the above utility
function subject to a standard budget constraint are
θciθ −1 = λpi , (3.1.1)
where λ is the shadow price on the budget constraint.

There is a single production factor, labor. Let N stand for labor force
(and the population). To take account of returns to scale, we specify a lin-
ear cost function with the property that average cost declines at all levels
of output at a diminishing rate. All goods are produced with the following
cost function
N i = α + βxi ,
where N i is labor used in producing good i and xi is the output of good
i . As firms can costlessly differentiate their products and all products en-
ter symmetrically into demand, each good will be produced by only one
firm.
The amount of goods produced is equal to that consumed xi = ci N .
From Eqs. (3.1.1) and xi = ci N , we obtain the demand curve for firm i 1
θx 
θ −1
(3.1.2)
pi =  i  , i = 1, ... , I .
λN 
1 Firm i refers to the firm that produces good i .

As the marginal revenue is given by θpi and the marginal cost is βw ,

we should have
βw (3.1.3)
pi = .
θ
Since θ , α , β and w are identical for all firms, the prices are equal,
that is, p = pi for all i . The assumption of full employment is expressed
by
I
(3.1.4)
N = ∑ (α + βx ).
i =1
i
The assumptions of free exit and entry in market and profit maximiza-
tion implies that equilibrium profits are always zero. Profits of firm i , π i ,
are
π i = pi xi − (α + βxi )w ,
where w is the wage rate. Setting π i = 0 yields
αw αθ (3.1.5)
xi = = , i = 1, ... , I ,
p − β w (1 − θ )β
where we use Eqs. (3.1.3). As output per firm is equal, we can use x = xi
for all i . Insert Eqs. (3.1.4) in Eq. (3.1.4)
N (1 − θ ) (3.1.6)
I = .
α
This equation determines the number of firms actually operating in the
market. As the model is so simple, we have already solved its equilibrium
when constructing it. The procedure of determining all the variables are: I
by (3.1.6) → xi = x for all i by (3.1.5) → N i = α + βxi → ci = xi / N →
choose w = 1 → pi = p by (3.1.3).
3.1.2 Effects of Trade
To examine effects of trade, we assume that two countries of the kind de-
scribed in Sect. 3.1.1 open trade with each other. In the world economy,
there is a single production factor. We still use the symbol ~ as in Chap. 2.
We neglect any kind of transaction costs. We also assume that two coun-
tries have the same taste and the same technologies. Because of the pres-
ence of increasing returns and each good is produced by only one country,
trade occurs and both may benefit from trade. The world economy will
produce a greater variety of goods.
Because of the assumed symmetry, the two economies will have the
same wage rate and the price of good produced in either country will be
the same. The direction of trade is indeterminate, even though one good is
produced only by one country. The volume of trade is determinate. Each
household maximizes the following utility
~
I I +I (3.1.7)
U = ∑ ciθ + ∑c θ
i , 1 < θ < 1,
i =1 i = n +1
~
where goods 1, ..., I are produced in Home and goods I + 1, ..., I + I in
Foreign. The numbers of goods produced in Home and Foreign can be de-
termined the full employment conditions. Similar to (3.1.6), we have
~
N (1 − θ ) ~ N (1 − θ ) (3.1.8)
I= , I = .
α α
Since all goods will have the same price, expenditures on each country’s
goods will be proportional to the country’s labor force. The share of im-
~
( ~
)
ports in Home will be N / N + N . The values of imports of each country
~
( ~
)
will be national income times the import share, i.e., wNN / N + N . Com-
paring the utility obtained in the closed economy and the utility in (3.1.7),
we conclude that the countries benefit from trade. This model shows that
economies of scale may give rise to trade and countries gain from trade
even when they are identical in tastes, technology and factor endowments.
The above example for demonstrating that trade is beneficial is sug-
gested in Krugman (1979). Another way suggested by Krugman (1980) in
demonstrating that trade benefits the world is to consider that there are two
industries (with many differentiated products within each industry). When
the two countries of the kind described in Sect. 3.1.1 trade, each will be a
net exporter in the industry for whose products it has the relatively larger
demand.
3.2 The Ricardian Theory with Monopolistic Competition
This section introduces the Chamberlinian-Ricardian model proposed by

Kikuchi (2004).2 Rather than assuming cross-country technical homogene-
ity like in Sect. 3.1, Kikuchi is concerned with cross-country technical het-
erogeneity. The world consists of two countries, Home and Foreign. The
two countries are identical with regard to consumers’ preferences but not
with regard to size and production technologies. There are two sectors: the
monopolistically competitive sector and the competitive sector – the for-
mer produces a large variety of differentiated products and the latter pro-
duces a homogeneous good. The homogeneous good is produced under
constant returns to scale. There is only one primary factor of production:
labor.
3.2.1 The Trade Model with Technical Heterogeneity
Let C stand for the quantity index of the differentiated products, which is
specified as
 n n~
1/ θ
 (3.2.1)
C =  ∑ ciθ + ∑ c~θi  , 0 < θ < 1,
 i =1 ~
i =1 
where n is the number of products produced in Home and Foreign, ci is
the quantity of product i , and 1 / (1 − θ ) > 0 is the elasticity of substitution
between every pair of products. The utility function for all the consumers
is specified as
Cε
U = + Y , 0 < ε < 1,
ε
where Y is the consumption level of the homogeneous goods. The con-
sumer’s problem is divided into two steps.3 First, minimizing the cost of
obtaining given C yields
For similar issues, we also refer to Venables (1987), Kikuchi and Zeng
2
(2004), and Suga (2005).

3 The consumer’s problem is actually solved in two steps (see Helpman and Krug-
man, 1985).
3.2 The Ricardian Theory with Monopolistic Competition 83
1 / (θ −1)
p  ~ (3.2.2)
di = γ  i  C , i = 1, ... , n , i = 1, ... , n~ ,
P
where pi is the price of good i and P is the price index given by
n~
(θ −1) / θ (3.2.3)
 n 
P =  ∑ piθ / (θ −1) + ∑p θ / (θ −1)
~
i  .
 i =1 ~
i =1 
Second, the consumer’s problem is to maximize the utility, dividing total
income between the differentiated products in aggregate and the homoge-
neous good. The demand function for C is given by
C = P 1 / (ε − 1 ) . (3.2.4)
From Eqs. (3.2.2)-(3.2.4), we obtain
 n n~

ζ (3.2.5)
d i = pi1/ (θ −1)  ∑ piθ / (θ −1) + ∑ p~θi / (θ −1)  ,
 i =1 ~
i =1 
where
θ −ε
ζ ≡ .
(ε − 1)θ
Differentiated products are supplied by monopolistically competitive
firms. Let α and β represent respectively the fixed cost and constant
marginal cost in Home and Foreign. As the numbers of firms are assumed
to be large, the elasticity of demand for each product is 1 / (1 − θ ). Thus,
each product is priced at a markup over marginal cost
β (3.2.6)
pi = .
θ
Before examining trade pattern, we look at the autarky case (that is,
n~ = 0 ). Assume that n A firms with marginal cost β are active in Home.
By (3.2.6) we see that the prices are the same, equaling pi = β / θ . Thus
we can drop index i . The profit for each firm is
θ / (1 − θ )
 A θ θ / (1 − θ ) ζ
 (3.2.7)
θ  
π = ( p − β ) x − α = (1 − θ )  n    −α,
β    β  
where we use Eq. (3.2.5). In the case of ε > (<) θ , the profit rises (falls) in
the number of firms. In the case of ε > θ , the differentiated products
would be complements rather than substitutes. To exclude this case, we re-
quire ε < θ . Setting π = 0 , we solve the zero profit condition as follows
θ / (1 − θ )
 α  β θ / (1 − θ ) 
1/ ζ (3.2.8)
β 
n = 
A
    .
θ  1 − θ  θ  
3.2.2 Trade Equilibrium
We are now concerned with trading equilibrium. If both countries produce

differentiated products, prices of their goods are p = β / θ . If both coun-
tries’ firms co-exist, profits must be identical for each country’s firms, i.e.,
π = π~ = 0 , in equilibrium. Substituting Eqs. (3.2.5) and p = β / θ into
π = π~ , we have
  β θ / (θ −1) ~ θ / (θ −1)  ζ
β  α − α~
2(1 − θ )θ θ / (θ −1)
 n  ~
+ n    = θ / (θ −1) ~θ / (θ −1) .
 θ  θ   β −β (3.2.9)
 
Insert the right-hand side of (3.2.9) in the profit function
(α − α~ )β θ / (θ −1)
π = θ / (θ −1) ~θ / (θ −1) − α .
(3.2.10)
β −β
It should be noted that the equilibrium number of firms for the case in
which only one country’s firms exist is
~ εθ / (θ − ε )
 (1 − θ ) 
1/ ζ
~ β 
n =  
T
 α~  , if n = 0 ;
θ   
 (1 − θ ) 
εθ / (θ − ε ) 1/ ζ (3.2.11)
β 
n = 
T
 α  , if n~ = 0 ,
θ   
where T refers to the value in trading equilibrium. In free trade equilib-
rium with the co-existence of firms, the profit must be zero: π = π~ = 0 .
From (3.2.10), we see that this condition is satisfied only if the technology
index which is defined as
3.3 The Heckscher-Ohlin Theory with Monopolistic Competition 85
Λ≡
(β /β)
~ ( θ / 1−θ )
,
α / α~
is equal to unity. If Λ ≠ 1, one country produces only the homogeneous
good and the other country produces both kinds of goods. This implies that
the co-existence of both countries’ firms in the monopolistically competi-
tive sector is very unlikely in a trading equilibrium.
Lemma 3.2.1
If Λ > (<) 1, only Foreign (Home) firms produce differentiated products
and Foreign (Home) is an exporter of differentiated products. Intra-
industry trade occurs only when Λ = 1. 4
This lemma implies that if the two countries are different in technolo-
gies, then intra-industry trade would not occur in the Chamberlinian-
Ricardian model.
3.3 The Heckscher-Ohlin Theory with Monopolistic

Competition
This section analyzes the interplay between factor abundance and agglom-
eration forces, basing on a model of agglomeration by Epifani (2005). The
model synthesizes the Heckscher-Ohlin theory and the monopolistic com-
petition.5 As the model takes account of more forces than the traditional
trade models, it tends to predict more possible patterns of trade.
4 The proof is given in Kikuchi (2004).

5 Epifani’s model is much influence by Fujita et al. (1999: Chap. 16) who em-
bed Heckscher-Ohlin features within the monopolistic competition framework
with two immobile factors and inter-indifferences in factor intensities. But they
assume the absence of international differences in the factor ratios, which is the
key feature in the Heckscher-Ohlin theory. Epifani allows international differences
in the factor ratios. See also models for similar issues by, for instance, Davis
(1995), Kikuchi (1996), Shimomura (1998), Fujiwara and Shimomura (2005) and
Kikuchi and Shimomura (2006).
3.3.1 The Model
Consider a world economy with two countries, called Home and Foreign,
and two industries, indexed by 1 and 2 . There are two internationally im-
mobile production factors, capital and labor, respectively denoted by
K and N . 6 The two countries have identical preferences and technology.
~ ~
Assume that Home is capital abundant, i.e., K / N > K / N . The two indus-
tries are monopolistically competitive à la Dixit and Stiglitz, and produce
differentiated goods under increasing returns to scale. Both industries incur
identical ice berg transport costs: τ ( > 1 ) units must be shipped from one
country in order that one unit arrives in the other country. The price indi-
ces for the two industries, q j , are defined by
[
q j = n j p1j−σ + n~ j ( ~
p jτ ) 1−σ ](
1 / 1−σ )
, j = 1, 2 , (3.3.1)
where n j are the varieties of industry j produced in Home and Foreign

and p j are the prices charged for each variety. Production of each variety
requires a fixed amount of α and a variable amount β of an input whose
unit cost is denoted by C j , j = 1, 2 . Firms in each industry are symmet-
ric. The total cost of a firm in industry j which produces output x j is
given by
TC j = (α + βx j )C j .
Let σ ( > 0 ) stand for the constant demand elasticity products. We

choose parameter values so that
1
α= , βσ = σ − 1.
σ
The price that maximizes the firms’ profits is
βσ (3.3.2)
pj = Cj = Cj .
σ −1
The zero profit condition is given by
6 Here, we are concerned with the equations relative to Home, as those for For-
eign are analogous.

x=
(σ − 1)α
= 1.
(3.3.3)
β
The equilibrium output is the same across firms and industries. The unit
cost functions, C j , for the inputs of the two industries are
C1 = w(1−δ )γ r (1−δ )(1−γ )q1δ , C2 = w(1−δ )(1−γ )r (1−δ )γ q2δ , (3.3.4)
where 0 < δ , γ < 1. Here, δ is the share of own industry output in total
cost in the two industries.
Let K j and N j stand for the distribution of capital and labor between
the two industries. The two factors are fully employed. That is
K1 + K 2 = K , N1 + N 2 = N .
From these equations and Eqs. (3.3.4) the shares of capital and labor in to-
tal cost are
wN1 = (1 − δ )γn1 p1 , w(N − N1 ) = (1 − δ )(1 − γ )n2 p2 ,
rK1 = (1 − δ )(1 − γ )n1 p1 , r (K − K1 ) = (1 − δ )γn2 p2 .

From the above equations, we solve
K1 1 − γ w K 2 K − K1 γ w (3.3.5)
= , = = .
N1 γ r N 2 N − N1 1 − γ r
Assume γ > 1 / 2 , which implies that industry 1 is labor-intensive.
Consumers have Cobb-Douglas preferences over the CES aggregate of
the two industries. They spend an equal share of their income
( Y = rK + wN ) on each industry’s varieties. A share δ of revenue is used
to purchase its own industry varieties. Hence, total expenditure, e j , for
the two industries varieties is
rK + wN (3.3.6)
ej = + δn j p j .
2
Total demand for each of the two industries’ varieties is
e qσ −1 + ~
e jτ 1−σ q~ σj −1 (3.3.7)
xj = j j .
pσj
If industry j ' s demand is active in equilibrium then x j = 1. We have

thus described the model which consists of Eqs. (3.3.7) and the analogous
equations for Foreign. As it is difficult to explicitly solve the model, Epi-
fani simulated the model with various combinations of parameters.7
3.3.2 Specialization and Relative Factor Prices
Like in Sect. 2.3, we are interested in the situation in which both industries
are active in the absence of trade costs.8 In the rest of the section, specify
~ ~ (3.3.8)
N = K = 0.7 , K = N = 1, σ = 5 , γ = 0.8 .
Home is capital abundant and Foreign is labor abundant. Introduce the
share, s2 , of the capital-intensive industry’s output in Home and the share,
~s1 , of the labor-intensive industry’s output in Foreign as
p 2 n2 ~
p n~
s2 = , ~
s1 = ~ ~ 1 1~ ~ .
p1n1 + p2 n2 p1n1 + p2 n2
Because of the symmetry of the two countries, we have s2 = ~ s1 .

The shares are determined as functions of τ . The model simulated the
model for 1 ≤ τ ≤ 2.5 and the results are plotted in Fig. 3.3.1.9 In the ab-
sence of agglomeration economies generated by the linkages among pro-
ducers (i.e., δ = 0 ), as shown in the traditional Heckscher-Ohlin theory,
trade liberalization monotonically increases specialization according to
comparative advantage. In the presence of the linkages (i.e., δ > 0 ), trade
liberalization also fosters specialization according to comparative advan-
tage. For trade costs lower than τ , i.e., τ ≤ τ , the degree of international
specialization exceeds the one attained in free trade (with τ = 1 ). We in-
terpret that agglomeration economies exert a sort of magnification effect
on the specialization based on comparative advantage. This comes from
that a country specialized in its comparative advantage industry has a dou-
ble advantage with respect to its partner country. The industry exploits the
The next section is only concerned with the parameter values which guarantee
7
a unique equilibrium point. It can be demonstrated that the model may have multiple
equilibrium points.
8 This occurs when the difference between two countries’ factor ratios is not too
large.
9 The illustrations in this section are based the plots in Epifani (2005).
advantage of using intensively its abundant factor as well as the positive

externalities generated by the linkages among producers in this industry.
The second advantage strengthens the first advantage. The figure shows
that international specialization raises, then reaches a peak, and finally
starts to decline as trade costs are increased.
0.75
s2 = ~
s1 (δ = 0.5)
0.65
s2 = ~
s1 (δ = 0)
0 .5 τ
τ
1 1.5 2 2.5
Fig. 3.3.1. Trade costs, agglomeration and specialization
The effects on the behavior of factor prices are plotted in Fig. 3.3.2. The
rental/wage ratios in the two countries are plotted as functions of trade
costs. The solid and dashed monotonic curves represent the ratios in Home
and Foreign, respectively, in the case of δ = 0 . In the absence of the link-
ages for agglomeration, as trade costs fall, the factor price ratios converge,
as predicted in the traditional trade theory. As the parameters are specified
such that the two goods will be produced in the absence of trade costs, we
have factor price equalization in the free trade equilibrium. The solid and
dashed nonmonotonic curves represent the ratios in Home and Foreign, re-
spectively, in the case of δ > 0 . There are relative factor price conver-
gence and divergence as trade costs vary. The factor price equalization is
achieved at τ = τ . As demonstrated in the figure, when the two similar
countries become sufficiently integrated, in each country the abundant fac-
tor becomes relatively expensive. This is due to agglomeration forces, by
which specialization due to comparative advantage is strengthened and
hence exacerbate the traditional Stolper-Samuelson effect.
1.4
~ ~ (δ = 0)
r /w
~ ~ (δ = 0.5)
r /w
r / w (δ = 0.5)
r / w (δ = 0)
0.7 τ
τ
1 1.5 2 2 .5
Fig. 3.3.2. Trade costs, agglomeration and factor prices
3.4 Oligopoly and Intraindustry Trade
This section examines an important phenomenon observed in international

trade.10 It has been observed that a large part of international trade is intra-
industry in character.11 Countries may conduct intraindustry trade in an
identical product in the presence of positive transport costs. We now use a
simple model to show that although it is costly to export the product from
one country to another, firms in different countries may engage in cross-
hauling of an identical product, making positive profits.
Assume that the world consists of two countries, Home and Foreign.
There is no government regulation. We are concerned with one industry
which is sufficiently small in the economy so that all income and intersec-
toral effects are neglected. There is one firm in each country producing a
homogeneous product. If there is no international trade, the firm in each
country is a monopolistic. The market is characterized of Cournot competi-
The model is proposed by Brander (1981) and Brander and Krugman (1983).
10
This section is referred to Wong (1995).

11 Earlier theoretical studies of intraindustry trade include, for instance, Balassa
(1967), Grubel (1970), Grubel and Lloyd (1975). Krugman (1981) proposes a
formal model with Chamberlinian monopolistic competition to explain intraindus-
try trade.
tion and there is no arbitrage across countries. No arbitrage requirement

implies that the firms can price-discriminate in the two markets, and the
prices of the good in these two markets may not be the same event though
free trade is allowed. The two markets are said to be segmented. Let
p = q ( p ), q ' < 0 , stand for the inverse demand function, where p is the
price and q is the demand in Home and Foreign. Let c and f stand for
the marginal cost and fixed cost in Home and Foreign. We use x + X to
represent the output of one economy, where x and X respectively stand
for the amount supplied to Home and to Foreign. The per unit transport
cost, τ , is constant and exogenous to the firms.
According to the definitions, we have the following market-clearing
conditions for the good
~
q=x+~ x , q~ = X + X . (3.4.1)
The profits, π , are given by
π = p(q )x + ~p (q~ )X − cx − (c + τ )X − f ,
~ ~ ~
π~ = p(q )~x + ~p (q~ )X − c~X − (c~ + τ )~x − f . (3.4.2)
The first-order conditions for the two firms for a Cournot-Nash equilib-
rium are thus given by
∂π (3.4.3a)
= p (q ) + p ' (q )x − c ≤ 0 ,
∂x
∂π (3.4.3b)
p (q~ ) + ~
= ~ p ' (q~ )X − (c + τ ) ≤ 0 ,
∂X
∂π~ (3.4.3c)
= p(q ) + p' (q )~
x − (c~ + τ ) ≤ 0 ,
∂~x
∂π~ ~ ~ ~ ~ ~ ~ (3.4.3d)
~ = p (q ) + p ' (q )X − c ≤ 0 .
∂X
We are interested in whether (3.4.3) has an interior solution with all the
four variables being positive. For an interior solution, inequalities are re-
placed by equalities.
Substituting q = x + ~
x into (3.4.3a) and (3.4.3c) yields
p(x + ~
x ) + p' (x + ~
x )x − c = 0 ,
p(x + ~
x ) + p' (x + ~
x )~
x − (c~ + τ ) = 0 . (3.4.4)
Equations (3.4.4) contain two variables. Add the two equations in

(3.4.4)
Ω( z ) ≡ 2 p(z ) + p' ( z )z − c0 = 0 ,
where c0 ≡ c + c~ + τ . The equation has a unique positive solution, z > 0 ,

if Ω(0) > 0 and Ω(M ) < 0 for sufficiently large M and
Ω' = 3 p ' ( z ) + p" ( z )z < 0 , (3.4.5)
which is satisfied if p" is negative or sufficiently small. Once we deter-

mine z , from (5.4.4) we solve
c − p( z ) ~ c~ + τ − p( z ) (3.4.6)
x= , x= .
p' (z ) p' (z )
The solutions are positive if
p(z ) > max {c , c~ + τ }. (3.4.7)
As
c + c~ + τ p' ( z )z
p(z ) = − ,
2 2
we see that it is not strict to require (3.4.7). In particular, if c = c~ , the ine-
quality is always satisfied. We thus solved positive x and ~ x . Similarly,
~ ~
from q = X + X and Eqs. (3.4.3b) and (3.4.3d), we can show that if
~
3~p ' (~
z)+ ~
p" (~
z )~
z < 0 , then we have positive solutions X and X .
For illustration, we examine (3.4.4). Plot x and ~ x respectively in the
horizontal and vertical axes. The slopes of the two curves are given by
d~
x − p'
( 4.5.3 a ) = − 1,
dx p' + xp"
d~
x p' (3.4.8)
= − 1.
2 p' + ~
( 4.5.3 c )
dx x p"
~
x
p + p' x − c = 0
x − (c~ + τ ) = 0
p + p' ~
x
Fig. 3.4.1. Equilibrium in Home
If p' + xp" < 0 and 2 p' + ~x p" < 0 , 12 then in the Home market the reac-
tion function of the firm in Home is steeper than the reaction function of
the firm in Foreign. We see that there is a unique equilibrium point in the
Home market where the both economies supply the identical product in
~
Home. Similarly, in the Foreign market, if ~ p ' + X~
p" < 0 and
~ ~
2 p ' + Xp" < 0 , then the both economies supply the identical product in
Foreign. These discussions show that if these conditions are satisfied, then
the world has a unique equilibrium at which the both economies supply the
identical product in the both markets. It should be remarked that the unique
equilibrium point is guaranteed under less strict conditions, that is,
p ' + xp" < 0 and p ' + ~
x p" < 0 . 13
The phenomenon that the both countries supply the identical product in
the both markets is called intraindustry (two-way) trade, or “cross-hauling”
of, of an identical product. Because the markets are segmented, the prices
of the commodity in different markets may be different. For illustration,
assume that the two countries have the same marginal cost and the same
demand curve, that is, c = c~ and p( z ) = p (z ), and the transport cost is
positive (and not very high so that the existence of an interior solution is
12 From these two conditions, we have (3.4.5).

13 The conditions are called Hahn’s (1962) stability conditions.
~
guaranteed). Due to symmetry, in equilibrium p = ~ p , x = X and ~
x = X.
The intraindustry trade exists even if it is wasteful from the two countries’
~
point of view. From Eqs. (3.4.6), we have x > ~ x and X > X . We see that
each firm receives a smaller per unit profit from the other market than
from its own market. Brander and Krugman (1983) term this phenomenon
as “reciprocal dumping”.14
Transport costs play an important role in this model. Taking derivatives
of Ω( z ) = 0 with respect to τ yields
dz 1
= < 0.
dτ 3 p ' (z ) + p" z
The total consumption in Home falls as the transport cost rises. From
(3.4.6), we have
dx p ' + xp" dz d~
x 2 p ' (z ) + xp"
=− > 0, = < 0.
dτ p' dτ dτ (3 p ' + p" z ) p '
An increase in the transport cost increases domestic supply but discour-
ages import. If the transport cost is increased sufficiently large so that
~
x = 0 , the corresponding value of the transport cost, denoted by τ~ , is
called the critical value of τ . Similarly, we denote τ c the critical value of
τ for the domestic firm below which the home export is positive. We sup-
pose τ c < τ~ . Then we have three different possibilities: (1) intraindustry
trade exists if τ < τ c < τ~ ; (2) one-way trade exists with the foreign firm
exporting if τ c < τ < τ~ ; and (3) no trade exists if τ c < τ~ < τ .
We introduced the basic model of intraindustry trade. The model has
been extended and generalized in different ways. For instance, the model
with arbitrage but zero transport cost is referred to Markusen (1981).15
14 If the prices in the markets are different, at least one firm is dumping. It should
be remarked that Fung (1991) demonstrates that if the firms can collude, then no in-
traindustry trade will exist. Nevertheless, if the goods are differentiated, intraindustry
trade is still possible even if the firms collude.
15 Our discussions are limited to Cournot competition. Wong (1995) also analyzes,
for instance intraindustry trade when free entry and exit are allowed. It is also impor-
tant to study what will happen if the markets are characterized by Bertrand competi-
tion. See for instance, Tirole (1988), Venables (1990), and Ben-Zvi and Helpman
(1992).
3.5 Trade Pattern and Variable Returns to Scale
This section is concerned with extending the Heckscher-Ohlin interna-

tional trade theory to include variable returns to scale.16 The purpose of this
study is to introduce variable returns to scale to the 2× 2 small open eco-
nomic model proposed in Sect. 2.3.17 As most variables are the same as in
Sect. 2.3, we will not define those variables which are defined in Sect. 2.3.
3.5.1 The Model with Variable Returns to Scale
Total supplies of capital and labor, K and N , are fixed. The economy
produces two goods with the following Cobb-Douglas production func-
tions with variable returns to scale18
F j = φ j (F j )K j 0 j N j 0 j , j = 1, 2 , α 0 j , β 0 j > 0 , α 0 j + β 0 j = 1, (3.5.1)
α β

Variable returns to scale are measured by the functions, φ j (F j ). We as-
sume perfect competition in the product markets and factor markets. We
also assume that product prices, denoted by p1 (= p) and p2 (= 1), are
given exogenously. Assume labor and capital are freely mobile between
the two sectors and are immobile internationally. For individual firms,
φ j (F j ) are given. The marginal conditions are
α 0 j p j Fj β 0 j p j Fj (3.5.2)
r= , w= .
Kj Nj
For simplicity of analysis, we specify φ j (F j ) as
φ j (F j ) = A0 j F j j , A0 j > 0 , ν j < 1.
ν
16 Under variable returns to scale, the core theorems of the trade theory may be-
come invalid (Jones, 1968; Panagariya, 1980).

17 This section is influenced by Ide and Takayama (1991) who apply the dual
approach to obtaining the comparative statics results. See also Kemp (1969) and
Helpman (1984) for the approach. The economic environment in this section is
almost the same as that of Ide and Takayama.
18 This kind of functions is used widely now in the literature of economic the-
ory with variable returns to scale. In the trade theory, we refer to, for instance,
Mayer (1974a), Markusen and Melvin (1981), and Panagariya (1986).
If ν j = 0 , sector j exhibits constant returns to scale. We have already

examined the model when ν 1 = ν 2 = 0 in Sect. 2.3. Hence, this section
will not discuss this case. If ν j > (<) 0 , sector j exhibits increasing (de-
creasing) returns to scale.
From these equations and Eqs. (3.5.1), we have
α β
Fj = Aj K j j N j j , (3.5.3)
where
(
1 / 1−ν j ) α0 j β0 j
A j ≡ A0 j , αj ≡ , βj ≡ .
1 −ν j 1 −ν j
It should be noted that as α j + β j ≠ 1 for ν j ≠ 0 , the production func-

tions are not “neoclassical”.
The resource constraints are given
K1 + K 2 = K , N1 + N 2 = N . (3.5.4)
We have thus built the model for a small open economy with fixed
product prices. Equations (3.5.2) -(3.5.4) contain 6 variables, N j , K j , w
and r , and 6 equations for given p j , N and K . We now show that the
six variables can be solved as functions of p , N and K .
3.5.2 Determining Equilibrium
First, from Eqs. (3.5.3), we have

α 01 pF1 α 02 F2 β 01 pF1 β 02 F2 (3.5.5)
= , = .
K1 K2 N1 N2
From these relations, we have
N1 = αkN 2 ,
where
α 02 β 01 K
α = , k ≡ 1.
α 01β 02 K2
From N1 = αkN 2 and N1 + N 2 = N , we determine the labor distribu-

tion as a function of the ratio of the two sectors’ capital inputs as follows
αkN N (3.5.6)
N1 = , N2 = .
1 + αk 1 + αk
α β
Substituting F j = A j K j j N j j into β 01 p1 F1 / N1 = β 02 p2 F2 / N 2 yields
α β1 −1β 01 pA1k α1 + β1 −1 = β 02 A2 K 2α 2 −α1 N 2β 2 − β1 , (3.5.7)
where we also use K1 = kK 2 and N1 = αkN 2 . In this study, we require

α1 ≠ α 2 . From k = K1 / K 2 and K1 + K 2 = K , we have K 2 = K / (1 + k ).
Substituting K 2 = K / (1 + k ) and N 2 in (3.5.6) into Eq. (3.5.7) yields
(1 + k )α −α (1 + αk )β − β k α + β −1 = α 0 ,
2 1 2 1 1 1 (3.5.8)
where we use
β 02 A2 K α 2 −α1 N β 2 − β1
α0 ≡ .
α β1 −1β 01 pA1
Two goods are produced if k > 0 . As shown in Sect. 2.3, even when
υ1 = υ 2 = 0 , it is difficult to explicitly interpret economic conditions that
the economy will produce two goods.19 We assume that the good prices
and factor endowments are fixed at such values that Eq. (3.5.8) has a
meaningful solution. As we are mainly interested in comparative statics
analysis, this assumption is acceptable. Once we solve k , it is straightfor-
ward to solve all the other variables. From k = K1 / K 2 and K1 + K 2 = K ,
we have
kK K (3.5.9)
K1 = , K2 = .
1+ k 1+ k
The labor distribution is given by Eqs. (3.5.6). As the distributions of the
factor endowments are already determined, it is straightforward for us to
calculate the output levels and factor prices.
As the production functions are not neoclassical, in general the wage
and rate of interest will not be determined as functions of capital intensi-
ties, K j / N j . By Eqs. (3.5.2) and (3.5.3), we have
19 Nevertheless, as we have explicitly provided a single equation for determin-
ing the capital inputs ratio, we can solve the problem with computer when the pa-
rameter values are specified.
βr βw (3.5.10)
r= , w= ,
(1 + k ) (1 + αk )
α 2 −1 β2
(1 + k ) (1 + αk )
α2 β 2 −1
where we also use (3.5.6) and (3.5.9) and

β r = α 02 A2 K α 2 −1 N β 2 , β w = β 02 A2 K α 2 N β 2 −1 .
From Eqs. (3.5.2), (3.5.10), and (3.5.9), we have
rkK rK (3.5.11)
F1 = , F2 = .
(1 + k )α 0 j p (1 + k )α 0 j
We now find out the expressions for the capital intensities. From Eqs.
(3.5.6) and (3.5.9), we have
K1 (1 + αk )K K 2 (1 + αk )K (3.5.12)
= , = .
N1 (1 + k )αN N 2 (1 + k )N
3.5.3 Comparative Statics Analysis
This section effects of changes in some parameters.
The impact of the relative price

First, we are concerned with changes in p . Taking derivatives of Eq.
(3.5.8) with respect to p yields
dk ∆ (3.5.13)
=− .
dp p
where
 α − α1 α (β 2 − β1 ) α1 + β1 − 1 
−1
∆ ≡  2 + +  .
 1+ k 1 + αk k 
From Eqs. (3.5.11), we get
1 dF1 1  1 α −1 αβ 2  dk
= − +  − 2 −  ,
F1 dp p  k (1 + k ) 1 + k 1 + αk  dp
1 dF2  α 2 αβ 2  dk
=  +  ,
F2 dp  1 + k 1 + αk  dp
d (F1 / F2 ) ∆  k (3.5.14)
= −  + 1 2 ,
dp k p
where we use
1 dr  α −1 αβ 2  dk
= −  2 +  .
r dp  1 + k 1 + αk  dp
In general, it is difficult to explicitly interpret economic conclusions of
comparative statics analysis.20 It should be noted that we solved the prob-
lem and provide a computational procedure, it is straightforward to simu-
late the model. For simplicity of illustration, we require α = 1, that is,
α 01 = α 02 . By (3.5.12), the two sectors have the same capital intensity.
The capital input ratio is now determined by
(1 + k )θ −θ k θ −1 = αˆ ,
2 1 1 (3.5.15)
where we use
1 A2
αj + βj =θj ≡ > 0 , αˆ ≡ > 0,
1 −ν j pA1 K N β 01θ
α 01θ
θ ≡ θ1 − θ 2 .
We also have
dk
=−
(1 + k )k .
(3.5.16)
dp [(θ 2 − 1)k + θ1 − 1]p
As θ j − 1 = ν j / (1 − ν j ), we see that θ j − 1 is positive (zero, negative) if
sector j exhibits increasing (constant, decreasing) returns to scale. If the
two sectors exhibit increasing (decreasing) returns to scale,21 then the capi-
tal input ratio falls (rises) as the relative price is increased (decreased). If
one sector exhibits increasing returns and the other sector decreasing re-
turns to scale, then the effects are ambiguous. Equations (3.5.10) now be-
come
20 It is also difficult to explicitly interpret economic implications of the com-

parative statics results in the dual approach, for instance, by Ide and Takayama
(1991).
21 This holds even when one sector exhibits increasing (decreasing) returns and
the other sector is characterized of constant returns to scale.

βr βw (3.5.17)
r= , w= .
(1 + k ) θ 2 −1
(1 + k ) θ 2 −1
Hence, we have
1 dr 1 dw  1 − θ 2  dk
= =  ,
r dp w dp  1 + k  dp
d (w / r ) (3.5.18)
= 0.
dp
The wage-rental ratio is not affected by changes in the relative price. The
sign of dw / dp is the opposite to that of (θ 2 − 1)dk / dp . If the both sectors
exhibit increasing (decreasing) returns to scale, then the wage and rate of
interest rise. If one sector exhibits increasing returns and the other sector
decreasing returns to scale, then the effects are ambiguous.
From Eqs. (3.5.9) and (3.5.12), we have
d (w / r )
= 0,
dp
dK1 dK 2 1 dk
=− = ,
dp dp 1 + k dp
1 dN j 1 dK j
= .
N j dp K j dp
Hence, if k rises (falls) as p is increased, sector 1' s capital and labor

inputs are increased (reduced) and sector 2' s capital and labor inputs are
reduced (increases).
From (3.5.12)
β r Kk βr K F k (3,5,19)
F1 = , F2 = , 1 = .
(1 + k ) α 0 j p
θ2
(1 + k ) α 0 j F2 p
θ2
We have
1 dF1 θ1
=−
F1 dp [(θ 2 − 1)k + θ1 − 1] p
1 dF2 θ 2k
= ,
F2 dp [(θ 2 − 1)k + θ1 − 1]p
1 d (F1 / F2 ) θ1 + θ 2 k
=− .
F1 / F2 dp [(θ 2 − 1)k + θ1 − 1] p
If the two sectors exhibit increasing returns to scale, then if the relative
price rises, the output of sector 1 and the ratio between sector 1' s and sec-
tor 2' s output levels are increased and sector 2' s output level is increased.
We thus have the following lemma.22
Lemma 3.5.1
Let α 01 = α 02 . Then, the price-output responses are normal if the two sec-
tors exhibit decreasing returns to scale.23
The effects of change in capital

We still require α = 1, that is, α 01 = α 02 . By (3.5.15), we have
dk
=−
(1 + k )α 01kθ . (3.5.20)
dK [(θ 2 − 1)k + θ1 − 1]K
As
ν1 − ν 2
θ1 − θ 2 = ,
(1 − ν 1 )(1 − ν 2 )
if the two sectors exhibit increasing returns and if ν 1 > (<) ν 2 , then k
falls (rises); if the two sectors exhibit decreasing returns and if
ν 1 > (<) ν 2 , then k rises (falls). If one sector exhibits increasing returns
and the other sector decreasing returns to scale, then the effects are ambigu-
ous. Equations (3.5.17), we have
1 dr α 2 − 1  θ 2 − 1  dk
= −   ,
r dK K  1 + k  dK
22 Ide and Takayama (1991) show that if A is positive, then the price-output
responses are normal.
23 Here, “the price-output responses are normal” means that when the price of a
good is increased, the output of the good is increased and the output of the other
good is reduced.
1 dw α 2  θ 2 − 1  dk
= −  ,
w dK K  1 + k  dK
d (w / r ) 1
= > 0.
dK K
1 dK1 1 dK 1 dk
= + ,
K1 dK K dK (1 + k )k dK
1 dK 2 1 dK 1 dk
= − ,
K 2 dK K dK (1 + k ) dK
1 dK1 1 dk
= ,
N1 dK (1 + k )k dK
1 dN 2 1 dk
=− .
N 2 dK (1 + k ) dK
From (3.5.19), we have
1 dF1 α 2 1 + k − θ 2 k dk
= + ,
F1 dK K (1 + k )k dK
1 dF2 α 2 θ k dk
= − 2 ,
F2 dp K (1 + k ) dK
1 d (F1 / F2 ) dk
= .
F1 / F2 dp dK
We see that the existence of invariable returns to scale makes the core
theorems in trade theory invalid under certain conditions.
3.5.4 Some Comments
There are many important issues which can be further examined within the
model proposed here. We can simulate the model with various combina-
tions of the parameters. We may also study what will happen if we use
some other production functions. Like in Ide and Takayama (1991), we
may examine relations between the Marshallian stability and comparative

statics. It is challenging to study behavior of a 2 × 2 × 2 world economy.24
3.6 Transboundary Pollution and Trade
We now introduce a model proposed by Benarroch and Thille (2001), to

analyze effects of transboundary pollution on trade and welfare in a gen-
eral equilibrium. Production in one industry generates pollution that nega-
tively effects on productivity, at home and abroad, in another industry. The
model allows for the possibility that pollution generated in one country
crosses the border and affects productivity in the other country.
Consider a model in which two countries, indexed by 1 (home) and
2 (foreign), produces two goods, a and b , with a single input, labor. The
production technology for producing goods b is
F jb = N jb , j = 1, 2 ,
where F jb and N jb are respectively the output of goods b and the amount
of labor devoted to b production in country j .
Assume that the output of goods b reduces the productivity of labor in
the production of goods a via a pollution externality. The production
technology for producing goods a is
F ja = (1 − β j F1b − γ j F2 b )N ja , j = 1, 2 . (3.6.1)
where F ja and N ja are respectively the output of goods a and the amount
of labor devoted to a production in country j . The parameter β1 repre-
sents the degree to which local pollution from b production in country 1
harms labor productivity in a production, while β 2 represents the degree
to which transboundary pollution from b production in country 1 harms
labor productivity in country 2 ’s production. We can similarly interpret
γ j . The quantity (β j F1b + γ j F2 b ) measures the total amount of pollution
24 We can do actually with any number of countries, factors and goods if we

simulate the model. Nevertheless, it is quite difficult to obtain analytical results
with explicit economic interpretations even if we are constrained to a simple two-
factor, tow-good, two-country economy.
damage to industry a in country j . We restrict (β j F1b + γ j F2b ) < 1 to en-

sure that labor productivity in a industry is always positive.
Let c jb and c ja denote consumption of goods b and a in country j .
Preferences for a representative consumer in country j are given by
U (c jb , c ja ) = ξ ln c jb + (1 − ξ )ln c ja , 0 < ξ < 1, j = 1, 2 .
We assume that the consumers in the two countries have an identical

preference. The identical preference implies that comparative advantage
derives from differences in the production side in each economy. For given
wage rates w j in country j , the consumers choose the following levels of
consumption to maximize utility subject to the budget constraints
wj wj (3.6.2)
c jb = ξN j , c ja = (1 − ξ )N j ,
p jb p ja
where p jb and p ja are prices of goods b and a in country j and N j is

the labor force of country j .
Autarky
We now examine the case that countries do not trade but production of
goods b in each country does affect the productivity of labor in a produc-
tion in the other country. Given the linear production technology for the
production of goods b , equilibrium entails w j / p jb = 1. Hence, by Eqs.
(3.6.2)
c jb = F jb = ξN j , j = 1, 2
From these equations and Eqs. (3.6.1), the marginal product of labor in
country j is 1 − ξ (β j N1 + γ j N 2 ) . Equilibrium consumption and produc-
tion in the market for goods a is
[ ]
c ja = F ja = (1 − ξ ) 1 − ξ (β j N1 + γ j N 2 ) N j , j = 1, 2 .
With wages in terms of goods b equal to one in each country, the rela-
tive price of goods b is the wage in terms of goods a , i.e.
p jb
= 1 − ξ (β j N1 + γ j N 2 ), j = 1, 2 .
p ja
From these equations we conclude that the relative price of goods a in

country 1 is lower than that in country 2 if
ξ (β1 N1 + γ 1 N 2 ) > ξ (β 2 N1 + γ 2 N 2 ). (3.6.3)
The left hand side of the above equation represents the amount of pollu-
tion damage in country 1 in autarky, while the right hand side represents
the pollution damage incurred in country 2 . We see that the country with a
higher incidence of pollution will have a comparative advantage in goods
b due to the greater degree of damage to productivity in its a industry.
Two countries
We now consider a case that the two countries are neighboring and they
can trade with the rest of the world. They are so small that the prices of
two goods are fixed for them. Assume that the rest of the world is not af-
fected by pollution from the two economies. We show that the autarky
price ratios for the two countries are determined by the extent to which
they experience pollution in autarky. If country 1, for instance, experi-
ences higher levels of pollution than country 2 , it will have a comparative
advantage in b production as its a industry is less productive than coun-
try 2 ’s in autarky. The remainder of this section is limited to inequality
(3.6.3). If inequality is reversed, the trade is reversed.
Proposition 3.6.1
If inequality (3.6.3) holds, then trading equilibrium is described as follows
(i) If ξ > N1 / ( N1 + N 2 ), then country 1 is specified in producing goods b
and country 2 is diversified. Equilibrium wages are given by
w1 w w
= 2 = 1, 1 = 1 − γ 2 [ξN 2 − (1 − ξ )N1 ] − β 2 N1 ,
p1b p1b p1a
w1 w
= 2.
p1a p1a
(ii) If ξ ∈ (ξ 0 , N1 / ( N1 + N 2 )), country 1 is specified in goods b and
country 2 is specified in goods a . Equilibrium wages are
w1 w
= 1, 2 =
(1 − ξ )N1 , w1 = ξN 2 (1 − β N ),
ξN 2 p1a (1 − ξ )N1
2 1
p1b p1b
w2
= 1 − β 2 N1 .
p1a
(iii) If ξ < ξ 0 , country 1 is diversified and country 2 is specified in goods

a . Equilibrium wages are
w1 w β − ξN1 w1 w
= 1, 2 = 0 , = 1 − β1 β 0 , 2 = 1 − β 2 β 0 ,
p1b p1b ξN 2 p1a p1a
where
ξ0 ≡
(1 − β1 N1 )N1 ,
(1 − β1 N1 )N1 + (1 − β 2 N1 )N 2
1 + ξ (β 1 N 1 + β 2 N 1 )
β0 ≡
2 β1
{[1 + ξ (β N
1 1 + β 2 N1 )] − 4 β1ξ (N1 + N 2 )
2
} 1/ 2
.
2 β1
The proof is referred to Benarroch and Thille (2001). The proposition
implies that the terms of trade change for each country relative to the au-
tarky price even if it remains diversified.
4 Trade with Factor Mobility
As mentioned before, some important conclusions in international trade

theory are held when only goods are allowed to move between countries. It
is necessary to check whether these conclusions are still held when factors
move between countries as well. In his pioneering analysis on international
mobility of factors, Mundell (1957) emphasizes.
Chapters 2 and 3 examined traditional trade theories with factor mobil-
ity between sectors with each country but factor immobility between coun-
tries. Commodity movements are at least to some extent a substitute for
factor movements. The absence of trade impediments implies commodity
price equalization and, even when factors are immobile, it is argued that
there is a tendency toward factor-price equalization. This chapter is con-
cerned with trade with factor mobility. We are concerned with trade pat-
terns with internationally mobile factor endowments. We are concerned
with capital and labor mobility. We will show that international capital
or/and labor movement may invalidate some of the four core theorems de-
veloped in Chap. 2. Section 4.1 studies the validity of the four fundamental
trade theorems, the factor equalization theorem, the Rybczynski theorem, the
Stolper-Samuelson theorem, and the Heckscher-Ohlin theorem, in the pres-
ence of international capital movement.1 We are still concerned with a model
similar to the 2× 2 model analyzed in Sect. 2.3. The 2× 2 model is extended
in two ways. Capital moves freely between countries. Moreover, land is con-
sidered as a production factor. The three-factor model still has two immobile
factor endowments, labor and land. Section 4.2 is concerned with immiseriz-
ing growth. We are concerned with a trade model with international factor
mobility and variable returns to scale. The model of this section is a synthesis
1 The same issue is examined by Leamer (1984), Ethier and Svensson (1986).
This section is much influenced by Wong (1995), even though we follow the ap-
proach in Sect. 2.3. It should be remarked that one might also consider another
possibility in the model with two sectors and three factors which allows capital to
move internationally freely but makes some of the factors to be sector-specific
(see, Batra and Casas, 1976; Das and Lee, 1979). Following Batra and Casas
(1973) and Der (1979), we may introduce intermediate products into the basic
model and examine the core theorems with intermediate products.
108 4 Trade with Factor Mobility
of the trade model with variable returns to scale in Sect. 3.4 and the model
with international capital mobility in Sect. 4.1. Section 4.3 is concerned with
a model of emigration and wage inequality proposed by Marjit and Kar.
Rather than following the dual approach accepted by Marjit and Kar, we will
use the approach as in the previous sections. The model deals with issues re-
lated to trade and wage inequality for developing economies. Section 4.4 in-
troduces a model with Chamberlinian agglomeration, basing on the core-
periphery model proposed by Krugman. The model studies interactions
demand linkages.
4.1 A Two-Good, Three-Factor Model with Capital Mobility
This section studies the validity of the four fundamental trade theorems,
the factor equalization theorem, the Rybczynski theorem, the Stolper-
Samuelson theorem, and the Heckscher-Ohlin theorem, in the presence of
international capital movement. We are still concerned with a model simi-
lar to the 2× 2 model analyzed in Sect. 2.3. The 2× 2 model is extended
in two ways. Capital moves freely between countries. Moreover, land is
considered as a production factor. The three-factor model still has two
immobile factor endowments, labor and land. Almost all the symbols have
the same definitions as in Sect. 2.3. We will define new variables. Let L
stand for the total fixed amount of land and L j for the amount of land used
by industry j .
4.1.1 The model and its general solution
The economy produces two goods with the following Cobb-Douglas pro-
duction functions
α β ς
F j = A j K j j N j j L j j , j = 1, 2 , (4.1.1)
α j , β j , ς j > 0 , α j + β j + ς j = 1,
Let w , r , and R stand for wage, rate of interest, and land rent respec-
tively. Here, the rate of interest is exogenously fixed. Three prices,
p1 , p2 , r are fixed exogenously and wage and land rent, w and R are de-
termined endogenously. Profits of the two sectors, π j , are given by
π j = p j F j − wN j − rK j − RL j .
Marginal conditions for maximizing profits are given by
α j p j Fj β j p j Fj ς j p j Fj (4.1.2)
r= , w= , R= .
Kj Nj Lj

K1 + K 2 + K E = K , N1 + N 2 = N , L1 + L2 = L , (4.1.3)
where K E is the outflow of domestic capital (negative K E for an amount

of foreign capital used in Home). Equations (4.1.2) and (4.1.3) contain
nine variables, N j , K j , L j , K E , w and R , and nine equations for given
p j , r , N , K , and L . We now show that the nine variables can be
solved as functions of the parameters.
From the marginal conditions in r and w , we have
α1 p1 F1 α 2 p2 F2 β1 p1 F1 β 2 p2 F2
= , = .
K1 K2 N1 N2
From this equation we obtain N1 / N 2 = βk , where β ≡ α 2 β1 / α1 β 2 and

k ≡ K1 / K 2 . From N1 / N 2 = βk and N1 + N 2 = N , we solve
βkN N (4.1.4)
N1 = , N2 = .
1 + βk 1 + βk
Similarly, from
α1 p1 F1 α 2 p2 F2 ς 1 p1 F1 ς 2 p2 F2
= , = ,
K1 K2 L1 L2
we solve
L1
= ςk ,
L2
where ς ≡ ς 1α 2 / ς 2α1 . From this equation and L1 + L2 = L , we solve

ςkL L (4.1.5)
L1 = , L2 = .
1 + ςk 1 + ςk
α β ς
From r = α j p j F j / K j and F j = A j K j j N j j L j j , we solve
(
1/ 1 − α j )
 α p A N β j Lς j 
Kj =  j j j j j  .
 r 
 
Dividing the above two equations yields
k=r α (α p A N
1 1 1
β1
1 Lς11 )
1 / (1 − α1 )
,
(α p A N
2 2 2
β2
2 Lς22 )
1 / (1 − α 2 )
where
α 2 − α1
α≡ .
(1 − α1 )(1 − α 2 )
Substituting Eqs. (4.1.4) and (4.1.5) into the above equation yields
1 = r0 (1 + βk ) 1 (1 + ςk ) 2 , (4.1.6)
r r
where
r0 ≡ r α
(α p A (βN )
1 1 1
β1
(ςL )ς 1
)(
1 / 1 − α1 )
,
(α 2 p 2 A2 N L )
β2 ς 2 1 / (1 − α 2 )
β2 β1 ς2 ς1
r1 ≡ − , r2 ≡ − .
1 − α 2 1 − α1 1 − α 2 1 − α1
We assume that Eq. (4.1.6) has a unique positive solution.2 This implies
that Home produces two goods. For a positive k , all the variables are de-
termined by the following procedure: N j by (4.1.4) → L j by (4.1.5) →
K E = K − K1 − K 2 → w and R by (4.1.2) → F j by (4.1.1).
w=
(1 + βk )rβ1 K1 , R=
(1 + ςk )rς 1 K1 . (4.1.7)
α1 βkN ςkL
where
2 As the expression is tedious, it is difficult to interpret economic implications
of this condition.
1 / (1 − α1 ) β1 / (1 − α1 ) ς 1 / (1 − α1 )
 α p A β β1 N β1ς ς1 Lς1   k   k 
K1 =  1 1 1      .
 r   1 + βk   1 + ςk 
So long as two goods are produced, factor prices, (w , R ), are affected
by factor endowments. We see that the property of factor price insensitiv-
ity is not valid in general when factor mobility is allowed.
The factor price equalization theorem stated in Sect. 2.3 tells that if two
countries are engaged in free trade, having identical technologies but dif-
ferent factor endowments and if both countries produce both goods, then
the factor prices (w, R ) are equalized across the countries. As (w, R ) are
affected by the factor endowments, the factor price equalization theorem
does not hold when factor mobility is allowed.
Another well-known question in the trade literature is that when product
prices are changed, how the factor prices will be changed. Taking deriva-
tives of Eqs. (4.1.7) with respect to p1 and p2 results in
1 dw 
= 1 −
(β − ς )ς 1 p0  1
,

w dp1  (1 + βk )(1 + ςk )(1 − α1 ) (1 − α1 ) p1
1 dR 
= 1 −
(ς − β )β1 p0  1
,

R dp1  (1 + βk )(1 + ςk )(1 − α1 ) (1 − α1 ) p1
1 dw [(β − ς )ς 1k − (1 + ςk )α 1 ] p0
= ,
w dp2 (1 + ςk )(1 + β k )(1 − α 2 ) p2 k
1 dR [(ς − β )β1k − α1 (1 + βk )] p0 (4.1.8)

= ,
R dp2 (1 + ςk )(1 − α 2 ) p2 k
where we use
r1β rς
p0 ≡ + 2 .
1 + β k 1 + ςk
From its definition, we have
 β2 β1  β  ς ς1  ς
p0 =  −  +  2 −  .
 1 − α 2 1 − α 1  1 + β k  1 − α 2 1 − α 1  1 + ςk
We see that the sign of p0 is ambiguous in general. Even if can determine
the sign of p0 , it is still difficult to judge effects of changes in the prices
on the economic equilibrium. This implies that the four core theorems may
not be held in general. For illustration, we are concerned with a special
case of α1 = α 2 .
4.1.2 The core theorems of traditional trade theory with α 1 = α 2
We have shown that it is difficult to get explicit conclusions if we don’t

further specify parameter values. We now examine equilibrium properties
of the model by α1 = α 2 . It should be noted that this requirement also im-
plies β1 + ς 1 = β 2 + ς 2 . Under α1 = α 2 , by (4.1.6) we can explicitly
solve k as a function of the prices as follows
r0 − 1 (4.1.9)
k= ,
ς − r0 β
where we use ς = ς 1 / ς 2 , β = β1 / β 2 , and
1 / ( β 2 − β1 )
 p A β β1 ς ς 1  L
r0 ≡  1 1  ,
 p2 A2  N
β 2 − β1
r1 = − r2 = .
1 − α1
We assume that the parameter values satisfy: k > 0 . From Eqs. (4.1.2), we
get
ς 1 / (1 − α1 )
β (α p A )
1 / (1 − α1 )
 L1 
w = 1 1 α11 / (11 − α1 )   ,
α 1r  N1 
β1 / (1 − α1 )
ς (α p A )
1 / (1 − α1 )
 N1 
R = 1 1 α11 / (11 − α1 )   ,
α 1r  L1 
where we use K1 = (α1 p1 A1 N1β1 Lς11 / r )

1 / (1 − α1 )
. Insert N1 in (4.1.4) and L1 in
(4.1.5) in the above equation
α *ς 1
β (α p A )
1 / (1 − α1 )
 p2 A2ς α 2 
w = 1 1 α11 / (11 − α1 )   ,
α 1r  p1 A1 β
β2

α * β1 (4.1.10)
ς (α p A )
1 / (1 − α1 )
 p1 A1 β β 2 
R = 1 1 α11 / (11 − α1 )   ,
α 1r  p2 A2ς
α2

where we also use (4.1.9) and
1
α* ≡ .
(β 2 − β1 )(1 − α1 )
From Eqs. (4.1.10), the following lemma holds.
Lemma 4.1.1 (Factor Price Insensitivity)

So long as two goods are produced under α1 = α 2 , then each price vector
( p1 , p2 , r ) corresponds to unique factor prices (w , R ).
This lemma implies that the immobile factor endowments ( N , L ) do not

affect their prices, (w , R ). Another direct implication of our analytical re-
sults is Samuelson’s factor price equalization theorem.
Theorem 4.1.1 (Factor Price Equalization Theorem, Samuelson, 1949)

Suppose that two countries are engaged in free trade under α1 = α 2 , hav-
ing identical technologies but different factor endowments. If both coun-
tries produce both goods, then the prices of the immobile factors, (w , R ),
are equalized across the countries.
When trade takes place, then the prices, p1 , p2 , r , are equal across the
countries. As the two countries have the identical technologies, that is,
α j , β j and A j are identical across the countries, from Eqs. (4.1.10) we
see that Samuelson’s theorem holds even when we allow one factor to be
freely mobile under the strict condition of α1 = α 2 . This theorem says that
trade in goods may equalize factor prices across the countries even when
some production factors are immobile and some others are mobile.
From (4.1.4) and (4.1.5), we have
L1 L
− 2 = (ς 1 − ς 2 )
(1 + βk )(1 − α1 )L .
N1 N 2 (1 + ςk )β 2ς 2 βN
Under α1 = α 2 , we say that sector 1 is land intensive, with a higher

land-labor ratio than that in sector 2 at any given factor prices, that is
L1 / N1 > L2 / N 2 . Sector 1 being land intensive is equal to
ς 1 − ς 2 = β 2 − β1 > 0 . (4.1.11)
In the reminder of this section, we require (4.1.11). We also have
α > 0.
*
We now examine how the factor prices will be changed when product
prices are changed. Taking derivatives of Eqs. (4.1.10) with respect to p1
and p2 results in
1 dw − ς2
= < 0,
w dp1 (β 2 − β1 )(1 − α1 ) p1
1 dR β2
= > 0,
R dp1 (β 2 − β1 )(1 − α1 ) p1
1 dw α *ς 1 1 dR α *ς 1 (4.1.12)
= > 0, =− < 0.
w dp2 p2 R dp2 p2
From Eqs. (4.1.12), we have
 p1  d (w / p1 ) 1 dw 1
  = − < 0,
 w  dp1 w dp1 p1
 p1  d (R / p1 ) β 2 − (β 2 − β1 )(1 − α1 ) (4.1.13)
  = > 0.
 R  dp1 (β 2 − β1 )(1 − α1 ) p1
Theorem 4.1.2 (Stolper-Samuelson Theorem)

An increase in the relative price of a good will increase the real return to
the factor used intensively in that good, and reduce the real return to the
other factor.
We now examine effects of changes in the endowments. From Eq.

(4.1.8), we directly have
1 dk
=
(β − ς )r0 < 0,
k dN (r0 − 1)(ς − r0 β )N
1 dk − (β − ς )r0 (4.1.14)
= > 0,
k dL (ς − r0 β )(r0 − 1)L
where we use β − ς = − (β1 + ς 1 )(β 2 − β1 ) / β 2ς 2 < 0 . From Eqs. (4.1.4),

(4.1.5) and (4.1.14), we obtain the effects of change in the labor force on
the factor distributions
1 dN1 1 1 dk
= + ,
N1 dN N (1 + βk )k dN
1 dN 2 1 β dk
= − > 0,
N 2 dN N (1 + βk ) dN
1 dL1 1 dk 1 dL2 − ς dk (4.1.15)

= < 0, = > 0.
L1 dN (1 + ςk )k dN L2 dN 1 + ςk dN
From Eqs. (4.1.4), (4.1.5) and (4.1.14), we obtain the effects of change
in the land on the factor distributions
1 dN1 1 dk 1 dN 2 β dk
= > 0, =− < 0,
N1 dL (1 + βk )k dL N 2 dL (1 + βk ) dL
1 dL1 1 1 dk 1 dL2 1 ς dk (4.1.16)
= + > 0, = − .
L1 dL L (1 + ςk )k dL L2 dL L 1 + ςk dL
We note that changes in the endowments have no effect on the wage and
the rate of interest. From Eqs. (4.1.2), we directly obtain
1 dF1 1 dL1 1 dF2 1 dL2
= < 0, = > 0,
F1 dN L1 dN F2 dN L2 dN
1 dF1 1 dN1 1 dF2 1 dN 2 (4.1.17)

= > 0, = < 0.
F1 dL N1 dL F2 dL N 2 dL
We notice that industry 1 is land intensive and industry 2 is labor in-
tensive.
We have demonstrated that the factor price insensitivity lemma,
Samuelson’ factor price equalization theorem, Stolper-Samuelson theorem,
and Rybczynski’s theorem, are still valid when one production factor is in-
ternationally mobile. We now show that the Heckscher-Ohlin theorem is
also valid when one factor is internationally mobile.
Theorem 4.1.3 (Heckscher-Ohlin Theorem)

Each country will export the good that uses its abundant factor intensively.
Like in Sect. 2.3, we describe the consumer’s utility-maximizing

problem as follows
Max C1ξ1 C 2ξ 2 , s.t. : p1C1 + p2C 2 = Y ,
parameters, and Y is the total income given by Y = rK + wN + RL . For
convenience of representation, we require ξ1 + ξ 2 = 1. The optimal
solution is given by
p j C j = ξ jY .
As the economy is autarky, we have C j = F j . From p j C j = ξ jY and

C j = F j , we have
p1 F1 ξ1
= .
p2 F2 ξ 2
Substituting r = α j p j F j / K j into the above equation yields k = ξ1 / ξ 2 ,

where we use α1 = α 2 . Substituting Eq. (4.1.9) into the above equation
yields
1 / ( β1 − β 2 )
L  ς (ξ1 / ξ 2 ) + 1  A1β β1ς ς1  (4.1.18)
p1/ ( β 2 − β1 ) =   ,
N  β (ξ1 / ξ 2 ) + 1 A2 
where p = p1 / p2 . Equation (4.1.18) determines the relative price in the
home country in autarky. According to the assumptions that the two coun-
tries have the identical technology and preference, according to Eq.
(4.1.18) we have
~ (4.1.19)
~ 1 / ( β 2 − β1 ) L 1 / ( β 2 − β1 ) L
p ~ = p ,
N N
~ ~
when the countries are in autarky. If L / N > L / N , then we have
p1/ ( β 2 − β1 ) < ~
p 1/ ( β 2 − β1 ) .
As β 2 > β1 , we have p < ~

p , that is
p1 ~
p
< ~1 .
p2 p2
That is, when the two countries are in autarky, the relative price in Home
is lower than the relative price in Foreign. Hence, when the two countries
start to trade, good 1 is exported to Foreign and good 2 is imported from
Foreign. We have thus confirmed the Heckscher-Ohlin theorem.
This section is mainly concerned with whether the core theorems in the
traditional trade theory are valid when we allow one factor to be mobile. It
can be seen that in general (that is, when α1 ≠ α 2 ) the theorems are inva-
lid. But when α1 = α 2 , the core theorems are all held. As the condition of
α1 = α 2 implies that the internationally mobile factor affects symmetri-
cally the neoclassical production functions and the core theorems mainly
refer to the relative properties of the two sectors, it is reasonable to expect
that the core theorems hold under the requirement. Like in the previous
chapter, we may also extend our analysis to allow for differences in tech-
nology and taste within a multi-country world economy.3
4.2 Variable Returns to Scale and Immiserizing Growth
An important question in international trade theory is whether free trade

improves a country’s welfare. We will show that in a dynamic world with
capital and knowledge accumulation, even when we assume that all the
economic production functions are neoclassical, free trade may benefit no
country.4 In fact, during the early 1950s, some economists held that devel-
oping countries, which primarily exported raw materials, are likely to ex-
perience declining terms of trade over time. It was argued that growth in
developed economies tend to develop new synthetic substitutes for raw
materials, while developing countries would further extend their capacity
of producing what they had already exported rather than make efforts for
rapid industrialization. Developed economies were likely to become im-
port biased and developing economies were likely to become export bi-
ased. Some economists even suggested that export biased growth by de-
veloping economies would worsen their terms of trade so much that they
3 Another approach to comparative statics analysis is through introducing local

dynamics (see, Das and Lee, 1979).
4 The result is proved Zhang (1992) in the Solow growth model with capital and
knowledge accumulation.
would be worse off if they had not grown at all. This situation is termed as
immiserizing growth. This phenomenon was initially formally modeled by
Bhagwati (1958). Since then, immiserizing growth has been examined
with different models, emphasizing various aspects of trade, such as capi-
tal accumulation, tariff and quotas.5
This section is concerned with immiserizing growth. We are concerned
with a trade model with international factor mobility and variable returns
to scale. The model of this section is a synthesis of the trade model with
variable returns to scale in Sect. 3.4 and the model with international capi-
tal mobility in Sect. 4.1.6 In order to connect this section to the traditional
approaches, we will deal with the economic system proposed by Yabuchi
and Kakimoto (1991).7
4.2.1 The model with variable returns to scale and capital

mobility
The economy has two sectors, producing two goods, indexed by 1 and 2 .
The economy is endowed with three factors, capital, K , labor, N , and
land, L . The returns of the three factors are respectively r , w , and R .
Labor is a common factor, while capital and land are specific to sector 1
and sector 2 , respectively. It is assumed that returns to scale are variable
and external to firms.
The economy produces two goods with the following Cobb-Douglas
production functions with variable returns to scale
F1 = φ1 (F1 )K1α 0 N1β 01 , α 01 , β 01 > 0 , α 0 + β 01 = 1,
F2 = φ2 (F2 )N 2β 02 Lς 0 , β 02 , ς 0 > 0 , β 02 + ς 0 = 1, (4.2.1)
where K 01 is capital input employed by sector 1 and N j are labor inputs

of sector j . Variable returns to scale are measured by the functions,
φ j (F j ). We assume perfect competition in the product markets and factor
markets. We also assume that product prices, denoted by p1 (= p ) and
5 See Bhagwati (1958b), Johnson (1967a), Bertrand and Flatters (1971), Hamada
(1974), Brecher and Diaz-Alejandro (1977), Martin (1977), and Dei (1985).
6 It is easy to examine issues related to immiserizing growth in the models of
perfect competition presented in the previous chapters.

7 The main features of the approach different from the model in Sect. 4.1 are
that capital and land are sector-specified.

p2 (= 1), are given exogenously. Assume that labor and land are interna-
tionally immobile and capital is internationally mobile. As there is no cost
for factor mobility, the rate of interest is fixed in international market and
the wage rate is identical for the two sectors in the domestic market. For
individual firms, φ j (F j ) are given. The marginal conditions are
α 0 pF1 β 01 pF1 β 02 F2 ς 0 F2 (4.2.2)

r= , w= = , R= .
K1 N1 N2 L
Like Sect. 3.4, we specify φ j (F j ) as
φ j (F j ) = A0 j F j j , A0 j > 0 , ν j < 1.
ν
From the above functions and Eqs. (4.2.1), we have

F1 = A1 K1α N1β1 , F2 = A2 N 2β 2 Lς , (4.2.3)
where
(
1 / 1−ν j ) α0 β0 j ς0
A j ≡ A0 j , α≡ > 0, β j ≡ > 0, ς ≡ > 0.
1 − ν1 1 −ν j 1 −ν2
Like in Sect. 2.3, we describe the consumer’s utility-maximizing

problem as follows
Max C1ξ1 C2ξ 2 , s.t. : pC1 + C2 = Y ,

parameters, and Y is the total income given by
Y = rK + wN + RL .
For convenience of representation, we require
ξ1 + ξ 2 = 1.
The optimal solution is given by
pC1 = ξ1Y , C2 = ξ 2Y . (4.2.4)
dowments found in the economy. The factor constraints are given
K1 + K E = K , N 1 + N 2 = N , (4.2.5)
where K E is the outflow of domestic capital (negative K E for an amount

of foreign capital used in Home).
Let X j stand for the amount of (net) imports of good j by Home.
When the variable is negative (positive), then the country exports (imports)
that good. The country’s consumption plus its exports is equal to its prod-
uct. That is
C j = F j + X j , j = 1, 2 . (4.2.6)
In terms of value, the country is assumed to be in trade balance, that is

pX 1 + X 2 − rK E = 0 . (4.2.7)
4.2.2 Equilibrium
We now show how to determine equilibrium. From Eqs. (4.2.2), we have

β 02α 0 A2 Lς (4.2.8)
K1 = N1 N 2β 2 −1 ,
β 01r
where we also use F2 = A2 N 2β 2 Lς . From r = α 0 pF1 / K1 and

α β1
F1 = A1 K1 N1 , we have
N1 = θ1 K1(1−α )/ β1 , (4.2.9)
where
1 / β1
 r 
θ1 ≡   .
 α 0 pA1 
Insert Eq. (4.2.9) in Eq. (4.2.8)
N 2 = θ 2 K1(α + β1 −1)/ β1 ( β 2 −1) , (4.2.10)
where
1 / ( β 2 −1)
 (α pA )1 / β1 β 01r 1−1 / β1 
θ2 ≡  0 1  .
 β 02α 0 A2 Lς 
Inserting Eqs. (4.2.9) and (4.2.10) in N1 + N 2 = N yields
Ω(K1 ) ≡ θ1 K1( β 01 −ν 1 ) / β 01 + θ 2 K1θ − N = 0 , (4.2.11)

where
α + β1 − 1 v (1 − ν 2 )
θ≡ = 1 .
β1 (β 2 − 1) β 01 (ν 2 − ς 0 )
It is reasonable to require β 01 − ν 1 > 0 and ς 0 − ν 2 > 0 . The require-
ments imply that any sector’s increasing returns to scale is not very strong.
In the reminder of this section, we require β 01 − ν 1 > 0 and ς 0 − ν 2 > 0 .
We have
 β −ν  (4.2.12)
Ω(0 ) > 0 , Ω(+ ∞ ) > 0 , Ω' =  01 1 θ1 K1−ν 1 / β 01 + θθ 2 K1θ −1 < 0 .
 β 01 
We see that Eq. (4.2.12) has a unique positive equation.8 Once we solve
K1 , we solve the other variables as follows: N 2 by (4.2.10) → N1 by
(4.2.9) → F j by (4.2.3) → w and R by (4.2.2) → Y by its definition →
C j by (4.2.4) → U = C1ξ1 C 2ξ 2 → X j by (4.2.6) → K E = K − K1 .
4.2.3 Immiserizing growth
This section is concerned with effects of changes in some parameters and

thus provide some insights into issues related to immiserizing growth in
the trade system with variable returns to scale. In this section, we always
assume that two goods are produced in the country.
Effects of changes in the sector-specific and land

We now examine effects of land on the equilibrium. First, by Eq.
(4.2.11), we have
dK1 ς 0 θ 2 K1θ
Λ* = > 0,
dL ς 0 − ν 2 L
where Λ* ≡ − dΩ / dK1 > 0 under β 01 − ν 1 > 0 and ς 0 − ν 2 > 0 . If the

country has more land, it will employ more capital. From Eqs. (2.2.9) and
N1 + N 2 = N , we obtain
8 It is straightforward to confirm that if we require β 01 −ν 1 < 0 and

ς 0 − ν 2 < 0 , the equation has a unique positive solution; if β 01 −ν 1 > 0 and
ς 0 − ν 2 < 0 (or β 01 −ν 1 < 0 and ς 0 − ν 2 > 0 ), the equation has two positive so-
lutions. Hence, the problem has multiple equilibrium points.
dN1 dN 2 (1 − α )N1 dK1

=− = > 0.
dL dL β K1 dL
Some workers move from sector 2 to 1 as land is increased. From (4.2.3),
we have
1 dF1 α dK1 β1 dN1
= + > 0,
F1 dL K1 dL N1 dL
1 dF2 ς β dN 2
= + 2 .
F2 dL L N 2 dL
Sector 1' s output is increased. The impact on sector 2' s output is am-
biguous. Taking derivatives of Eqs. (4.2.2) with respect to L yields
1 dw ν − ς 0 dN 2 ς
= 2 + > 0,
w dL (1 − ν 2 )N 2 dL L
1 dR β −ν2 β dN 2
= − 02 + 2 < 0.
R dL (1 − ν 2 )L N 2 dL
As land is increased, the land rent falls and the wage rate rises. From the
definition of Y , we have
dY [(ν 2 − ς 0 )N1 + ν 2 N 2 ]w dN 2 ςwN ς0R

= + + ,
dL (1 − ν 2 )N 2 dL L (1 − ν 2 )
where we also use w / R = β 02 L / ς 0 N 2 . If (ν 2 − ς 0 )N1 + ν 2 N 2 < 0 , which is
guaranteed, for instance when the two sectors exhibit decreasing or weak
increasing returns to scale, then dY / dL > 0 . The first term in the right-
hand side of the above equation is negative when (ν 2 − ς 0 )N1 + ν 2 N 2 > 0 ,
and the other terms are positive. We see that the impact on the total income in
this case is ambiguous. Insert Eq. (4.2.4) in the utility function U = C1ξ1 C 2ξ 2
U = ξY ,
where
ξ ≡ ξ1ξ1 ξ 2ξ 2 p −ξ1 .
From U = ξY and Eqs. (4.2.4), we have
1 dU 1 dC1 1 dC 2 1 dY
= = = .
U dL C1 dL C2 dL Y dL
The effects on the utility level and consumption levels of the two goods
are ambiguous. We can see that an increase in land may be immiserizing
only when at least one sector is characterized of strong increasing returns
to scale. Otherwise, an increase in land benefits the households.
Effects of changes in the sectorally mobile but internationally immo-

bile factor, labor
By Eq. (4.2.11), we have
dK1
Λ* = − 1 < 0.
dN
As the total labor force is increased, the economy will employ less capital.
From Eqs. (2.2.9) and N1 + N 2 = N , we obtain
dN1 (1 − α )N1 dK1 dN 2 dN1
= < 0, =1− > 0.
dN βK1 dN dN dN
1 dF1 α dK1 β1 dN1
= + < 0,
F1 dN K1 dN N1 dN
1 dF2 β dN 2
= 2 < 0.
F2 dN N 2 dN
Sector 1' s output is increased. The impact on sector 2' s output is am-
biguous. Taking derivatives of Eqs. (4.2.2) with respect to N yields
1 dw ν − ς 0 dN 2 1 dR β 2 dN 2
= 2 < 0, = > 0.
w dN (1 − ν 2 )N 2 dN R dN N 2 dN
The impact on the income is given by
dY [(ν − ς 0 )N + ς 0 N 2 ]w dN 2 .
=w+ 2
dN (1 − ν 2 )N 2 dN
If (ν 2 − ς 0 )N1 + ν 2 N 2 > 0 , then dY / dN > 0 . If (ν 2 − ς 0 )N1 + ν 2 N 2 < 0 ,

then the impact on the income is ambiguous. If (ν 2 − ς 0 )N1 + ν 2 N 2 < 0 ,
then dY / dL > 0 ; but if (ν 2 − ς 0 )N1 + ν 2 N 2 > 0 , then dY / dN > 0 . We
also see that both when (ν 2 − ς 0 )N1 + ν 2 N 2 is positive and negative, it is

possible for economic growth to be immiserizing. From U = ξY and Eqs.
(4.2.4), we have
1 dU 1 dC1 1 dC 2 1 dY
= = = .
U dN C1 dN C2 dN Y dN
The effects on the utility level and consumption levels of the two goods are
ambiguous.
Effects of the sector-specific and internationally mobile factor, capital

It is straightforward to see that change in K has no impact on K1 ,
N j , F j , w and R . By the definition of Y , we have dY / dK = r . From
U = ξY , we have dU / dK = ξdY / dK > 0 . An increase in capital always
increase the utility level.
Effects of price changes

We now examine effects of changes in the price on the equilibrium.
First, by Eq. (4.2.11), we have
dK1  θ Kθ  1
Λ* = − θ1 K1( β 01 −ν 1 ) / β 01 + 2 1  < 0.
dp  1 − β 2  β1 p
If good 1' s price is increased, the capital stock used by sector 1 falls. From
Eqs. (2.2.9) and N1 + N 2 = N , we obtain
dN1
=−
dN 2 N
=− 1 +
(1 − α )N1 dK1 < 0 .
dp dp β1 p β1 K1 dp
Some workers move from sector 2 to 1 as good 1' s relative price is in-
creased. From (4.2.3), we have
1 dF1 α dK1 β1 dN1 1 dF2 β dN 2
= + < 0, = 2 > 0.
F1 dp K1 dp N1 dp F2 dp N 2 dp
Sector 1' s real output falls and sector 2' s real output rises. The impact
on sector 2' s output is ambiguous. Taking derivatives of Eqs. (4.2.2) with
respect to p yields
1 dw 1 − β 2 dN 2 1 dR 1 dF2
=− < 0, = > 0.
p dp N 2 dp R dp F2 dp
From the definition of Y , we have

dY dw dR
=N +L .
dp dp dp
The impact on the total income is ambiguous. From U = ξY and Eqs.
(4.2.4), we have
1 dU 1 dC1 1 dC 2 1 dY
= = = .
U dp C1 dp C2 dp Y dp
4.3 A Trade Model with Emigration
This section is concerned with a model of emigration and wage inequality

proposed by Marjit and Kar (2005). Rather than following their dual ap-
proach accepted, we will use the approach as in the previous sections. The
model studies issues related to trade and wage inequality for developing
economies.9
4.3.1 The model with emigration and wage inequality
The model is still a two good and three input specific-factor model as de-
veloped in Sect. 4.2. But the three sectors are now capital, unskilled work-
ers, and skilled workers. The two, unskilled and skilled, sectors are in-
dexed respectively with 1 and 2 . Assume that the unskilled sector
employs unskilled labor and capital and the skilled sector employs skilled
labor and capital. The two kinds of labor are the specific factors and capi-
tal is the mobile factor. Different from the model in Sect. 4.2 where capital
is sector-specific and labor is mobile, this section assumes that labor is sec-
tor-specific and capital is mobile. As this model is mainly referred to de-
veloping economies where technologically advanced sectors often co-exist
with primitive indigenous sectors and the two sectors use different types of
labor but have the same sources of capital, this assumption is reasonable.
9 There are a large number of the literature on relations between trade and wage
inequality for developing economies (e.g., Davis, 1998; Feenstra and Hanson,
1997, 2003; Jones and Marjit, 2003; Kar and Beladi, 2004).
We introduce F j , K j , N j , w j , and r as before. It should be noted that

N j are fixed. The economy produces two goods with the following Cobb-
Douglas production functions
α β
F j = A j K j j N j j , j = 1, 2 , α j , β j > 0 , α j + β j = 1. (4.3.1)
Initially, there is no international factor mobility. The two prices,

p1 , p2 , are fixed internationally and wage and rate of interest, w and r ,
are determined endogenously. Marginal conditions for maximizing profits
are given by
r= , wj = .
Kj Nj
Capital is fully employed, that is

K1 + K 2 = K . (4.3.3)
The system has seven variables, K j , F j , w j and r , and seven equa-

tions for given p j , N j , and K . We now show that the variables can be
solved as functions of the parameters.
From the marginal conditions in r , we have
α1 p1 F1 α 2 p2 F2
= .
K1 K2
From this equation and (4.4.3), we solve
K 2 = nK1β1 / β 2 , (4.3.4)
where
1/ β 2
 α p A 
n ≡  2 2 2 β1  N2 .
 α1 p1 A1 N1 
Ω(K1 ) ≡ K1 + nK1β1 / β 2 − K = 0 . (4.3.5)
Equation (4.3.5) has a unique solution as Ω(K1 ) has the following prop-
erties
β1nK1β1 / β 2 −1
Ω(0 ) < 0 , Ω(K ) > 0 , Ω' (K1 ) = 1 + > 0.
β2
Once we determine K1 by (4.3.5), it is straightforward to confirm that we
can determine uniquely all the other variables. We will denote the equilib-
rium values with circumflex accent.
4.3.2 The effects of trade when labor emigrates
First, we examine possible effects of unskilled labor emigration. We al-

ways assume that the prices are fixed in the international markets and will
not be affected by any change in Home. Nevertheless, the wage rates and
rate of interest are determined domestically. We now allow unskilled labor
to be internationally mobile but still assume that skilled labor and capital
are internationally immobile. We assume that the global wage for un-
skilled, w1* , is higher than wˆ 1 . Some unskilled labor will emigrate. We
now determine how many will emigrate. Assume that Home is so small
that the foreign market can absorb any number of unskilled labor from
Home with w1* . and any change in Home has negligible effects on the
world market. All the variables in the factor mobile economy are indexed
with asterisk.
We now determine equilibrium with given w1* . From w1* = β1 p1 F1* / N1*
in (4.3.2), we solve
*α1 β1 p1 A1 K1*α1 (4.3.6)

N 1 = *
.
w 1

α1 p1 F1* α 2 p2 F2*
= .
K1* K 2*
From this equation and Eqs. (4.3.2) and (4.3.6), we solve
 α p w*β1 / α1 A N * 
1/ β 2 (4.3.7)
K =  2 2 1 1/ α21 2 
*
.
 (β1 p1 A1 )
2

From this equation and K1* + K 2* = K , we solve
 α p w*β1 / α1 A N * 
1/ β 2 (4.3.8)
K = K −  2 2 1 1/ α21 2 
*
.
 (β1 p1 A1 )
1

If the world wage, w1* , is very high, then K1* negative; in other words,
all unskilled labor will emigrate. We assume, w1* , to be properly fixed so
that K1* is positive. Once we determine K1* by (4.3.8), we can determine
all the variables.
To examine the effects on the capital distribution, from (4.3.5) and
(4.3.8) we calculate
1/ β 2
 α p w*β1 / α1 A N * 
Ω(K ) ≡ −  2 2 1 1 / α21 2 
*
+
 (β1 p1 A1 )
1

β1 / β 2
  α 2 p2 w1*β1 / α1 A2 N 2*  
1/ β 2
(4.3.9)
nK −    .
 (β1 p1 A1 )
1 / α1
  
( )
As Ω(K1 ) rises in K1 and Ω Kˆ 1 = 0 , we see that if Ω(K1* ) > (<) 0 ,
then K * > (<) Kˆ . From (4.3.2), we see that for the both cases of the fac-
1 1
tor immobility and mobility, we have

1 / α1
K1  w1  (4.3.10)
=  .
N1  A1 β1 p1 
As wˆ 1 < w1* , we have Kˆ 1 / Nˆ 1 < K1* / N1* , where Nˆ 1 = N1 . As unskilled

labor emigrates, the capital intensity of the skilled sector is increased.
From (4.3.2), we also see that for the both cases, we have
β1 β2 α2
N  N  K 
r = α1 p1 A1  1  = α 2 p2 A2  2  , w2 = β 2 p2 A2  2  .
 K1   K2   N2  (4.3.11)
Kˆ 1 / Nˆ 1 < K1* / N1* r = α1 p1 A1 (N1 / K1 ) 1 ,
β
From and we conclude
rˆ > r . As unskilled labor emigrates, the rate of interest falls as unskilled
*
labor’s wage becomes higher. From rˆ > r * and (4.3.11), we get
Kˆ 2 K 2*
< * , wˆ 2 < w2* .
ˆ
N2 N2
4.4 Human Capital Mobility and Chamberlinian Agglomeration 129
As unskilled labor emigrates, skilled labor’s wage rises. As Nˆ 2 = N 2* ,

we have Kˆ 2 < K 2* . Hence, sector 2' s capital is increased. As the total
capital is fixed, we have Kˆ > K * . From (4.3.2), we have
1 1
wˆ 2 w2*  N * K * Kˆ  α β N Kˆ
− * = 1 − 1 2* 1  1 2 1 2 .
wˆ 1 w1  N1 K1 Kˆ 2  β1α 2 N 2 Kˆ 1
As N1* / N1 < 1 and
K 2* Kˆ 1 K / K1* − 1
= > 1,
K1* Kˆ 2 K / Kˆ 1 − 1
where we use K 2 = K − K1 for the both cases, we see that in general the
impact on the wage gap is ambiguous.
We can similarly analyze the case when only skilled labor is interna-
tionally mobile. There are other possible cases. For instance, we may ex-
amine what will happen when capital and unskilled labor are mobile. An-
other important issue that we don’t mention is capital ownership. It is
possible that emigrants take capital with them.
4.4 Human Capital Mobility and Chamberlinian

Agglomeration
This section introduces a model with Chamberlinian agglomeration.10 The

model by Pflüger (2004) is actually based the so-called core-periphery
model proposed by Krugman (1991).11 The model studies interactions
10 This model is based on a model by Pflüger (2004). For similar issues, we re-
fer to Rauch (1991) and Ricci (1999).
11 Krugman’s 1991 paper on economic geography has brought about a large
number of publications in the literature of the NEG. See also Krugman and
Venables (1995), and Venables (1996). Comprehensive reviews on the literature
of the new economic geography are given by Fujita and Thisse (2002), Baldwin and
Martin (2004), Capello and Nijkamp (2004), and Henderson and Thisse (2004). The
new economic geography deals with many important issues which are not properly
treated by the traditional trade theories. This book will not further study the literature
in this new direction as it needs much space. It should be noted that my approach to
economic geography (which is a part of my integrated approach to economic dynam-
ics) with endogenous population, capital and knowledge was published in the early
1990s (for instance, Zhang, 1991a, 1991b, 1992, 1993a, 1993b).
demand linkages. The world is composed of two countries, Home and For-
eign, two factors of production, labor and human capital, N and H . We
use subscripts, i and a , to stand for two sectors, manufacturing and agri-
culture, respectively. Labor is intersectorally mobile and countries have
identical preferences, technology and trade costs. In the long-run, human
capital is mobile internationally, while labor is not. The agricultural good
is homogeneous, traded without costs ad produced perfectly competitively
under constant returns with labor as the only input. The agricultural good
is the numéraire and is assumed to be produced in both countries after
trade. Manufacturing sector is monopolistically competitive, employing
both factors to produce differentiated goods with a linear cost function.
Labor is a variable input and human capital enters only the fixed cost.
Trade in goods i is inhibited by iceberg costs.
There are N + H households, N labors and H human capital owners
each of whom supplies one unit of labor and human capital, respectively.
Let wl and wH stand for respectively their wages. Each household’s util-
ity is specified as
U = α ln Ci + ln C a ,
1-1/σ
 D 1-1/σ D* 
Ci =  ∫ xk d k + dj 
1-1/σ
0 ∫x j

, α > 0 , σ > 1,
 D 
where Ci is the manufacturing aggregate, C a is the consumption of the
agricultural good, xk and x j are respectively the levels of consumption of
a domestic variety k and a foreign variety j , D and D* are the number
of varieties produced in Home and Foreign and σ is the elasticity of sub-
stitution between manufacturing varieties. Iceberg transport costs are for-
malized by a constant τ , which implies that only 1 / τ of a unit of a for-
eign variety arrives for consumption and that the consumption price of an
imported variety j is τp j , where p j is the price set by a foreign firm. The
budget constraint is given by12
[
pCi + C a = Y , p = Dp1k−σ (k ) + D * (τp j )
1−σ
](
1 / 1−σ )
, τ > 1,
12 The utility function is also used by, for instance, Martin and Rogers (1995)
and Pflüger (2001).

4.4 Human Capital Mobility and Chamberlinian Agglomeration 131
where Y is the household’s income, p is the perfect CES-price index, pk

and p j are the prices set by a domestic and foreign firm, respectively.
Maximizing the utility subject to the budget constraint yields the demand
functions and indirect utility, V 13
α
, C a = Y − α , xk = αpk−σ p σ −1 , x j = α (τp j ) p σ −1 ,
−σ
Ci =
p
V = − α ln p + Y + α (ln α − 1). (4.4.1)
Let N a stand for labor input. We specify the production function of the
agricultural sector as Fa = N a . Perfect competition implies that the wage
rate of the sector is unity, wa = 1. Market clearing for domestic variety k
is given by
~ ~
Fk = ( N + H )xk + N + H τ~ (
xk , ) (4.4.2)
where Fk is production and ~ xk is the demand of the foreign representative

household. Each product type is supplied by a single firm. With wk = 1
and the technology N k = cFk , the marginal cost is equal to c . The fixed
cost due to the requirement of one unit of human capital is given by R .
Let pk represent the producer prices charged to domestic and foreign
households. Profits of the representative firm in Home are given by
~ ~
( )
π k = ( pk − c )(N + H )xk + ( ~pk − c ) N + H τ~xk − R .
With the Chamberlinian large group assumption, profit maximizing
prices constant markups on marginal costs
cσ (4.4.3)
pk = ~
pk = .
σ −1
The compensation of human capital ensures zero profit equilibrium.
From the condition, and Eqs. (4.4.2) and (4.4.3), we have
R
Fk = (σ − 1) .
c
13 The maximization problem is referred to Dixit (1990). α < Y is required so

that both goods will be consumed.
In the long run, human capital owners are internationally mobile and
will move to the region where their indirect utility is higher. Hence, in long
~
run equilibrium we should have V − V = 0 . From the definitions of Y
~ ~
and R , we have Y − Y = R − R . From Eqs. (4.4.1), we have
~ ~p ~
Ω ≡ V − V = α ln  + R − R .
 p
It can be shown that from the previous equations, the difference between
Home and Foreign’s indirect utility is given as follows
α  λφ + 1 − λ 
Ω(λ ) = ln  +
1 − σ  λ + (1 − λ )φ 
α  ρ+λ ρ~ + 1 − λ 
− ,
(1 − σ )  λ + (1 − λ )φ λφ + 1 − λ 
 (4.4.4)
where
H N
λ≡ ~, ρ ≡ ~ , φ ≡τ
1−σ
≤ 1.
H +H H +H
By Ω(λ ) = 0 , we determine the human capital distribution. From
pCi = α and the production functions, we determine p . Using the other
equations in the model, we can determine all the other variables. It is
~
straightforward to find one solution. When λ = 1 / 2 , we have V − V = 0 .
For identical countries, the even distribution of human capital is always an
equilibrium solution. Nevertheless, this solution may be unstable as the
model contains two agglomerative forces: a supply linkage and a demand
linkage. The supply linkage is that the region with the higher share of hu-
man capital has a larger manufacturing sector and therefore a lower price
index, as reflected in the first term in Eq. (4.4.4). The demand linkage is
that a higher share of human capital implies a larger market in the country,
as in the second term in Eq. (4.4.4). Transport costs act as a stabilizing
force in the model in the sense that a higher transport costs tend to disperse
production.14 In this model, when transport costs are nil, the difference
does not matter in the model and human capital owners are indifferent
14 When transport costs become higher, it tends to profit these firms which are
located near the immobile customers.

4.5 Trade and Factor Mobility 133
where to locate. Simulating the model, Pflüger demonstrates supercritical

pitchfork bifurcation with transport costs as the bifurcation parameter.
4.5 Trade and Factor Mobility
This chapter examined economic forces for determining trade patterns with
factor movements. We are mainly concerned with labor and capital mobil-
ity. An important question not examined is whether labor and capital flows
are complements or substitutes. Standard models predict that migration
and foreign direct investment are substitutes. The main economic mecha-
nism for substitutability in the standard static models is that as migration
reduces the number of workers in the economy which tends to decrease the
domestic return to capital and thus generate a compensating outflow of
capital, migration leads to less FDI. Another explanation is that as a skilled
labor force is an important determinant of FDI inflows, a more skilled
emigration will lower the proportion of skilled in the home population and
tends to reduce FDI.15 But recent literature on the role of diasporas in fa-
voring trade with, and capital flows to, the migrants’ origin countries
shows that they are complements.16 As there are forces for substitutability
and complementarity, it is expected that there should be “to be or not to
be” in empirical studies. Using US data, Kugler and Rapoport (2007) dem-
onstrate contemporaneous substitutability and dynamic complementarity
between migration and FDI. To analyze the issue, we need a genuine dy-
namic framework with factor and goods flows, capital and human capital
accumulation.
15 This effect is often referred to as the technological externality arising from

human capital formation (e.g., Klenow and Rodriguez, 2005).
16 A force for complementarity is that migrants provide information about fu-
ture investment opportunities in their origin countries.

5 Money, Exchange Rate, and Trade
So far this book has been focused on non-monetary international econom-

ics. We have neglected possible effects of international monetary institu-
tions. Nevertheless, monetary institutions such as fixed and floating ex-
change rates and the golden standard may have significant effects upon
trade patterns and economic growth. Mundell (1963) shows that higher in-
flation can induce investors to lower their cash balances in favor of in-
creased real capital formation. This implies that expected inflation has real
economic effects. Tobin (1965) makes a similar argument. This effect of
inflation is labeled the Mandell-Tobin effect. Mundell (1961) argues
It is patently obvious that periodic balance-payments crises will remain

an integral feature of the international economic system as long as fixed
exchange rates and rigid wage and price levels prevent the terms of
trade from fulfilling a natural role in the adjustment process.
This chapter introduces money and exchange rates into trade models.
Section 5.1 first defines the current account balance for closed economies
and for open economies. Open economies can trade in goods and services,
borrow resources from the rest of world, and lend them abroad. Section 5.2
is concerned with the IS-LM model for an open economy. The model is
also a standard tool for analyzing balance-of-payments (BOP) behavior
when exchange rate is fixed. Section 5.3 introduces a classical model of
monetary open economy with the gold standard. This model and its vari-
ous extensions provide insights into many important monetary issues. The
model deals with the interactions among money, spending and prices in the
open economy with full price flexibility. Section 5.4 introduces a simple
monetary model of international trade developed by Ohyama. The model
studies an interaction of monetary and real factors affecting the terms of
trade and governing the adjustment process of current account imbalances
under the system of flexible rates. Section 5.5 concludes the chapter.
136 5 Money, Exchange Rate, and Trade
5.1 Measurement and Accounting Relations of Economies
This section introduces some concepts and accounting relations in measur-

ing economies, which are widely used.1 The national income accounts are
based on the idea that the amount of economic activity during a period of
time can be measured in three different but connected terms: (1) the
amount of produced, excluding output used up in intermediate stages of
production; (2) the incomes received by the producers of output; and (3)
the amount of spending by the ultimate purchasers of output. The three
measurements are called respectively the product approach, the income
approach, and the expenditure approach. The product approach measures
economic activity by adding up the market values of goods and services,
excluding any goods and services used up intermediate stages of produc-
tion. In other words, the approach sums the valued added by all producers,
where the value added of any producer is the value of its output minus the
value of the inputs it purchases from other producers.2 The income ap-
proach sums all income received by producers of output, including wages
received by workers and profits received by owners of firms. The expendi-
ture approach adds the amount spent by all ultimate users of output. As the
three approaches describe the same economic activity and the market value
of goods and services produced is equal to the amount that buyers must
spend to purchase them, the measurements from the three approaches are
identical. The equivalence of the three approaches yields the following
fundamental identity of national income accounting
Total production = total income = total expenditure. (5.1.1)
We now introduce the concept, gross domestic product (GDP). In the
product approach, a nation’s GDP is the market value of final goods and
services newly produced within a nation during a fixed period of time.3
Here, “newly produced” implies that purchases or sales of goods that were
produced in previous periods are not included in the GDP in the current
period. For instance, GDP includes the market price paid for a newly con-
structed house not the price paid in the sale of a used house. To define fi-
1 The concepts and relations in this section can be found in standard macroeco-
nomic textbooks. This section is based on Abel and Bernanke (1998).
2 If a firm produces some product which it cannot sell during the period, the un-
sold goods are treated as though they were purchased by the firm itself. Thus ex-
penditure and production remain equal even if some goods are unsold.
3 From its definition, we see that nonmarket goods services, such as many gov-
ernment services, and homemaking and child-caring services performed within the
family without pay, are important but are not included in GDP.
nal goods and services, we introduce intermediate goods and services

which are those used up in the production of other goods and services in
the same period that they themselves were produced. Final goods and ser-
vices are these goods and services that are not immediate. It should be
noted that capital goods are classified as final goods in calculating GDP. A
capital good is a good that is itself produced and used to produce other
goods. We see that natural resources, such as land, are not capital good.
Another important component related to GDP is inventories, which are
stocks of unsold finalized goods, goods in process, and raw materials held
by firms. Inventory investment is the amount by which inventories in-
crease during the period.4 Inventory investment, like capital, is also treated
as a final good and included in GDP.
In calculating national economic activity, another concept, called gross
national product (GNP) is also very important. The concept includes the
market value of final goods and services newly produced by domestic fac-
tors of production during the period. The importance of this concept is that
GNP also involves economic activities outside the nation as well. For in-
stance, the wages paid to workers who are employed abroad are included
in the nation’s GNP, but not in GDP. The relation between GDP and GNP
is given by the following equation
GDP = GNP − NFP , (5.1.2)
where NFP (net factor payment from abroad) represents the income paid
to domestic factors of production of the world minus income paid to for-
eign factors of production by the domestic economy.
We now discuss how to measure GDP in the expenditure approach. The
total spending on final goods and services produced within the nation con-
sists of four categories, consumption, C , (which is spending by domestic
households by domestic households on final goods and services5), invest-
ment, I , (which includes both spending for new capital goods and in-
creases in firms’ inventory holdings, respectively called fixed and inven-
tory investment6), government purchases of goods and services, G ,
(which include any expenditure by the government for a currently pro-
4 This amount can be negative as well.

5 Consumption is further classified as consumer durables (which include long-
lived consumer items such as cars and furniture, but not houses), nondurable
goods (which are short-lived, such as food, clothing), and services.
6 Fixed investment consists of business fixed investment and residential in-
vestment (which is spending on the construction of new houses).

duced good or service, domestic or foreign7), and net exports of goods and
services, NX , (which are exports minus imports), that is
Y = C + I + G + NX , (5.1.3)
where Y stands for GDP. Equation (5.1.3) is called the income-
expenditure identity.
The income approach to measure GDP is to sum up the incomes re-
ceived by producers and taxes paid to the government. To obtain GDP we
add national income, indirect business taxes, depreciation, and net factor
payments. National income is the sum of compensation of employees
(which is the income of workers and employers’ contributions to Social
Security), proprietors’ income (which is the income of the nonincorporated
self-employed), rental income of persons (which is the income earned by
individuals who own land or structure that they rent to others), corporate
profits (which are the profits earned by corporations), and net interest
(which is interest earned by individuals from businesses and foreign
sources minus interest paid by individuals).
The total income can also be divided into the incomes received by the
private sector and by the government sector. The income of the private
sector, called private disposable income, is the income the private sector
has available to spend. Private disposable income equals private sector in-
come earned at home and abroad, plus payments to the private sector from
the government sector. It is given by
private disposable income = Y + NFP + TR + INT − T , (5.1.4)
where TR is transfers received from the government, INT is the interest
payments on the government’s debt, and T is taxes. The part of GDP that
is not included in the private disposable income is net government income,
which is given by
net government income = T − TR − INT . (5.1.5)
GNP = private disposable income + net government = Y + NFP . (5.1.6)
National economy depends on not only on income but also on wealth. In
order to know a household’s economic condition, we need to know not
only its current income, but also what the household owns (its assets) and
7 The government purchases do not contain transfers (which include govern-
ment payments for Social Security and Medicare benefits, unemployment insur-
ance, welfare payments and so on) and interest payments on the national debt.
owes (its liabilities). The difference between assets and liabilities is called
wealth. The wealth of a nation is called national wealth. An important de-
terminant of wealth is saving. Here, the saving is the current income minus
its spending. National saving consists of private saving and government
saving. The private saving is given by
private saving = private disposable income - consumption = (5.1.7)
Y + NFP − T + TR + INT − C ,
where we use Eq. (5.1.4). The government saving is defined as
government saving = net government income -
(5.1.8)
government purchases = T − TR − INT − G ,
where we use Eq. (5.1.5). Let S stand for national saving. Then, we have
S = S p + S g = Y + NFP − C − G , (5.1.9)
where S p and S g are respectively private saving and government saving.

Another name for government saving is the government budget surplus,
which equals government receipts (which equals tax revenue, T ) minus
government outlays (which are the sum of government purchases of goods
and services, transfers, and interest payments on government debt. We see
that the government budget surplus is the same as government saving.
When government receipts are less than government outlays, the differ-
ence between outlays and receipts is known as the government budget
deficit. When the government runs a budget deficit, its saving is negative.
To obtain another important identity from the relations described before,
we substitute Eq. (5.1.3) into Eq. (5.1.9)
S = I + NX + NFP .
National saving is equal to the sum of investment, net exports and net
factor payments. The sum of net exports and net factor payments is also
called current account balance, denoted by CA. Hence, the above equation
can be rewritten as
S = I + CA . (5.1.10)
From Eq. (5.1.10) and S = S p + S g , we have
Sp = I + (− S g ) + CA. (5.1.11)
The relation is called the uses-of-saving identity. It shows that an econ-

omy’s private saving can be used in three ways: (1) investment; (2) the
government budget deficit; and (3) the current account balance.
5.2 The IS-LM Analysis for an Open Economy
This section is mainly concerned with the IS-LM model for an open econ-
omy. The IS-LM model was developed Hicks (1937).8 The model is often
identified with the Keynesian approach to macroeconomics. Since Hicks,
many economists have worked to refine the IS-LM model.9 In the standard
IS-LM, wages and prices are fixed, at least, in the short term. To classical
economists who hold that wages and prices move rapidly to clear markets,
the assumption of a fixed price is not acceptable. Nevertheless, as the
original IS-LM can also be modified to allow rapid adjustment of prices
and wage, the analytical framework is now used to analyze classical eco-
nomic problems as well.
5.2.1 Production and labor market equilibrium
We first describe economic production. There are many factors of produc-

tion, such as capital, energy and labor. For illustration, we take account of
only one production factor, labor. Moreover, we assume that workers are
all alike. We neglect any possible differences in skills, knowledge and
preference (for leisure) among workers. With capital stock fixed, we spec-
ify a production function as follows
 θ  (5.2.1)
F = AθN − 1 N 2  ,
 2 
in which F and N are respectively output and labor input, and A , θ , and
θ1 are positive parameters. Here the parameter, A , is called the total fac-
tor productivity. A change in the total factor productivity may be caused
by change in production technology or any other change in the economy,
such as an increase in capital, that affects the labor to be utilized more ef-
fective.
8 In his 1937 paper, Hicks tried to provide a graphical representation of the
ideas of Keynes’ The General Theory of Employment, Interest, and Money. This
book is only concerned with open economies. There are many studies on this
model. We refer the IS-LM analysis for the closed economies to some standard
textbooks by, for instance, Dornbusch and Fischer (1994), and Abel and Bernanke
(1998).
9 The IS-LM versions are based on Abel and Bernanke (1998: Chap. 10) and
McCallum (1996). The model is described in textbooks on macroeconomics (see

Jha, 2003).
Consider that firms view the wage of the workers they hire as being de-
termined in a competitive labor market. Firms’ goal is to maximize profit,
which equals, F − wN , where w is the real wage. Maximizing the profit
yields
w = A(θ − θ1 N ). (5.2.2)
This relation describes how many workers the firms will employ at the
current wage rate. This is the demand function for labor. The amount of
labor demand is determined by equalizing the real wage rate and the mar-
ginal product of labor. Labor demand rises in the productivity and falls the
real wage rate. If we consider that A is positively related to the capital
stocks used by the firms, we see that an increase in the capital stocks also
increase the demand for labor.
We have described how the labor demand is determined by the firms.
We now examine the supply of labor by the households. Assume that the
supply of labor is positively related to the real wage rate.10 We specify the
labor supply function as follows
N = n0 + nw (1 − τ w )w , (5.2.3)
in which n0 and nw are positive parameters and τ w ( 0 ≤ τ w < 1 ) is the tax

rate on wage income. This relation is the labor supply curve that relates the
amount of labor supplied to the current real wage rate, with all the other
factors11 that may affect labor supply fixed.
Equilibrium in the labor market is achieved when the quantity of labor
demanded equals the quantity of labor supplied. In the classical econom-
ics, it is assumed that the real wage adjusts quickly so that labor supply
and labor demand equal. If labor supply is less than labor demanded, firms
compete for scarce workers and the real wage rises. If labor supply is more
than labor demanded, the real wage will fall. The equilibrium level of em-
ployment is called the full-employment level of employment. When labor
demanded is equal to labor supplied, we have
n0 + θAnw (1 − τ w ) (5.2.4)
N* = .
1 + nwθ1 A(1 − τ w )
This is the full-employment level of employment. The corresponding
market-clearing real wage rate is given by
10 In general, this is a strict assumption as labor supply may be negatively re-
lated to the real wage income.

11 Such as wealth and expected real wages in the future.
w* =
(θ − θ1n0 )A
,
(5.2.5)
1 + nwθ1 A(1 − τ w )
where we require θ − θ1n0 > 0 . Full-employment output or potential out-

put, Y * , is the level of output that firms supply when wages and prices
have fully adjusted. The potential output is given by
 θ  (5.2.6)
Y * = AθN * − 1 N *2  .
 2 
Figure 5.2.1 describes the demand curve and the supply curve. The
amount of labor is on the horizontal axis. The real wage is on the vertical
axis. The labor demand curve given by (5.2.2) shows a negative relation-
ship between the real wage and the amount of labor demanded by the
firms. The labor supply curve given by (5.2.3) shows a positive relation-
ship between the real wage and the amount of labor supplied by the house-
holds.
w
w*
N* N
Fig. 5.2.1. Labor market equilibrium
Different factors affect the full-employment equilibrium level. For in-

stance, an improvement in the productivity increases the quantity of labor
demanded at any real wage level. Thus the labor demand curve shifts right.
As shown in Fig. 5.2.2, the technological change causes the real wage and
the full-employment equilibrium level to rise.12 This can be checked by

taking derivatives of Eq. (5.2.4) with respect to A
dN *
=
(θ − θ1n0 )(1 − τ w )nw N * > 0.
dA [1 + nwθ1 A(1 − τ w )][n0 + θAnw (1 − τ w )]
From Eq. (5.2.3), we have
dw 1 dN *
= > 0.
dA nw (1 − τ w ) dA
A↑
w*
N* N
Fig. 5.2.2. Effects of an improvement in the productivity
According to the classical approach, we see how the full employment is

determined. Nevertheless, in economic issues related to unemployment
cannot be analyzed simply there is no unemployment in the classical
world. A commonly accepted way to explain unemployment is to drop the
assumption that the real wage adjusts rapidly to equal supply and demand.
According to the Keynesian approach, the classical assumption is not gen-
erally valid, at least in the short-run analysis.
12 It is straightforward to examine effects of changes in the other parameters
upon the labor market equilibrium by shifting either the demand curve or supply
curve.
5.2.2 Goods market equilibrium
We studied the supply of goods and services in the national economy. We

now examine demand in the national economy. The national demand can
be divided into four components: the demand for consumer goods and ser-
vices by households, the demand for new capital goods by firms, govern-
ment purchases of goods and services, and the net demand for domestic
goods by foreigners (net exports). Demand for consumer goods and ser-
vices by households is also called consumption, and the demand for new
capital goods by firms is called investment.
The goods market is in equilibrium when the quantity of goods supplied
equals the quantity of goods demanded. The goods market equilibrium
condition is represented by
Y = C + I + G + NX , (5.2.7)
where G is the government’s purchases of goods and services. If we sub-
tract C + G from both sides of Eq. (5.2.7), then the above equation can be
written as
S = I + NX ,
where S is desired savings given by S = Y − C − S . This equation says
that the goods market equilibrium is achieved when the desired national
saving is equal to the desired investment.
We can also rewrite Eq. (5.2.7) as
NX = Y − C − I − G .
This means that in goods market equilibrium the amount of net exports
is equal to the country’s total output less total spending by domestic resi-
dents. Total spending by domestic residents, C − I − G , is called absorp-
tion. When output exceeds absorption, the country sends goods abroad and
has a current account surplus. When the country absorbs more than it pro-
duces, it is a net importer with a current account deficit.
In this model, both real consumption and investment are determined pri-
marily by the prevailing level of national income and the real rate of inter-
est. The level of government purchases is exogenously given. For an open
economy, the equation for desired consumption is given as follows
C = ξ 0 + ξ Y (Y − T ) − ξ r r , (5.2.8)
where Y , T and r are respectively income, taxes, and the real interest
rate, Y − T is disposable income, and ξ 0 , ξY and ξ r are positive parame-
ters. Here, ξY is the marginal propensity to consume. As people consume

some part of an increase in disposable income and save the rest, it is rea-
sonable to require 0 < ξY < 1. An increase in the real interest rate causes
desired consumption to fall.
We assume that the tax is positively linearly related to income as fol-
lows
T = τ 0 + τ wY , (5.2.9)
where τ 0 is a lump-sum tax and τ w is the tax rate on income (which is the
same as levied on wages).
We now examine investment by firms. It is considered that net invest-
ment will proceed more rapidly the higher is the marginal product of capi-
tal in relation to the cost of borrowing r . For simplicity we assume that
desired investment is given as
I = i0 − ir r , (5.2.10)
where i0 and ir are positive numbers. This equation means that desired in-
vestment falls when the real interest rises.
It is assumed that net exports, NX , are determined as follows
~
NX = η − ηY Y + η~Y Y − η r r + η~r ~
r,
~
where η , ηY , η~Y , η r , and η~r are non-negative numbers, and Y and ~ r are
foreign income and foreign rate of interest. It should be noted that if the
parameters, η , ηY , η~Y , η r , and η~r , are all zero, then the model is for a
closed economy. The equation says that the net exports are positively re-
lated to the foreign income and real rate of interest and negatively to the
domestic income and real rate of interest. As higher domestic output raises
demand for imports, net exports tends to fall. As foreign output is in-
creased, foreign demand for exports tends to rise. Hence, exports tends to
rise. We can similarly interpret the signs of the other parameters.
If we substitute the related equations into Eq. (5.2.7), we have
Y = ξ 0 + ξ Y (Y − τ 0 − τ wY ) − ξ r r + i0 − ir r + G + η − ηY Y
~
+ η~ Y − η r + η~ ~
Y r rr.
We express the above equation as follows

r = α IS − β IS Y , (5.2.11)
in which
~
ξ 0 + i0 + G − ξ Yτ 0 + η + η~Y Y + η~r ~
r
α IS ≡ > 0,
ξ r + ir + η r
1 − (1 − τ )ξ Y + ηY
β IS ≡ > 0.
ξ r + ir + η r
Equation (5.2.11) relates output to the real interest rate that clears the
goods market. This relationship between Y and r defines the IS curve.
The IS curve slopes downward.
We can also illustrate how we obtain the IS curve as in Fig. 5.2.1. The
goods market equilibrium condition is also given by S − I = NX , where
S − I = (1 − ξ Y + ξ Yτ w )Y + (ξ r + ir )r + G0 ,
~
NX = η − η Y + η~ Y − η r + η~ ~
Y Y r rr,
where G0 ≡ − G − i0 − ξ 0 + ξYτ 0 . In Fig. 5.2.3a, we plot the desired sav-

ing less desired investment, S − I , and net exports, NX , on the horizon-
tal and the real interest rate on the vertical axis. The S − I curve slopes
upwards and the I curve slopes downwards. For a fixed level of output,
say Y1 , the demand curve for real money is given in Fig. 2.2.3a. The inter-
section of the two curves is at point A . At point A the goods market is in
equilibrium for the fixed level of output Y1 . If we increase the output level
from Y1 to Y2 then the S − I and NX curves move downwards. The new
equilibrium point is point B . Hence, Fig. 5.2.3a shows relations between
S − I and NX for different levels of Y . If we plot the relation between
r and Y as in Fig. 5.2.3b which is actually given by Eq. (5.2.11), we ob-
tain the IS curve which shows the real interest rate that clears the goods
market for each level of the output.
We now examine how different factors affect the IS curve. First, we ex-
amine a rise in the government’s purchases, G . As G rises, the NX
curve is not affected (the variable does not affect the curve) but the S − I
curve moves upwards (as for the same level of S − I and Y , the real in-
terest rate should be raised to keep the equality). The new equilibrium in
Fig. 5.2.4a shows that the real interest rate rises. Hence, the IS curve
should shift upwards, as shown in Fig. 5.2.4b. We can also similarly exam-
ined effects of changes in other parameters.
r r
NX 1 S1 − I1
NX 2 S2 − I 2
A A
Y rises B
B
S − I , NX Y1 Y2 Y
(a) goods market equilibrium (b) the IS curve
Fig. 5.2.3. The IS curve
r r
S2 − I 2
S1 − I1
G rises
B B
A A
S − I , NX Y1 Y
(a) goods market equilibrium (b) the IS curve
Fig. 5.2.4. The is curve shifts as the government raises its expenditures
5.2.3 The asset market
We have discussed the labor and goods markets. We now examine the as-
set market. By asset market we mean the market in which people buy and
sell real and financial assets, including, for instance, gold, houses, stocks
and bonds. In macroeconomics money is the focus of the study of the asset
market. Households’ decisions about how much money to hold is part of
broader decisions about how to allocate wealth among the various assets.
The “LM” relationship describes relations between the behavior of money
demand and supply in the economy. This relation is established by consid-
ering the nature of money demand.13 Households decide how much of their
wealth will be held in the form of money, rather than in the form of other
assets such as bonds, stocks, houses, cars, and so on. In their choice,
households balance the expected transactional benefits of holding money
and the cost of doing so. The cost of holding money is the opportunity cost
of extra interest that is lost by no holding bonds or other interest-earning
assets. As the purpose of holding money is to facilitate planned transac-
tions, more money will be held that greater is the volume of transaction
planned. On the other hand, as households are concerned with real quanti-
ties of goods and services, rather than their nominal values, the quantity of
money demanded will be in real terms. We assume that all money has the
same risk and liquidity and is paid with the same nominal interest rate
(which is always assumed to be zero). It is assumed that the real demand
for money depends on real income, Y , and the nominal interest rate, i , on
nonmonetary assets,14 which in turn equals the expected real interest rate,
r , plus the expected rate of inflation, π e . We specify the money demand
function in the following form
(5.2.12)
= λ0 + λY Y − λr (r + π e ),
M
P
where M is the nominal demand for money15 and P is the price level, and
λ0 , λY and λr are positive parameters. In Eq. (5.2.12), the nominal money
demand is proportional to the price level. If the price doubles (with the fac-
13 The concept of money used here, like in McCallum (1996), is that of a tangi-
ble asset that serves as a generally accepted medium of exchange. Here, the rate of
interest paid on money is zero.
14 Nonmonetary assets such as stocks, bonds, land and so on, are assumed to
have the same risk and liquidity and to be paid the same nominal interest rate.
15 Here, we should use (a superscript) index to distinguish the variable for de-
mand from that for supply. For simplicity, we omit indexing the differences.
tors unchanged), nominal money demand will double, so that the same real
transactions is conducted. The money-demand relationship is actually de-
termined by various institutional and technological aspects of the econ-
omy. An equivalent way of the above equation expresses
M
= λ0 + λY Y − λr i .
P
For given levels of M , P and π e , Eq. (5.2.12) relates output to the real
interest rate that clears the asset market. For fixed P , money demand de-
pends on real income and the nominal interest rate on nonmonetary assets.
An increase in real income raises the demand for liquidity and thus in-
creases money demand. A decrease in the nominal interest rate makes
nonmonetary assets less attractive, which increases money demand. It
should be noted that the specified linear demand function neglects many
other factors, such as possible positive interest rates on money, wealth,
risks, liquidity of alternative assets, and payment technologies, which may
affect demand for money.
The asset market is in equilibrium when the quantity of each asset de-
manded equals the available supply of that asset. In this model, we have
money and nonmonetary assets. As there are only two types of assets, we
have that asset market is in equilibrium when the quantity of money sup-
plied equals the quantity of money demanded. To explain this, we notice
that the sum of demand for money and nonmonetary assets is equal to the
nominal wealth of the economy, that is
money demand + nonmonetary assets demand = nominal wealth.
On the other hand, the sum of the supplies of money and nonmonetary
assets is equal to nominal wealth, we should have
money supply + nonmonetary assets supply = nominal wealth.
From the above two relations, we have
money demand + nonmonetary assets demand =
money supply + nonmonetary assets supply.
Equivalently, we have
excess demand for money +
excess demand for nonmonetary assets supply = 0 ,
where
excess demand for money = money demand − money supply,
excess demand for nonmonetary asssets =

nonmonetary assets demand − nonmonetary assets supply.
This relation implies that if money assets market is in equilibrium (when
excess demand for money is equal to zero), then nonmonetary assets mar-
ket is also in equilibrium. This also implies that when the economy has
only two types of assets markets, it is sufficient for us to be concentrated
on demand and supply of money as long as the amount of money de-
manded equals the amount of money supplied, the entire asset market will
be in equilibrium.
We now describe asset market equilibrium which occurs when the
amount of money demanded equals the amount of money supplied. We as-
sume that the amount of money supply is fixed by the central bank. This
amount is equal now to the amount of money demanded, that is, M in Eq.
(5.2.12). We see that Eq. (5.2.12) describes the asset market equilibrium.
We see that the condition involves five variables, the nominal money sup-
ply, the price level, real income, the real interest rate, and the expected rate
of inflation. As assumed before, the nominal money supply is determined
by the central government through its open-market operations. We also as-
sume that the expected rate of inflation is fixed. We now have three vari-
ables, Y , r and P to determine. In both the classical and Keynesian ap-
proaches, it is considered reasonable to assume that in the long run all
markets are in equilibrium, including the labor market. That is, labor force
is fully employed. Hence, we can determine Y by Eq. (5.2.6). We have P
and r to be determined. As r is determined in goods market for given Y ,
we see that we determine P by Eq. (5.2.12).
We rewrite (5.2.12) as follows
M (5.2.13)
r = α LM − + β LM Y ,
λr P
where
λ0 λ
α LM ≡ − π e , β LM ≡ Y > 0 .
λr λr
This relation is called the LM curve. If we plot the relation with the in-
terest rate as vertical axis and the income as horizontal one, the curve
slopes upward. We derive the LM curve as in Fig. 5.2.5. In Fig. 5.2.5a, we
plot the demand and supply curves for real money with the real interest
rate on the vertical axis and the demand and supply of real money on the
horizontal axis. As the supply is fixed, it is given by a vertical line as in
Fig. 5.2.5a. For a fixed level of output, say Y1 , the demand curve for real
money is given in Fig. 2.2.5a. The intersection of the demand and supply
curves is at point A . At point A the asset market is in equilibrium for the
fixed level of output Y1 . If we increase the output level from Y1 to Y2 then
the demand curve for real money moves upwards as from Eq. (5.2.3). The
new equilibrium point is point B . Hence, Fig. 5.2.5 shows relations be-
tween M / P and r for different levels of Y . If plot the relation between
r and Y as in Fig. 5.2.5b which is actually given by Eq. (5.2.13), we ob-
tain the LM curve which shows the real interest rate that clears the asset
market for each level of the output.
r r
real money supply
B
B
A A
real money demand
Y1
M /P Y1 Y2 Y
(a) money demand and money supply (b) the LM curve
Fig. 5.2.5. The LM curve
We now examine how different factors affect the LM curve. First, we

examine a rise in the real money supply, for instance, due to rise in the
nominal money supply. From Eq. (5.2.13), we directly see that as M rises,
to maintain the equality r has to fall down for the same level of output.
That is, in order to clear the asset market as the real money supply is in-
creased, the real interest rate has to fall for the same level of output. This
implies that the LM curve moves down. We illustrate this process as in
Fig. 5.2.6. From Eq. (5.2.13), it is also straightforward to examine how the
LM shifts when other parameters are changed.
r r
real money supply ↑
A A
B B
real money
demand
M /P Y1 Y
(a) money demand and supply (b) the LM curve
Fig. 5.2.6. The LM curve shifts as real money supply rises
5.2.4 General equilibrium
From the supply and demand relationships and equilibrium conditions in

the three markets described above, we can calculate the general equilib-
rium values of the system. We have already solved for the general equilib-
rium levels of w, N and Y in the labor market by Eqs. (5.2.4)-(5.2.6).
From the equilibrium condition for the goods market, we solve the real in-
terest rate by Eq. (5.2.11), that is r = α IS − β IS Y * . As we solved r and
Y , we cal also determine the general equilibrium values of taxes, con-
sumption, and investment, T , C and I . We solve the price by (5.2.13) as
M
P= .
λr (α LM + β LM Y − r )
It is straightforward to examine effects of changes in the parameters upon
the economic equilibrium.
5.2.5 The AD-AS analysis
We have illustrated the IS-LM model. Another important model in macro-

economics is the AD-AS model. The output demanded at any price level is
the amount of output determined at the intersection of the IS and LM
curves. For a given level of price, the output level is determined from Eqs.
(5.2.11) and (5.2.13) as
α IS − α LM + M / λr P (5.2.14)
Y = .
β IS + β LM
This relation is the aggregate demand (AD) curve. For constant M , Y
is negatively related to P .
Short-run equilibrium
In the short run, the price level is fixed. The short-run aggregate supply
(SRAS) curve is a horizontal line given by P = P . 16 The short-run equilib-
rium of the economy is represented by the intersection of the AD curve
and the SRAS curve. From Eq. (5.2.14), we have
α IS − α LM + M / λr P
Y = .
β IS + β LM
Long-run equilibrium
In the long run, the long-run aggregate supply (LRAS) curve is deter-
mined at the full-employment level of output, Y = Y * . The long-run equi-
librium of the economy is represented by the intersection of the AD curve
and the LSAS curve. From Eq. (5.2.14), we have
M
P= .
[
(β IS + β LM )Y − α IS + α LM λr
*
]
5.2.6 Exchange rates and net exports
We need a few concepts about exchange rates. In this book, the nominal
exchange rate between two currencies, enom , is the number of units of do-
mestic currency that can be purchased with one unit of the foreign cur-
rency. For instance, in the foreign exchange market 120 Japanese yen can
purchase 1 U.S. dollar. For residents of Japan the domestic currency is the
Japanese yen, the nominal exchange rate is enom = 120 . In a flexible-
exchange-rate-system or a floating-exchange-rate-system, nominal ex-
change rates are not officially fixed but are determined by conditions of
supply and demand in the foreign exchange market. In a fixed-exchange-
16 See Abel and Bernanke (1998: Chap. 10).

rate system, nominal exchange rates are officially set at officially deter-
mined levels. Usually, these official rates were maintained by the com-
mitment of nations’ central banks to buy and sell their currencies at the
fixed rate.17
The nominal exchange rate does not tell about the purchasing power of a
currency. For instance, even we know the exchange rate between the Japa-
nese yen and the U.S. dollar is 120 , this does not mean that one who buys
a hamburger with 2 dollars in New York can buy a hamburger with 240
yen at Tokyo. In reality, for instance, one hamburger costs 480 in Tokyo.
That is, the price of a hamburger in Tokyo is 4 dollars. The price of a U.S.
hamburger relative to a Japanese hamburger is therefore equal to 0.5. The
Japanese hamburger is more expensive than the U.S. one. To measure the
purchasing power of currencies, we introduce the real exchange rate,
which is the number of domestic goods someone gets in exchange for one
foreign goods. In the hamburger example the real exchange rate between
Japan and the United States is 0.5 . 18
In general, prices, nominal exchange rate, and real exchange, are interre-
lated. Let us consider that the world consists of two economies, domestic
and foreign. Let a variable with tilde stand for foreign country. Let P and
~
P stand for respectively the prices measured in their own currencies in the
~
two economies. According to the definitions of e, enom , P and P , we
have the following relations19
~ (5.2.15)
e P
e = nom .
P
For the hamburger example, we have
17 For example, under the international gold standard system in the late 1800s,
the central banks of the countries involved maintained the value of its currency in
terms of gold by agreeing to buy or sell gold in exchange for currency at fixed
rates of exchanges. Another example is the Bretton Woods system under which
the values of various currencies were fixed in terms of the U.S. dollar, and the
value of the dollar was set $35 per ounce of gold.
18 It can be seen that if the two countries produce an identical product that can
be used for all purposes, then the real exchange rate is 1.

19 If all the economies produce the same good and goods are freely traded
among economies (without any transaction costs), then the real exchange would
~
equal 1. Hence, we have P = enom P .
0.5 Japanese hamberg per U.S. hamberg =

(120 yen/$1) ($2/U.S. hamburger)
.
480 yen/Japanese hamburger
In reality, a modern economy produces many thousands of different
goods. Real exchange rates are usually based on price index to measure P
~
and P . In this case, the real exchange rate is the rate of exchange between
a typical basket of goods in one economy and a typical basket of goods in
the other economy. Increases in the real exchange rate over time indicate
that the goods of the domestic country are becoming less expensive rela-
tive to the goods of the other country.
We consider that real exchange rate is determined by the incomes and
the real interest rates in the domestic and outside world. An increase in
~
foreign income, Y , or the domestic real interest, r , tends to raise the de-
mand for the domestic currency and thus appreciate the real exchange rate,
e . We may consider that an increase in domestic income, Y , or foreign
real interest rate, ~
r , tends to increase the supply of domestic currency and
depreciate the real exchange rate. We specify that for values of output, Y ,
the real interest rate, r , and the price level, P , real exchange rate, e , is
( ~
)
by a function, e = H Y , Y , r , ~r .
When the nominal exchange rate, enom , rises (falls) so that a dollar buys
more (less) Japanese yen, we say that the yen has undergone a nominal de-
preciation (appreciation). The terms, depreciation and appreciation, are
used in flexible-exchange-rates systems. In a fixed-exchange-rate system,
a weakening (strengthening) of the currency is called devaluation (revalua-
tion). Similarly, when the real exchange rate, e , rises (falls), we say that
the yen has undergone a real depreciation (appreciation). With (5.2.15), we
calculate the percentage change in the real exchange rate as follows
~
∆e ∆enom ∆P ∆P
= + ~ − .
e enom P P
This equation is purely definitional and thus always holds. As ∆P / P
~ ~
and ∆P / P are respectively the percentage changes in the domestic and
foreign prices, and thus are the same as the domestic rate of inflation, π ,
and the foreign rate of inflation, π~ , we can express the above equation as
∆e ∆enom ~ (5.2.16)
= +π −π.
e enom
Equation (5.2.16) states that the rate of real exchange rate depreciation
is equation to the rate of nominal exchange rate depreciation plus the ex-
cess of foreign inflation over domestic inflation. To see how to strengthen
the domestic currency, we may rewrite (5.2.16) as
∆enom ∆e
= + π − π~ .
enom e
To appreciate the domestic currency, we may encourage a real apprecia-
tion and/or lower the domestic inflation.
Another important concept is called purchasing power parity (PPP),
which means that similar foreign and domestic goods, or baskets of goods,
should have the same price in terms of the same currency. It is observed
that the PPP tends to hold in the long term; but over short periods PPP
does not describe exchange rate behavior well. As the real exchange rate is
1, from (5.2.15) we should have
P (5.2.17)
enom = ~ .
P
Corresponding to (5.2.16), we have
∆enom (5.2.18)
= π − π~ .
enom
The real exchange rate and net exports
We now relate trade in goods with the real exchange rate. If all the other
conditions remain the same, when the real exchange rate falls, the house-
holds in the domestic country are able to obtain more foreign goods and
services in exchange for a given amount of domestic production. In na-
tional level, the real exchange rate affects the country’s net exports.20 If the
real exchange rate is low so that a unit of foreign goods can buy little do-
mestic goods (in other words, a unit of domestic goods can buy relatively
many units of the foreign good), domestic residents will like to buy many
foreign goods and foreign residents will want to purchase relatively less
domestic goods. Hence, we may say that if all the other factors which may
affect an economy’s export and import are kept constant, then the lower
the real exchange rate is, the lower a country’s net exports will be.
20 Net exports = exports - imports.

We now introduce the so-called Marshall-Lerner condition, which states

that a real depreciation improves the currency account if export and import
volumes are sufficiently elastic with respect to the real exchange rate. The
currency account, denoted by CA , is assumed to be a function of real ex-
change rate and domestic income as follows21
CA(e , Y d ) = Ex(e ) − Im(e , Y d ),
where Ex and Im are respectively exports and imports measured in the
domestic product. An increase in the real exchange rate tends to increase
export, that is, dEx / de > 0 . Nevertheless, the impact of change in e on
imports is more complicated. As the real exchange rate rises, domestic
consumers respond to the price shift by purchasing fewer units of the more
expensive foreign products. As Im is the value measured in terms of do-
mestic output, not the volume of foreign products imported, we see that
imports measured in domestic output may not necessarily fall. As a rise in
e tends to raise the value of each unit of imports in terms of domestic out-
put units, it is possible for imports measured in domestic output to rise.
This implies that as e rises, Im may either rise or fall. Hence, in general,
as e rises, we can not be sure about the impact on CA .
To describe the Marshall-Lerner condition, we introduce a symbol, R ,
which stands for domestic imports measured in terms of foreign output.
This variable is used because domestic imports measured in foreign output
equal the volume of foreign exports to the home country. The variable, R ,
should be a function of the real exchange rate and the disposable income,
i.e., R = R (e , Y d ). Moreover, we should have ∂R / ∂e < 0 . According to
the definitions, we have
Im(e , Y d ) = eR(e , Y d ).
Hence, we have
CA(e , Y d ) = Ex(e ) − eR (e , Y d ).
Taking partial derivatives of this equation with respect to e , we have
∂CA ∂Ex ∂R
= −R−e .
∂e ∂e ∂e
21 Here, it is assumed that foreign income is fixed. The following discussion on
the condition is referred to Krugman and Obstfeld (2006: Chap. 16).

This equation involves the two current account effects of a real depre-
ciation, the volume effect (i.e., ∂Ex / ∂e − e∂R / ∂e > 0 ), and the value ef-
fect (i.e., − R < 0 ). The value effect says that a rise in e worsens the cur-
rent account to the extent that it raises the domestic output value of the
initial volume of imports. For ∂CA / ∂e > 0 , it is sufficient to have
1 ∂Ex e ∂R
− > 1.
R ∂e R ∂e
In particular, assume that before the real exchange rate is changed,
CA = 0 , that is, Ex = eR . Under this condition, the above inequality be-
comes
e ∂Ex e ∂R
− > 1,
Ex ∂e R ∂e
or equivalently
η + η * > 1,
where η and η * are respectively called the elasticity of export demand
with respect to e and the elasticity of import demand with respect to e ,
defined by
e ∂Ex * e ∂R
η≡ ,η ≡ − > 1.
Ex ∂e R ∂e
The condition, η + η * > 1, is called the Marshall-Lerner condition.22
This condition states that if the current account is initially zero, a real cur-
rency depreciation causes a current account surplus if the sum of the elas-
ticity of export demand and the elasticity of import demand is greater than
unit.23
5.2.7 Effects of change in money supply
We now use the IS-LM model to study the effects of monetary policy. We
examine respectively long-run and short-run effects. According to the
22 Alfred Marshall and Abba Lerner discovered the condition.

23 We emphasize that this condition holds when all the other conditions are
fixed and the initial current account is zero. If either of these conditions is broken,
the Marshall-Lerner condition is generally invalid.
Keynesian approach, in the short run the price is fixed. In the long run
price is flexible.24
Short-run analysis
In the short run price is fixed. From Eqs. (5.2.11) and (5.2.13), we get
dY 1 dr dY
= > 0, = − β IS < 0.
dM (β IS + β LM )λr P dM dM
As money supply is increased, the output level falls and the real interest
rate falls. From Eqs. (5.2.8)-(5.2.10), we obtain
dC dY dr
= ξY (1 − τ w ) − ξr > 0,
dM dM dM
dI dr
= − ir > 0,
dM dM
dNX dY
= − ηY < 0.
dM dM
As money supply is increased, the consumption and the investment are
increased and the amount of net exports falls. From Eqs. (5.2.1) and
(5.2.3), we have
dN 1 dY dw 1 dN
= > 0, = > 0.
dM (θ − θ1 N )A dM dM (1 − τ w )nw dM
The labor force and wage rate are increased.
Long-run analysis
In the long run price is flexible and labor is fully employed. From Eqs.
(5.2.4)-(5.2.6), we see that change in M has not effect on Y , N and w .
dP P
= > 0.
dM M
24 It should be noted that in the classical approach price is flexible even in the
short run. In the long run the effects should be the same in the Keynesian approach
and the classical approach.
It is straightforward to check that changes in M will not affect r , C

and w . That is, the price changes in the same ratio as change in the money
supply and all the real variables are not affected. That is, money is neutral
in the long term.
We can also illustrate the above short-run and long-run analyses as in
Fig. 5.2.7. Suppose that the system is located in equilibrium point A . Let
the central bank reduce money supply from M 1 to M 2 . The full employ-
ment (FE) line, is not affected by change in money supply. Also, the
change in money supply does also not directly affect the goods market.
Hence, the IS curve is not changed. The assets market is directly affected
by the increase in the monetary contraction. As discussed before, the LM
curve shifts up and to the left from LM1 to LM2. In the Keynesian ap-
proach, the price level is rigid in the short run so that the short-run equilib-
rium point is B . From the figure, we see that the real interest rises and the
output level falls due to the monetary contraction. In the long run the price
level is flexible. The price level will fall as firms find themselves selling
less than they desire. The LM curve returns to initial position LM1. Money
is neutral in the long run.
r
FE
LM2
B LM1
r*
A
IS
Y* Y
Fig. 5.2.7. Effects of an increase in money supply
From (5.2.19), we can examine effects of change in money on the ex-

change rate. In short run an increase in the money supply increases the
domestic output, reduces the domestic real interest rate, but does not affect
5.3 A Gold Standard Model 161
the domestic price level. As the foreign variables remain constant, these
changes cause the real exchange rate and the nominal exchange rate to fall.
In the long run money is neutral, so that Y and r return to their original
levels. Hence, in the long run, according to Eq. (5.2.19) the real exchange
rate is not affected. As a monetary expansion leads to a long-run increase
in the domestic price level, the nominal exchange rate depreciates.
5.3 A Gold Standard Model
We consider an economy in which golden is the single monetary commod-

ity and the basis for the monetary standard.25 Money consists of gold coins
and bullion. Each economy might have its own coinage system and mone-
tary units in terms of which prices are expressed. Nevertheless, these dif-
ferences are just different names for specified amounts of gold. If there is
free trade in gold among nations, then we may consider that the nations’
monetary systems are integrated. Exchange rates would then be deter-
mined by the specified quantities of gold in the coins and the monetary
units of the nations.
We now introduce a classical model of monetary open economy with
the gold standard. This model and its various extensions provide insights
into many important monetary issues.26 The model deals with the interac-
tions among money, spending and prices in the open economy with full
price flexibility. Spending is linked to money (gold) holdings. The world
consists of two economies, called domestic and foreign countries. There is
only one good in the world, the price of which is spatially arbitraged. Let a
variable with tilde stand for foreign country. Let G stand for the world
~
stock of gold and M and M the national money stocks, all measured in a
common, say yen. The money is the only asset. The world money stock
satisfies
~ (5.3.1)
G = M + M.
Assume that the link between money and spending is represented by the
following form of a constant expenditure velocity
C = VM , C = V M , (5.3.2)
25 The standard commodity may be silver, gold, zinc, or even a composite-

commodity bundle.
26 The literature on modeling economies with gold standard is referred to, for
instance, Barro (1979) and Chappell and Dowd (1997).

where C and C are national nominal spending levels in the domestic and
foreign countries and V and V are the constant expenditure velocities.
Let the two economies supply fixed amount of output, Y and Y . Let P
stand for the globally equal price of the good. The balance of world in-
come and spending is given by
(Y + Y )P = VM + V M .
In the reminder of this section, we require V = V . The model is closed by
the following equation for the balance of payments and money supply
M& = PY − V M = − M& , (5.3.3)
The equation says that the balance of payments surplus is equal to the
trade surplus, which is equal to the excess of demand over supply. Substi-
tuting P = VG / (Y + Y ) into Eq. (5.3.3) yields
M& = ( y G − M )V , (5.3.4)
where y ≡ Y / (Y + Y ). We see that a country’s economy growth will im-

prove its balance of payments. Evidently, the differential equation has a
unique stable equilibrium point. This equation is the central equation of
classical international monetary economics. The equation implies that
payments imbalances redistribute money over time until the world econ-
omy converges to the natural distribution. At equilibrium, the share of the
domestic economy in the world money supply depends on the economy’s
output share, y .
The simple model can also be used to discuss other issues. For instance,
we may allow velocities to vary among countries. An important extension
is to discuss the case that countries produce non-trade goods. We are still
concerned with a world economy with identical velocities and a single
trade good. We now assume that each country produces a fixed amount of
non-trade good per unit of time. The question is to determine the price of
the traded good and the balance of payments as well as the prices of the
non-traded goods. Let subscripts T and N denote respectively the traded
and non-traded goods sectors. Equilibrium in the market for non-traded
goods requires
PN YN = βV M , (5.3.5)
where β is the given expenditure share of domestic goods. Equilibrium

condition in the market for traded goods is
5.4 Exchange Rates and the Terms of Trade in a Two-Country Model 163
(YN + YN )PT = βV G . (5.3.6)
The balance of payments, which is equal to the excess of income over

spending when goods market clears, is represented by
M& = PT YT − (1 − β )V M .
From the above equation and Eqs. (5.3.5) and (5.3.6), we obtain
M& = (1 − β )V ( yT G − M ), (5.3.7)
where yT ≡ YT / (YT + YT ). The equation reveals that the balance of pay-

ments is affected by the presence of non-traded goods, measured by β .
The higher the value of β , the more gradually the specie flow mechanism
operates. In the long run yT G = M , which is not affected by β . From
Eqs. (5.3.5) and (5.3.6), we obtain
M (5.3.8)
p= ,
yN G
where p ≡ PN / PT and y N ≡ YN / (YN + YN ). As y N and G are fixed, we

see that the relative price moves positively in proportion to M .
In history gold-standard institutions were mostly characterized of an
impure type where the circulating medium consisted of paper (or other to-
ken) claims to quantities of gold. We refer to these as currency. The value
of currency is maintained by the central bank. Currency can be exchanged
for gold coins or bullion at the officially fixed rate. A nation’s currency is
thus fixed in terms of gold. We see that under free trade exchange rates be-
tween national paper currencies are also fixed.27
5.4 Exchange Rates and the Terms of Trade in a Two-

Country Model
This section introduces the monetary model of international trade devel-

oped by Ohyama (1991). The model studies an interaction of monetary and
real factors affecting the terms of trade and governing the adjustment proc-
27 We neglect factors such as transaction costs which may make exchange rates
to vary. We refer studies of the economies with national currencies and gold standard
to Barro (1979) and McCallum (1989: Chap. 13).
ess of current account imbalances under the system of flexible rates.28 The
world consists of two countries, Home and Foreign, which produce two
goods, goods 1 and 2 . Markets are perfectly competitive in any economy.
The factor endowment and production technology of each country are
fixed. The factors of production are fully employed. Free trade prevails
between two countries with no transportation costs. Assume that Home
exports good 1 and Foreign exports good 2 . Moneys are held as financial
assets by households of the two countries. Households can exchange mon-
eys freely and the exchange rate is determined so as to equilibrate the for-
eign exchange market.
5.4.1 The monetary model of international trade
Assume that a country’s nominal wealth, W , is a function of the exchange

rate, e , defined as the price of Foreign’s currency in terms of Home’s cur-
rency and the current transfer of Home money, Th , and that of Foreign
money, T f , as follows
~ (5.4.1)
~ ~ T ~
W = V (e ) + Th + eT f , W = V (e ) + h + T f .
e
The wealth constraints of the two countries are given by
~ (5.4.2)
D ~ ~
Dh + eD f = W , e + D f = W ,
e
where Dh and D f are respectively the demand for Home money and For-
eign money. Assume a country’s demand for Home money is a function of
the domestic country’s nominal wealth and expected rate of increase of the
exchange rate entertained by the domestic residents, π , as follows29
~ (5.4.3)
Dh ~ ~ ~
Dh = α (π )W , = α (π )W , 0 ≤ α (π ) ≤ 1, α ' (π ) < 0 .
e
The total demand for a country’s money is equal to its total supply
28 See also Kouri (1976), Calvo and Rodriguez (1977), and Dornbusch and
Fischer (1980).
29 Here, we neglect any possible effects of national income or any other vari-
able on the demand for domestic and foreign money.

~ ~
α (π )W + α~(π )eW = M + Th + Th ,
(1 − α )W + (1 − α~ )eW~ = e(M~ ~
+ Tf + Tf ,) (5.4.4)
where M are Home’s and Foreign’s initial supply of money and we use
W ~ ~
D f = (1 − α ) , D f = (1 − α~ )W ,
e
which are obtained from Eqs. (5.4.2) and (5.4.3). The value of the world
total wealth is equal to the value of the world total supply of money
~ ~ ~
(
W + eW = M + Th + Th + e M + T f + T f ,
~
) (5.4.5)
which can also be obtained by adding the two equations in (5.4.4).

From Eqs. (5.4.1) and the equation for Home in (5.4.4), we obtain the
following relation
(~ ~ ~
)
α (V + Th + eT f ) + α~ eV + Th + eT f = M + Th + Th .
~ (5.4.6)
This equation determines the exchange rate when the other variables in
the equation are given. We interpret this condition as that the exchange
rate is determined to equilibrate the total demand for the foreign money
with the total supply of the foreign money.
We now describe the commodity markets. Let p j stand for prices of
good j in the domestic currency. The international price arbitrage entails
p j = ep j , j = 1, 2 .
The relative price of good 2 relative to good 1 is p = p2 / p1 = ~

p2 / ~
p1 .
The excess demand functions are assumed to be dependent on the relative
price and the country’s real wealth and its wealth in terms of its export-
ables as follows30
~
 W ~ ~ W
=
Ej Ej p  ,  , E = E  p , .
p1 
j j ~ 
  p 2 
Commodity markets are at equilibrium, that is
30 This means that the excess demand functions are homogeneous of degree
zero in each country’s money prices and nominal wealth. This assumption is based
on that the factors of production are fully employed in each country and that price
expectations are static and the public is free from money illusion in each country.
~ (5.4.7)
 W  ~ W 
E j  p , ~  + E j  p , ~  = 0 , j = 1, 2 .
 ep1   pp1 
Short-run equilibrium in this model is defined as the state at which both

Eqs. (5.4.6) and (5.4.7) are satisfied for fixed Th , T f and π .
Home’s current account surplus (balance of trade) measured in the units
of Foreign currency, B , is defined as
~ (5.4.8)
~ W   W 
p1 E1  p , ~  − ~
B=~ p2 E2  p , ~  .
 pp1   pp1 
Each country’s wealth varies over time at the rate of its current account
surplus
W& ~& (5.4.9)
= − W = B.
e
The condition of the current account equilibrium is
~ (5.4.10)
~ W   W 
E1  p , ~  − pE2  p , ~  = 0 .
 pp1   pp1 
Given M , e , p and ~
p1 with Th = T f = 0 , Eq. (5.4.10) with Eqs.
(5.4.5) determine Home’s and Foreign’s wealth. The world economy’s
long-run equilibrium is defined as the state where Eqs. (5.4.10), (5.4.6) and
(5.4.7) for given M and π = 0 . We have thus built the model. We ana-
lyze some properties of the model.
5.4.2 Determination of exchange rate and price dynamics
The equilibrium exchange rate is determined in foreign exchange market,

independent of conditions in the commodity markets. We now examine
how the equilibrium exchange rate is affected by various exogenous
changes. First, we notice that from Eqs. (5.4.2) and (5.4.3), we have
~ ~ (5.4.11)
e ∂W eD f e ∂W eD
= =1−α, ~ = − ~h = − α~ .
W ∂e W W ∂e W
As the exchange rate is increased, ceteris paribus, Home’s nominal
wealth is increased and Foreign’s nominal wealth is reduced.
By (5.4.11), we have
[ ~
∂ α (π )W + α~ (π )eW] W ~
= α (1 − α ) + α~(1 − α~ )W > 0 .
∂e e
~
That is, the total demand for Home money, αW + α~eW , rises in e . As
the money supply is fixed, we see that the equilibrium exchange rate is de-
termined at point E as in Fig. 5.4.1.
e
M
~
αW + α~eW
e E
M M
Fig. 5.4.1. Determination of exchange rate
According to Fig. 5.4.1, it is now easy to illustrate effects of changes in

parameters on the equilibrium exchange rate. First consider a rise in the
expected rate of depreciation of Home currency (a rise in π and/or π~ ).
The public is motivated to sell Home money in exchange for Foreign
money. This means that the demand curve shifts to the left, as illustrated
by the dashed line in Fig. 5.4.1. Home currency is depreciated. We now
suppose that the monetary authority of either country intervenes in the for-
eign exchange market selling Foreign money in exchange for Home
money. For a fixed change rate, this operation causes the total supply of
Home money to fall and the total supply of Foreign money to rise. The
demand curve shifts to the left, as illustrated by the dashed line in Fig.
5.4.1. Home currency is depreciated.
Another change is due to monetary transfers. Assume that a monetary
transfer from Foreign to Home brings about, ceteris paribus, a rise in W
~
and a fall in W . If Home’s propensity to hold Home currency, α , is
greater (less) than Foreign’s propensity to hold Home currency, α~ , then
the demand curve shifts to the right (left), resulting in the appreciation (de-
preciation) of Home currency. From Eqs. (5.4.2) and (5.4.11), we have
∂e
=−
(α − α~ )e , (5.4.12)
~ ~
∂Z αD +αD f f
~
where Z stands for the sum of the transfer and we use dZ = dT f = − dT f .
Lemma 5.4.1
An increase in the monetary transfer from Foreign to Home results in an
appreciation (depreciation) of Home currency if and only if α > (<) α~ .
If α~ = 0 , that is, foreigners do not hold Home currency, then the trans-
fer causes Home currency to appreciate. From Eqs. (5.4.1) and (5.4.12),
we have
~ ~
∂W
=
α~eM
> 0 ,
∂W
=−
(1 − α )M / e < 0 .
~ ~ ~
∂Z αD f + α D f ∂Z αD f + α~D f
The directions of effects on the wealth are definite.
Another important question for this (kind of) trade model is price dy-
namics and its stability. Let us consider a case that the commodity markets
are out of equilibrium,31 even though the foreign exchange market is
cleared at all time. As the equilibrium prices are given by Eqs. (5.4.7), we
introduce price dynamics when the equations are not held as follows
~
( ~
) ( ~
)
p& 1 = F E1 + E1 , p& = F E2 + E2 , F (0) = 0 , F ' (0) > 0 .
~ (5.4.13)
The specified dynamics simply mean that the money price of each good
rises (falls) when the total demand for that good exceeds (falls short of) its
total supply.
Before stating stability conditions, we introduce an assumption and a
few notations. For simplicity, assume that the current account is balanced,
that is
~ ~
p1 E1 = ~
p 2 E2 > 0 .
31 This means that Eqs (5.4.7) may not hold.

Let η j stand for the elasticity of a country’s excess demand for good j
with respect to the relative price, that is
~
p ∂E j ~ p ∂E j
ηj ≡ − , ηj ≡ ~ .
E j ∂p E j ∂p
We see that η j may be either positive or negative. Let m j represent a

country’s propensity to spend on good j , that is
∂E1 1 ∂E1
m1 ≡ , m2 ≡ ,
∂ (W / p1 ) p ∂ (W / p1 )
~ ~
~ ≡ p ∂E1 , m ~ ≡ ∂E2 .
m1 ~
(
∂W /~ p2 ) 2 ~
∂W /~ (
p2 )
It is assumed that m j > 0 , j = 1, 2 . We introduce
~
ε j ≡ η j + η~j , ε~j ≡ m jW + m
~ eW
j .
By assumption, we always have ε~j > 0 . The equilibrium point of

(5.4.13) is locally stable if the determinant of its Jacobian matrix is posi-
tive and its trace is negative. It is straightforward to show that the determi-
nant is positive if
~ (5.4.14)
WW
ε 2ε 1 + ε 1ε 2 + (m1m2 − m2 m1 ) ~
~ ~ ~ ~ > 0,
p2 E2
and the trace is negative if ε~j > 0 (which are assumed to hold) and
~W ~ (5.4.15)
m
ε2 + ~ 2
> 0.
p2 E2
The equilibrium point is locally stable if (5.4.14) and (5.4.15) hold near
the point. To rewrite these two conditions, define
~
~ E ~
E ≡ E1 + pE2 , E ≡ 1 + E2 .
p
Obviously, E is a country’s excess expenditure measured in the units of

the country’s exportables. Assume that E are not affected by a change in
the relative price of its importables in the neighbor of the equilibrium, or32
~ (5.4.16)
∂E ∂E
= 0, = 0,
∂p ∂ (1 / p )
~
where E = E = 0 . From the definitions of E and (5.4.16), we have
η1 = η 2 − 1, η~2 = η~1 − 1.
Under the above equations, we can rewrite conditions (5.4.14) and
(5.4.15) as follows
~
WW
η m ≡ (ε 1 + ε 2 )(η1 + η 2 − 1) + (m1m2 − m2 m1 ) ~
~ ~ ~ ~ ~ > 0,
p2 E2
~W~ (5.4.17)
m
η~1 + η 2 − 1 + ~ 2 > 0 .
p 2 E2
We conclude that the Marshall-Lerner condition
η ≡ η~ + η − 1 > 0
0 1 2
is either sufficient or necessary for the stability of the short-run equilib-

rium, dependent on the sign of m1m ~ −mm ~
2 2 1.
5.4.3 Exchange rate, terms of trade and the current account
First, we are still concerned with the effect of a monetary transfer from
Foreign to Home on the commodity markets with e being fixed. It can be
~
shown that with e fixed, from Eq. (5.4.7) and ~p1 E1 = ~
p2 E2 we obtain
~
1 ∂~p1  W  e
~ = (m − m )η 0 + (m1m2 − m2 m1 ) ~
~ ~ ~
 ,
p1 ∂Z  p2 E2  η m
32 This section is limited to the situations when the two conditions hold. It
should be noted that Ohyama (1991) also examines the system when the condi-
tions are not held as an appendix.
~ (5.4.18)
1 ∂p W + eW
=− ~ (m1m~ 2 − m2 m~1 ),
p ∂Z p2 E2η m
where m ≡ m1 + m2 . We still assume η m > 0 . As shown before, in asso-

ciation with a rise in Z , Home’s nominal wealth is increased and For-
eign’s nominal wealth is reduced. If m > (<) m ~ , ceteris paribus, the in-
crease in Home’s excess expenditure exceeds in absolute value the
decrease in Foreign’s excess expenditure, generating an inflationary (defla-
~ , j = 1, 2 , an inter-
tionary) pressure on the world price level. If m j = m j
national monetary transfer has no impact on the price of any good. In gen-
eral, we see that prices may be either increased or decreased, depending on
combinations of the parameter values.33
It is often taken for granted that a depreciation of Home currency gener-
ates pressure in Home and a deflationary pressure in Foreign and that
Home’s terms of trade is deteriorated. We now use this simple model to
address this issue. Rather than fixing e , we now allow e to vary. Still
from Eq. (5.4.7), we obtain
e ∂~ ~~
p1
= − α + (α − ~ ) eη 0 mW ,
α
~
p1 ∂e ηm
~ (5.4.19)
e ∂p WW
=− ~ (α − α~ )(m1m~ 2 − m2 m~1 ).
p ∂e p2 E2η m
If α = α~ , then terms of trade are not affected by a change in the exchange

rate. From Eqs. (5.4.19), we immediately have the following lemma.
Lemma 5.4.2
A depreciation of Home currency brings about a deterioration in Home’s
terms of trade iff
(α − α~ )(m m~ − m m~ ) > 0 .
1 2 2 1
We now examine effects of a change in the exchange rate on the current

account balances. Home’s current account balance is given by (5.4.8),
which can be equivalently expressed as
33 It should be noted that it is often believed that the terms of trade will deterio-
rate for the country which pays the transfer. This is notably argued by Keynes
(1929). The orthodox assumption in this model holds under m1m ~ >mm ~
2 2 1.
~
  W   W 
B=− ~
p1  E1  p ,  + pE 
 p ,  .
p1 
p~ p1 
p~
2
  
Under (5.4.16), taking total differentials of the above equation yields
 W d~
p1 de  (5.4.20)
dB = − m  dZ − − 2  .
 p1 e 
If e is fixed, then from (5.4.20) and (5.4.18), we have
∂B
=−
mm 0 (
~ η W + eW ~
.
) (5.4.21)
∂Z de = 0 ηm
As η m is assumed to be positive, the transfer of money from Foreign to

Home makes Home’s current account to a deficit iff the Marshall-Lerner
condition, η 0 > 0 , holds.
We now consider effects of change in e , keeping Z constant. From
(5.4.20) and (5.4.19), we obtain
∂B
= (α − α )
~
~ η W + eW
mm 0
~
.
( ) (5.4.22)
∂e eη m
The direction of the impact is not determined solely by the Marshall-
Lerner condition, but also on the portfolio preference condition.34 From Eq.
(5.4.22), the following lemma holds.
Lemma 5.4.3
Under (5.4.16), a depreciation of Home currency improves Home’s bal-
ance of current account iff
(α − α~ )η > 0 .
0
Under (5.4.16) and α > α~ , we have that the Marshall-Lerner condition

is necessary and sufficient for a depreciation of Home currency to improve
Home’s balance of current account.
34 Robinson (1937) and Metzler (1948) hold that the Marshall-Lerner condition
is necessary for a devaluation to improve the current account balance of the de-
valuing country. It should be also noted that Johnson (1976: 281) considers the
Marshall-Lerner condition to “be completely irrelevant to a monetary international
economy because it is the condition for the stability of the exchange in a barter
economy.”
5.5 On Money and Trade
The main problem for the models in this chapter is that they lack (optimal)
mechanisms for determining household behavior. Although they can be
applied to analyze issues related to money and exchange rates, they do not
explain how the unemployed, for instance, make decisions in consumption
and saving. Although the Ohyama model provides an exploration of short-
run dynamics of exchange rates and current account balances, as it is con-
structed with fixed trade pattern and fixed wealth, essential long-term
problems of international trade can not be properly addressed. As
McCallum (1996: 97-98) pointed out,35 “neither short-run nor long-run
analysis of the comparative static type is fully satisfactory, of course. What
would be preferred is true dynamic analysis that traces out the path of all
variables as they evolve over time.”
35 It should be remarked that the IS-LM analysis for open economies has been
generalized to dynamic frameworks, for instance, by introducing rational expecta-

tions (for instance, McCallum, 1989, 1996).
6 Growth of Small Open-Economies with Capital
Accumulation
It is significant to examine possible effects of trade upon personal income

distribution in a globalizing world economy. It is argued, for instance, that
the rise in inequality between the rich and the poor and the decline of real
wages of the less skilled in the US is closely related to international trade
with low-wage countries.1 Nevertheless, some economists argue that the
role of foreign trade for enlarged inequality is negligible. Keller (2004) ex-
amines the extent of international technology diffusion and channels
through which technology spreads.2 It is shown that productivity differ-
ences explain much of the variation in incomes across countries, and tech-
nology plays a key role in determining productivity. The pattern of world-
wide technical change is determined largely by international technology
diffusion because a few rich countries account for most of the world’s
creation of new technology. Cross-country income convergence turns on
whether technology diffusion is global or local. There is no indication that
international diffusion is inevitable or automatic, but rather, domestic
technology investments are necessary. Winter et al. (2004) examine the
impact of trade policy reform on poverty in developing countries. It is
demonstrated that there is no simple generalizable conclusion about the re-
lationship between trade liberalization and poverty. In the long run and on
average, trade liberalization is likely to be strongly poverty alleviating, and
there is no convincing evidence that it will generally increase overall pov-
erty or vulnerability. But there is evidence that the poor may be less well
placed in the short run to protect themselves against adverse effects and
take advantage of favorable opportunities. In extensively and intensively
connected world markets, workers are confronted with increasing competi-
tion from other countries and capital owners can move their wealth easily
1 See Nahuis (2003: Chap. 2), which surveys some empirical studies on possi-
ble causes for the decrease in the relative wage of low-skilled workers in the US in
the 1980s. For trade and wage inequalities for developing economies, see also
Marjit and Acharyya (2003) and Edmonds and Pavcnik (2006).
2 Other channels of enlarged inequalities are modeled by, for instance, Krug-
man and Venables (1995), Manasse and Turini (2001).

176 6 Growth of Small Open-Economies with Capital Accumulation
to wherever returns appear likely to be the highest. Yet, modern technol-

ogy tends to diminish the demand and therefore the wages for low-skilled
workers, while pushing up the demand for highly-educated specialists. As
globalization is deepening, it is important to provide analytical frameworks
for analyzing global economic interactions. For instance, it is important to
examine how a developing economy like India or China may affect differ-
ent economies and different people in a special economy as its technology
is improved or population is enlarged; or how the global trade patterns
may be affected as technologies are further improved or propensities to
save are increased in developed economies like the US or Japan.
As mentioned in Introduction, classical economists constructed different
trade theories to explain why countries make trade. They argued that coun-
tries make trades due to various reasons under different conditions. They
trade because they are different from each other. These differences may be
either in real terms such as climates, technology and natural resources, or
in monetary variables, such as prices, interest rates and wage rates. Classi-
cal economists proved that it does often benefit a nation to exchange desir-
able things which it cannot produce. Nations may benefit from trading as
each of them may produce things it does relatively well. Nevertheless, we
have so far assumed that total factor supplies are fixed. This chapter intro-
duces capital accumulation into trade models.
As observed by Wong (1995), international factor mobility has received
little attention in the literature of international trade. In most books on in-
ternational trade, international trade is considered nearly synonymous to
international trade in goods. Many trade theorems are obtained when only
goods are allowed to move between countries. Two reasons for the omis-
sion are pointed out. The first is that historically economic relationships
between countries have been determined mainly by the movement of
goods. During most periods of economic history, international factor
movements did not play a significant role in economic evolution. Move-
ments of factors were generally strictly regulated by governments or were
very costly. It happened, though not very frequently, that the gaps between
factor prices in different countries became so large that some significant
movements of factors did occur. The second reason is that international
factor movement can be analyzed by the same framework for studying
trade in goods. The Arrow-Debreu general equilibrium framework can be
extended to examine factor mobility by regarding factors inputs as nega-
tive outputs. Production outputs and factor inputs can thus be analyzed si-
multaneously and symmetrically. In a classical work, Mundell (1957)
shows international trade in goods and factor mobility are substitutes in the
senses that either of them reaches the same world equilibrium and an in-
crease in the volume of one will discourage the volume of the other. This
result is obtained under static conditions. Factor mobility may not be sub-
stitutive with trade in goods once we perceive economic evolution in a dy-
namic and accumulative way. This becomes evident when we introduce
changeable returns to scale in economic dynamics. It can be seen that in
general, factor mobility and trade in goods cannot be treated in symmetry.
The Mundell substitutability between trade in goods and factor mobility is
generally not valid. This chapter will suggest a dynamic one-commodity
and multiple-country trade model to examine interdependence between
trades and global growth. We analyze trade issues within the framework of
a simple international macroeconomic growth model with perfect capital
mobility.
This chapter studies a few models of small open economies with inter-
national capital mobility. As mentioned before, the main deviation of this
book from traditional approaches in modeling dynamics of international
trade is how to model households’ decision making. Section 6.1 introduces
the one-sector growth (OSG) model of an isolated economy. In the rest of
this book, we use the OSG framework to stand for the one sector growth
model developed in this section and its various extensions. Section 6.2 ex-
amines the Ramsey growth model (which is the most popular approach in
economic growth theory with optimal foundation) also for a closed econ-
omy. As the OSG approach is an alternative approach to the Ramsey ap-
proach, we will also compare the two approaches. Section 6.3 describes
dynamics of a small country economy. An open economy can import
goods and services and borrow resources from the rest of the world or ex-
ports goods and services and lend resources abroad. For convenience of il-
lustration, assume that there is a single good in the world economy and the
price of the goods is unity. Section 6.4 extends the model in Sect. 6.3 to a
multi-regional economy. The model examines economic growth of a
multi-regional small open economy in a perfectly competitive economy.
The national economy consists of multiple regions and each region has one
production sector and one housing sector. Households move freely among
regions, equalizing utility level among regions by choosing housing, goods
and saving. A region’s amenity is endogenous, depending on the region’s
output and population. We explicitly solve the dynamics of the multi-
regional economy. As a concluding remark, Sect. 6.5 discusses the theo-
retical basis for the utility function used in Chap. 6. Section A.6.1 intro-
duces a typical model of a small overlapping-generalizations (OLG) econ-
omy, proposed by Galor. Section A.6.2 studies a small country model
proposed by Ikeda and Gombi to study the equilibrium dynamics of sav-
ings, investment and the current account. Section A.6.3 proves Lemma
6.4.1. Section A.6.4 studies the Keynesian consumption function and ex-
amines its possible relations to the consumption function obtained from the
OSG approach. Section A.6.5 introduces the Solow growth model and ex-
amines its possible relations to the OSG growth model.
6.1 The One-Sector Growth (OSG) Model of a Closed

Economy3
The main deviation of this book from traditional approaches in modeling

dynamics of international trade is how to model households’ decision mak-
ing. Although this approach has been extensively explained by Zhang,4 this
section introduces the one-sector growth (OSG) model of an isolated
economy. In the rest of this book, we use the OSG framework to stand for
the one sector growth model developed in this section and its various ex-
tensions.
6.1.1 The Model
We consider an economy of one production sector and one type of house-

holds. With regard to production, almost all the aspects of the OSG model
are similar to the standard Solow and Ramsey one-sector growth models. It
is assumed that there is only one (durable) good in the economy under
consideration. Households own assets of the economy and distribute their
incomes to consume and save. Production sectors or firms use inputs such
as labor with varied levels of human capital, different kinds of capital,
knowledge and natural resources to produce material goods or services.
Exchanges take place in perfectly competitive markets. Production sectors
sell their product to households or to other sectors and households sell
their labor and assets to production sectors. Factor markets work well. Sav-
ing is undertaken only by households, which implies that all earnings of
firms are distributed in the form of payments to factors of production, la-
bor, managerial skill and capital ownership.
First, we describe behavior of the production sector.5 Time is repre-
sented continuously by a numerical variable which takes on all values from
zero onwards ( t ≥ 0 ). Let K (t ) denote the capital existing at each time t
and N (t ) the flow of labor services used at time t for production. Capital
is malleable in the sense that one need distinguish neither its previous use
3 This section is based on Zhang (2006a: Chaps. 1 and 2).

4 See, for instance, Zhang (2005a, 2006b).
5 The description of behavior of producers and production sectors follows the
traditional approach (e.g., Burmeister and Dobell, 1970, and Azariadis, 1993).
nor the factor productions of its previous use. We use the conventional
production function to describe a relationship between inputs and output.
The function F (t ) defines the flow of production at time t . The produc-
tion process is described by neoclassical production function6:
F (t ) = F (K (t ), N (t ) ). In the rest of this book, we omit time subscripts and
in the subsequent analysis whenever no ambiguity results.
We assume that the production function exhibits constant returns to
scale.7 It is straightforward to check that a linear homogenous production
has the following properties:
(i) The production function can be written in terms of per capita output as
a function of per capita capital
F K (6.1.1)
= F (k , 1) ≡ f (k ), k ≡ .
N N
Output per worker depends only on the amount of capital employed by one
worker. Equation (6.1.1) is called the intensive form of the aggregate pro-
duction function. It is also referred to as the per-worker production func-
tion.
(ii) The slope of f (k ) represents the marginal product of capital, i.e.

∂F ∂ (F / N )
FK = = = f ' (k ) > 0 .
∂K ∂ (K / N )
(iii) The marginal product of labor can be obtained by f (k ) as follows
6 A production function F ( K , N ) is called neoclassical if it satisfies the following

conditions: (1) F (K , N ) is non-negative if K and N are non-negative; (2)
F (0 , 0) = 0 ; (3) marginal products, FK and FN are non-negative; (4) there exist
second partial derivatives of F with respect to K and N ; (5) the function is
homogeneous of degree one: F (λK , λN ) = λF (K , N ), for all non-negative λ ;
(6) the function is strictly quasi-concave.
7 For the production function F (K , N ) we define the homogeneity of degree
n for capital and labor inputs as follows: F (λK , λN ) = λn F (K , N ), where λ is an
arbitrary non-negative number. When n = 1, we say that the production function
has constant returns to scale. It is linearly homogeneous or homogeneous of
degree one.
∂F ∂ (NF / NK ) ∂ ( f (k ) / k )
FN = = = = f (k ) − k f ' (k ) > 0 .
∂N ∂(N / K ) ∂ (1 / k )
(iv) The Euler Theorem holds
KFK + NFN = F .
We assume (identically numerous) one production sector. Its goal of

economic production is to maximize its current profit
π (t ) = p(t ) F (t ) − (r (t ) + δ k ) p(t ) K (t ) − w(t ) p(t ) N (t ) ,
where p (t ) is the price of product, r (t ) is the real rate of interest, w(t ) is
the real wage rate, and δ k is the fixed depreciation rate of capital. We as-
sume that the output good serves as a medium of exchange and is taken as
numeraire. We thus set p (t ) = 1 and measure both wages and rental flows
in units of the output good. The rate of interest and wage rate are deter-
mined by markets. Hence, for any individual firm r and w are given at
each point of time. The production sector chooses the two variables K and
N to maximize its profit. Maximizing π with regards to K and N as
decision variables yields
r + δ k = FK = f ' (k ), w = FN = f (k ) − kf ' (k ), (6.1.2)
in which k (t ) ≡ K (t ) / N (t ). We assume that factor markets work quickly

enough so that our system always displays competitive equilibrium in fac-
tor markets. Since we assumed that the production function is homogenous
of degree one, we have KFK + NFN = F , or
rK + wN + δ k K = F . (6.1.3)
This result means that the total revenue is used up to pay all factors of
the production.
We now describe behavior of consumers. Consumers obtain income
Y = rK + wN , (6.1.4)
from the interest payment rK and the wage payment wN . We call Y the
current income in the sense that it comes from consumers’ daily toils
(payment for human capital) and consumers’ current earnings from owner-
ship of wealth. The current income is equal to the total output as we ne-
glect any taxes at this initial stage. The sum of income that consumers are
using for consuming, saving, or transferring are not necessarily equal to
the temporary income because consumers can sell wealth to pay, for in-
stance, the current consumption if the temporary income is not sufficient
for buying food and touring the country. Retired people may live not only
on the interest payment but also have to spend some of their wealth. The
total value of wealth that consumers can sell to purchase goods and to save
is equal to p(t )K (t ) (with p(t ) = 1 ). Here, we assume that selling and
buying wealth can be conducted instantaneously without any transaction
cost. The disposable income is equal to
Yˆ (t ) = Y (t ) + K (t ). (6.1.5)
It should be noted that in Eq. (6.1.5), like Y (t ), the value of wealth, K (t ),

is a flow variable. The disposable income is used for saving and consump-
tion.
At each point of time, consumers would distribute the disposable in-
come between saving, S (t ), and consumption of goods, C (t ). The budget
constraint is given by
C (t ) + S (t ) = Yˆ (t ). (6.1.6)
In our model, at each point of time, consumers have two variables to de-
cide. A consumer decides how much to consume and to save. Equation
(6.1.6) means that consumption and savings exhaust the consumers’ dis-
posable personal income. The slope of the budget line is equal to − 1, i.e.,
dS / dC = − 1.
We assume that utility level, U (t ), that the consumers obtain is depend-
ent on the consumption level of commodity, C (t ), and the saving, S (t )
U (t ) = U (C (t ), S (t )). (6.1.7)
A typical consumer is to choose his most preferred bundle (c(t ), s (t )) of

consumption and saving under his budget constraint. Here, c ≡ C / N and
s ≡ S / N . The utility maximizing problem at any time is defined by
Max U (c(t ), s(t ))
c,s ≥ 0
s.t.:
c(t ) + s(t ) ≤ yˆ (t ), (6.1.8)
in which yˆ (t ) ≡ Y (t ) / N (t ) + k (t ). The following theorem holds.

Proposition 6.1.1
Let U (c , s ) : R+2 → R1 be a C 1 function that satisfies the monotonicity as-
sumption, which says that ∂U / ∂c > 0 and ∂U / ∂s > 0 for each (c , s )
satisfying the constraint set in problem (6.1.8). Suppose that (c * , s * )
maximizes U on the constraint set. Then, there is a scalar λ * > 0 such that
∂U * *
(c , s ) ≤ λ * , ∂U (c* , s* ) ≤ λ * .
∂c ∂s
We have ∂U / ∂c = λ * if c* ≠ 0 and ∂U / ∂s = λ * if s * ≠ 0 . If both
c* > 0 and s * > 0, then
∂U * *
(c , s ) = λ * , ∂U (c* , s * ) = λ * .
∂c ∂s
Conversely, suppose that U is a C 1 function, which satisfies the
monotonicity assumption and that (c * , s * ) > 0 and the first order condi-
tions. If U is C 2 and if
0 1 1
H = 1 U cc U cs = 2U cs − U cc − U ss > 0 ,
1 U sc U ss
then (c * , s * ) is a strict local solution to the utility maximization problem. If

U is quasiconcave and ∇U (c, s ) for all (c, s ) ≠ (c * , s * ), then (c * , s * ) is a
global solution to the problem.
The proof of this proposition and other general properties of the prob-
lem can be found in standard textbooks of microeconomics or mathemati-
cal economics.8 We require that U is a C 2 function, and satisfies
U c > 0, U s > 0 for any (c , s ) > 0 . It can be shown that that
0 < ds / dyˆ < 1 and 0 < dc / dyˆ < 1 in the case of U sc ≥ 0 under the sec-
ond-order condition of maximization. We denote an optimal solution as
function of the disposable income
(c(t ), s(t )) = (c( yˆ (t )), s( yˆ (t ))).
8 See Chiang (1984), Mas-Colell, et al. (1995), and Simon and Blume (1994).
The vector (c( yˆ (t )), s ( yˆ (t ))) is known as the Walrasian (or ordinary or
market) demand function, when it is single-valued for all positive dispos-
able income.
If the utility function is taken on the Cobb-Douglas function
U (t ) = c ξ (t )s λ (t ), ξ + λ = 1, ξ , λ > 0 , (6.1.9)
where ξ and λ are parameters, it is straightforward to solve the optimal

choice of the consumers as
c(t ) = ξyˆ (t ), s (t ) = λyˆ (t ). (6.1.10)
It appears reasonable to consider population as independent of economic
conditions, as a first approximation. We assume that the population dy-
namics is exogenously determined in the following way
N& (t ) = nN (t ),
where n is a constant growth rate of N .
The change in the households’ wealth is equal to the net savings minus
the wealth sold at time t , i.e.
K& (t ) = s ( yˆ (t ))N (t ) − K (t ). (6.1.11)
Inserting
K& (t )
k&(t ) = − nk (t ),
N (t )
in Eq. (6.1.11) yields
k&(t ) = s ( yˆ (t )) − (1 + n )k (t ),
where
Yˆ (t )
yˆ (k (t )) ≡ = f (k (t )) + k (t ).
N (t )
In a stationary state
s( yˆ ( k ) ) = (1 + n )k .
It can be shown that this equation has a unique solution.
Theorem 6.1.19
Given a neoclassical production function and a utility function that is a C 2
function, and satisfies U c > 0, U s > 0 for any (c(t ), s(t )) > 0 . Let the
bordered Hessian be positive for any nonnegative (c(t ), s (t )). Then the
capital-labor ratio converges monotonically to a unique positive steady
state. The unique stationary state is stable.
The stability guaranteed above is local. We now show that if s( yˆ ) is

concave in ŷ , then the system is globally stable. Because of
d 2 c / dy 2 = − d 2 s / dy 2 by equation 1 = dc / dyˆ + ds / dyˆ , concavity of s
implies convexity of c . From the first-order conditions, it is straightfor-
ward to give that conditions under which s is concave, we omit the ex-
pression because we lack a clear economic interpretation. Asymptotical
stability can be proved by applying Lyapunov’s theorem.10
We illustrate dynamics of capital-labor ratio in Fig. 6.1.1. The dynamic
system has a unique stable equilibrium.11
k&(t )
0 k* k
k& = s ( yˆ ) − (1 + n )k
Fig. 6.1.1. Evolution of capital-labor ratio in the OSG model
9 The theorem is proved in Zhang (2006a, Chap. 2).

10 See Zhang (1991, 2005a).
11 The proof is referred to, for instance, Burmeister and Dobell (1970), or
Zhang (2005a).
6.2 The Ramsey Growth Model and the OSG Approach12
Section 6.1 introduces the OSG model. This section examines the Ramsey
growth model (which is the most popular approach in economic growth
theory with optimal foundation). As the OSG approach is an alternative
approach to the Ramsey approach, we will compare the two approaches.
The Ramsey growth model is a neoclassical model of economic growth
based primarily on the work of Frank Ramsey. Keynes considered Ram-
sey’s 1928 classic paper to be
one of the most remarkable contributions to mathematical economics ever

made.13
The influences of Ramsey’s classical contribution are reflected in the

fact that almost all the contemporary dynamic models of national, urban,
interregional, or international economic growth with microeconomic foun-
dation for behavior of households are based on the paper and its variations
(like the overlapping-generations model in discrete version).14
Most aspects of the Ramsey model are similar to the OSG model de-
fined in Sect. 6.1. The variables, F (t ) , K (t ) , N (t ) , k (t ) , w(t ) , r (t ) , in
the Ramsey model have the same meanings as in the OSG model. The
production process, marginal conditions, population growth are the same
as in the OSG model. We now describe households’ behavior. In the Ram-
sey approach, households’ decisions on saving are represented by assum-
ing that consumers maximize the discounted value of their flow of utility,
using a constant rate of impatience. The extended family is assumed to
grow at an exogenously given rate n . Let the number of adults at time 0 be
unity, the family size at time t is N (t ) = e nt . The household’s preferences
are expressed by an instantaneous utility function, u (c(t )), where c(t ) is
the flow of consumption per person, and a discount rate for utility, denoted
by ρ . For simplicity, specify u (c ) as
12 This section is based on Zhang (2005a: Chap. 2).

13 Macroeconomic Dynamics (2006: vol. 10). The early literature on the Ram-
sey model, is referred to Ramsey (1928), Cass (1965), and Koopmans (1965).
14 Although the acceptance of this framework has not been based on any pro-
found reason or empirical test, any valid alternative to the dominant framework
will rationally meet with obstacles.
c1 − θ (t ) − 1 (6.2.1)
u (t ) = , θ > 0,
1−θ
where θ is a parameter, u ' > 0 , u" < 0 , and u satisfies the Inada condi-
tions: u ' → ∞ as c → 0 and u ' → 0 as c → ∞ .
Assume that each household maximizes utility U as given by
∞
U = ∫ u (c(t ))e nt e − ρt dt , c(t ) ≥ 0 , t ≥ 0 .

0
The household makes the decision subject to a lifetime budget con-

straint. We denote the net assets per household by k (t ) which is measured
in units of consumables. The total income at each point of time is equal to
w + rk . The flow budget constraint for the household is
k& = w + rk − c − nk = f (k ) − c − nk . (6.2.2)
The equation means that the change rate of assets per person is equal to
per capita income minus per capita consumption and the term, nk .
The first-order conditions are
∂J
= 0 ⇒ λ = u ' e −( ρ − n ) t ,
∂c
dλ ∂J dλ (6.2.3)
=− ⇒ = − (ρ − n )λ ,
dt ∂k dt
where λ is the present-value shadow price of income. By Eq. (6.2.3), we
can derive
u" c  1 dc  (6.2.4)
r=ρ−  .
u '  c dt 
This equation says that households choose consumption so as to equate
the rate of return r to the rate of time preference ρ plus the rate of de-
crease of the marginal utility of consumption u ' due to growing per capita
consumption c. Inserting Eq. (6.2.1) in Eq. (6.2.4) yields
r−ρ f'− ρ (6.2.5)
c& = c (t ) = c.
θ θ
The trajectory of the economy is determined by Eqs. (6.2.2) and (6.2.5).

The phase diagram in c(t ) and k (t ) is shown by Fig. 6.2.1. Along the ver-
tical line defined by f ' (k * ) = ρ , the change rate of consumption per capita
is equal to zero, that is, c& = 0 . The consumption per capita increases to the
left of the curve and falls to the right. Along the locus defined by
c = f − nk , the change rate of the capital-labor ratio equals zero. The
capital-labor ratio falls above the curve and increases below it. With the
requirement ρ > n (without which the utility becomes unbounded along
feasible paths), the intersection of the two curves determines a unique
steady state, (k * , c * ).
c(t )
c&(t )
c*
k&(t )
k* k (t )
Fig. 6.2.1. The dynamics of the Ramsey model
The two eigenvalues are given by
(ρ − n ) ± (ρ − n )2 − 4 f "c / θ (6.2.6)
φ1, 2 = .
2
The Ramsey model is controlled by a system of two differential equa-
tions. Together with the initial conditions and the transversality condition,
this system determines the path of the two variables. At stationary state,
the per capita variables, k , c and y ( ≡ Y / N ), grow at the rate, 0, and
the level variables, K , C and Y , grow at the rate, n. It can be shown that
the system has a unique steady state. Since the two eigenvalues have the
opposite signs, the system is locally saddle-path stable.15
The dynamical behavior of the Ramsey model is controlled by
k& = w + rk − c − nk = f − c − nk ,
r−ρ f ' (k ) − ρ (6.2.7)

c& = c= c.
θ θ
If we find some equation of preference change in the OSG model to
generate the same behavior as Eq. (6.2.7), then the two systems should ex-
hibit the same behavior in terms of consumption, capital accumulation and
incomes, even though they are built on different assumptions.
We now consider consumption of the OSG model when the utility func-
tion is specified as in (6.1.9). The consumption per capita in the OSG
model is given by
c(t ) = (1 − λ (t ))[ f (k (t )) + k (t )].
Differentiation of this equation with respect to time yields
c& f'+δ & λ& (6.2.8)
= k− .
c f (k ) + δk 1− λ
For Eqs. (6.2.7) and (6.2.8) to be equal, it is sufficient for λ (t ) to evolve

according to
f' +1 & f' − ρ (6.2.9)
λ& = ξk − ξ.
f +k θ
The propensity to own wealth λ tends to rise (fall) when k& rises (falls);
it tends to rise (fall) when r < (>) ρ . We may interpret that the direction of
change in λ is influenced by the direction of change in wealth as well as
whether the rate of return of wealth is larger or smaller than the rate of
time preference. If the wealth is increasing and the rate of time preference
is larger than the rate of return, then the propensity to save will definitely
rise. If the wealth is falling and the rate of time preference is smaller than
the rate of return, the propensity tends to fall. In the other cases, the pro-
pensity may either increase or decrease.
15 We will not provide a complete analysis of the model. Refer to Takayama
(1985) and Romer (1996) in detail.

Under Eq. (6.2.9), the consumption per capita in the OSG model
evolves in the same way as in the Ramsey model. We now examine the
fundamental equation of the OSG, i.e.
k& = λf (k ) − (1 − λ + n )k .
By c = (1 − λ )( f + k ), the above equation can be rewritten as
k& = f (k ) − c − nk . (6.2.10)
Theorem 6.2.1
Let the production sectors be identical in the OSG model and the Ramsey
model. If the propensity to save, λ (t ), evolves according to Eq. (6.2.9),
then the OSG model generates the same dynamics of capital-labor ratio,
k (t ), and per-capita consumption, c(t ), as the Ramsey model does.
This example illustrates how the Ramsey model is related to the OSG
model. We can similarly examine relationships between the two ap-
proaches when utility functions are taken on other forms.
We now explain another difference between the OSG and Ramsey ap-
proaches. The OSG model determines consumption as follows
c& = (1 − λ )( f ' + 1)k& ,
where λ is a constant. The change rate of consumption is positively re-
lated to the rate of interest. The rational household has increasing, station-
ary, or decreasing consumption according to whether the wealth rises, is
stationary, or falls. The consumer adapts consumption level not according
to the difference between the interest rate and discount rate for utility as
the Ramsey model predicts, as shown below. According to the this model,
a Japanese consumer would consume more, irrespective of low interest, if
his wealth increases; he would consume less, irrespective of high interest
rate, when his wealth falls. On the other hand, the Ramsey model predicts
f ' (k (t )) − ρ
c&(t ) = c(t ).
θ
This implies that the difference between r and ρ determines whether
households choose a pattern of per capita consumption that rises, stays
constant or falls over time. The optimizing household has increasing, sta-
tionary, or decreasing consumption according as the current real interest
rate exceeds, equals, or falls short of the utility discount rate. According to
this result, consumption always falls if the interest rate is low and the util-
ity discount rate is high.
It should be noted that in 1937 Paul Samuelson published an article on
discounted utility. Since then, the discounted utility was rapidly adopted as
the framework of choice for intertemporal decisions. It is worthwhile to
cite from Samuelson’s following cautions:
Any connection between utility as discussed here and any welfare concept is
disavowed.16
It is completely arbitrary to assume that the individual behaves so as to maxi-
mize an integral of the form envisaged in [the discounted utility model].17
It is easy to see what Samuelson means by looking at the form of utility

formulation in the Ramsey optimal growth theory
∞
∫ U [C (t )]e
− ρt
dt .
0
The specified form means that the household’s utility at time 0 is a

weighted sum of all future flows of utility. The parameter, ρ (≥ 0), is de-
fined as the rate of time preference. A positive value of ρ means that utili-
ties are valued less the later they are received. There are two assumptions
involved in the Ramsey model. The first is that utility is additional over
time. Although we may add capital over time, it is unrealistic to add utility
over infinite time. Intuitively it is not reasonable to add happiness over
time. It is well known in utility theory that when we use utility function to
describe consumer behavior an arbitrary increasing transformation of the
function would result in identical maximization of the consumer at each
point of time. Obviously, the above formulation will not result in an iden-
tical behavior if U is subjected to arbitrarily different increasing transfor-
mations at different times. The second implication of the above formation
is that the parameter ρ is meaningless if utility is not additional over
times. It should be noted that Ramsey considered the meanings of this pa-
rameter from ethical perspectives. Ramsey interpreted the agent as a social
planner, rather than a household. The planner chose consumption and sav-
ing for the current and future generations. Ramsey assumed ρ = 0 and
16 Samuelson (1937: 161). It is nowadays common to use the utility in modeling

and comparing welfare.
17 Samuelson (1937: 159). This reservation does not affect the dominant role of
the discounted utility. Almost all the papers involved with intertemporal decisions
in well-cited theoretical economic journals use the utility concept.
considered ρ > 0 “ethically indefensible”. If ρ = 0, by equation con-

sumption per capita always grows if the interest rate is positive irrespective
of whether wealth grows or falls.
The Ramsey framework has not been proved to be effective when we
take account of variations in households’ preferences. As empirical studies
have convinced existence of great differences in impatience among house-
holds and the Ramsey approach proves futile for dealing with the issues, it
is necessary to search alternative ways to explain the reality. In fact, as
shown in a recent survey on studies of estimating individuals’ discount
rates by Frederick et al.,18 rates differ dramatically across studies, and
within studies across individuals. There is no convergence toward an
agreed-on rate of impatience. It is estimated, for instance, by Warner and
Pleeter19 that individual discount rates vary between 0 and 70 percent per
year. As observed by Frederick et al.
The [discounted utility] model, which continues to be widely used by econo-

mists, has little empirical support. Even its developers – Samuelson, who origi-
nally proposed the model, and Koopmans, who provided the first axiomatic
derivation – had concerns about its descriptive realism, and it was never em-
pirically validated as the appropriate model for intertemporal choice.
… [D]eveloping descriptively adequate models of intertemporal choice will not
be easy.20
Although the validity of the Ramsey approach has been questioned over
years, it is quite another matter to create a “more effective” alternative.21
Instead of searching for another approach, the main attitude toward the ap-
proach is illustrated by Turnovsky (2000: 273)
Any model as widely employed as the representative agent model begins to

take on a life of its own and to be accepted almost as an axiom. It is therefore
18 Frederick et al. (2002).

19 Warner and Pleeter (2001). The studies, for instance, by Rader (1981) and
Jouini and Napp (2003) also hold that there is no reason to believe that different
consumers have identical time preferences for utility streams. It should be re-
marked that Becker (1992) first observed that if individuals have heterogeneous
constant rates of impatience, the representative agent will not in general use a con-
stant rate to discount the future.
20 Frederick et al. (2002: 393-84).
21 As rational economics predicts, the acceptance of an alternative approach to a
dominant idea like the discounted utility may take years or decades. Keynes
(1936) says: “the difficulty lies, not in the new ideas, but in escaping the old ones,
which ramify … into every corner of our minds.”
useful to remind ourselves periodically of its limitations. Despite the criticisms

that have been made, we feel that the representative agent model provides a
useful framework that offers a good deal of insight, and we shall continue to
develop it further.
This “reformist” attitude of refinement and extensions will not solve es-
sential problems in the approach.
This book will use an alternative utility function not only because the
validity of the discounted utility concept has been questioned from phi-
losophical, psychological or/and empirical aspects,22 but also because
many obviously significant issues, such as growth with heterogeneous
households and growth with interregional dynamics, can hardly be prop-
erly discussed with the concept as having become evident in the history of
theoretical economics in the last 40 years. Since the Ramsey approach has
been so influential in the contemporary monetary growth theory, I will de-
scribe monetary growth models within the approach in the main context.
6.3 A Small Open Economy with Capital Accumulation
This section describes dynamics of a small country economy.23 An open

economy can import goods and services and borrow resources from the
22 A comprehensive survey on time discounting and time preference is given by

Frederick et al. (2002). It is observed that there is a growing list of anomalies for
the discounted utility model – patterns of choice that are inconsistent with the
model’s theoretical predictions. Scholars have also proposed different models to
replace the discounted utility model; nevertheless no one has been successful in
the replacement. As observed by Frederick et al., when this model “eventually be-
came entrenched as the dominant theoretical framework for modeling intertempo-
ral framework for modeling interremporal choice, it was due largely to its simplic-
ity and its resemblance to the familiar compound interest formula, and not as a
result of empirical research demonstrating validity.” This book is based on an al-
ternative utility approach to handle with intertemporal choice problems without
reference to the compound interest formula. Truth should be expressed with sim-
plicity and beauty.
23 Refer to, for instance, Song (1993), Lane (2001), Koolmann (2002), Obstfeld
and Rogoff (1995b), Benigno and Benigno (2003), and Galí and Monacelli (2005),
for the literature of open economies. It can be seen that the model here can be
generalized and extended in different directions. Nevertheless, this book will not
deal with open economies when we study international trade. We try to treat every
economy as a part of the integrated whole. As shown later on, as we can develop a
global economy model of any number of economies, it is not necessary, at least
technically, to be concerned with small open economies.
rest of the world or exports goods and services and lend resources abroad.
For convenience of illustration, assume that there is a single good in the
world economy and the price of the goods is unity.24
6.3.1 The Model with General Production and Utility Functions
The production sector is identical to that in the OSG model for the closed
economy. Let K (t ) denote the capital stocks employed by the economy at
time t and N ( = 1 ) the flow of labor services used at time t for produc-
tion.25 The production function F (t ) defines the flow of production at time
t. We assume that F (K (t ), N ) is neoclassical.26 Let w(t ) stand for the real
wage rate and r * (t ) the real interest rate for borrowing or lending in the
world capital market at time t. For illustration, we fix the interest rate dur-
ing the study period. The marginal conditions are
r * + δ k = f ' (k (t )), w(t ) = f (k (t )) − k (t ) f ' (t ), (6.3.1)
in which k (t ) ≡ K (t ) / N . We assume that factor markets work quickly

enough so that our system always displays competitive equilibrium in fac-
tor markets. As r * is fixed, we see that both k (t ) and w(t ) are functions of
r * as
k = g (r * ), w = h(r * ).
24 We may also classify output into traded and non-traded goods. There are
some models of small open economies with non-traded goods (for instance, Engel
and Kletzer, 1989). We will deal with an open monetary economy with traded and
non-traded goods in Chap. 11. By the way, it is important to introduce tariffs (see,
Sen and Turnovsky, 1989), fixed specific factors (see, for instance, Guilló and
Perez-Sebastian, 2007), and renewable resources (see, for instance, Harris, 1981;
Tawada, 1982; Brander and Taylor, 1997; Hannesson, 2000) into small-open eco-
nomic models. It can be seen that the main ideas of these approaches can be inte-
grated into the framework proposed in this section.
25 We assume a homogeneous population of size 1 and full employment of the
production factors at any point of time.

26 We may introduce changeable returns to scale to open economies either via
knowledge accumulation as or Marshallian externalities. Recent publications on

the issues are numerous.
It is straightforward to show dg / dr * = 1 / f " < 0 and dh / dr * = − g < 0.

That is, as the rate of interest rises, both the capital density and the wage
rate fall.
We now describe behavior of consumers. Denote a(t ) the wealth per
capita at time t. A typical consumer obtains current income
y (t ) = r * a (t ) + w(t ), from the interest payment ra and the wage payment
w. We call Y (t ) ( ≡ y (t )N ) the current income. Introduce B(t ) as the
value of the economy’s net foreign assets at t and define b(t ) ≡ B (t ) / N .
According to the definitions, we have a(t )N = K (t ) + B(t ). That is
a(t ) = k (t ) + b(t ). As
Y (t ) = r * a(t )N + wN = F (t ) − δ k K (t ) + E (t ), (6.3.2)
where E (t ) ≡ r * B(t ) and we use
r * K (t ) + w(t )N = F (t ) − δ k K (t ).
The current income of the households is equal to the sum of the econ-
omy’s net output, F − δ k K , and the country’s interest earned on foreign
assets, r * B . The gross national product (GNP) is measured as the sum of
the value of the net output produced within its borders and net interna-
tional factor payments. The GNP is given by F + E. The output produced
within the country’s geographical borders is called gross domestic product
(GDP), The GDP is given by F . A country’s current balance at time t is
the change in the value of its net claims over the rest of the world – the
change in its net foreign assets. If B& (t ) > 0, the economy as a whole is
lending (in this case we say that the current account balance is in surplus);
if B& (t ) < 0, the economy as a whole is borrowing (the current account bal-
ance is in deficit); and if B& (t ) = 0, the economy as a whole is neither bor-
rowing nor lending (the current account balance is in balance).
The disposable income is given by Y (t ) = Y (t ) + a (t )N . From (6.3.2),
we have
Y (t ) = (1 + r * )a(t )N + wN = w0 N + (1 + r * )B(t ), (6.3.3)
where
w0 ≡ (1 + r * )g + h .
Here, we require Y (t ) > 0, i.e.

a(t )N + F (t ) > − r * B(t ) + δ k K (t ).

The requirement means that the sum of the economy’s total assets and
output is more than the sum of the interest payment to rest world and the
capital depreciation. Otherwise, the economy has nothing to consume after
paying the two parts.
The disposable income is used for saving and consumption. At each
point of time, consumers would distribute the disposable income between
saving, S (t ), and consumption of goods, C (t ). The budget constraint is
given by
C (t ) + S (t ) = Y (t ). (6.3.4)
A typical consumer is to choose his most preferred bundle (c(t ), s (t )) of

consumption and saving under his budget constraint. Here, c ≡ C / N and
s ≡ S / N . The utility maximizing problem at any time is defined by
Max U (c, s )
c,s
s.t.: c(t ) + s (t ) = y (t ). (6.3.5)

We denote an optimal solution as function of the disposable income
(c(t ), s(t ) ) = (c( y (t )), s( y (t ) ).
The change in the households’ wealth is equal to the net savings minus
the wealth sold at time t , i.e.
a& (t ) = s ( y ( k ) ) − a(t ) . (6.3.6)
From y (t ) = w0 (r * ) + (1 + r * )b(t ) and a(t ) = g (r * ) + b(t ), for any fixed

level of r * , we see that the national economic dynamics is determined by
the following motion of per-capital foreign assets
b&(t ) = s(w0 (r * ) + (1 + r * )b(t )) − g (r * ) − b(t ). (6.3.7)
In a stationary state
s (w0 (r * ) + (1 + r * )b ) = g (r * ) + b .
We now show that this equation has a unique solution. Define
Φ(b) ≡ s (w0 (r * ) + (1 + r * )b ) − g (r * ) − b . (6.3.8)
The condition Y ≥ 0 is guaranteed if
~ w (r * )
b≥b ≡− 0 *.
1+ r
We have Φ (b ) = h / (1 + r * ) > 0. As 0 < s ' ( y ) < 1, for sufficiently large b,

~
we may have Φ(b ) < 0. As Φ ' (b) = (1 + r * )s' − 1, we may have Φ ' (b ) < 0
if r * is small and s ' is properly smaller than unity.27 If Φ (b ) < 0 and
~
Φ' (b ) < 0 for b ≥ b , then the dynamic system has a unique equilibrium. Let
b* stand for an equilibrium point. As
∂b&
= Φ' (b* ) = (1 + r * )s ' − 1.
∂b b = b*
Hence, if Φ ' (b ) < 0, the dynamic system has a unique stable equilibrium
point.
In the case of Φ' (b ) < 0 at the equilibrium we can examine effects of
change in the rate of interest. Take derivatives of Φ' (b ) < 0 with respect to
r*
dg 1 − (1 + r * )s' (6.3.9)
Φ'
db
= − (w0 (r *
) + b )s ' + = − bs ' ,
dr * dr * f"
where we use
dh 1 + r *
dw0
= g + (
1 + r )
* dg
+ = < 0.
dr * dr * dr * f"
Using Φ' < 0, 0 < s ' ≤ 0, f " < 0 and 1 > (1 + r * )s ' , we conclude
db / dr * > 0. As the rate of interest increases, the value of the country’s net
foreign assets rises. As
dy 1 + r *
+ b + (1 + r * ) * ,
db
*
=
dr f" dr
27 We will specify production and utility functions to further demonstrate these
properties.
we see that the sign of dy / dr * is ambiguous in general. As the impacts on

c and s are in the same direction as on y , we need additional conditions
in order to explicitly judge the impacts on c and s.
6.3.2 The Dynamics with the Cobb-Douglas Functions
To illustrate the analytical results and to simulate the model, we now ex-
amine the model with the following utility and production functions
F (t ) = AK α (t )N β , α , β > 0, α + β = 1,
U (t ) = c ξ (t )s λ (t ), ξ + λ = 1, ξ , λ > 0. (6.3.10)
From f = Ak α and Eqs. (6.3.1), we solve
k = r01/ β , w = βAr0α / β , (6.3.11)
where
αA
r0 = .
r + δk
*
We have y = w0 + (1 + r * )b, where w0 = (1 + r * )k + w. The optimal

choice of households is given by
c = ξy , s = λy.
From Eq. (6.3.7), s = λy and y = w0 + (1 + r * )b, we have
b& = λw0 − r01 / β − (ξ − λr * )b . (6.3.12)
Assume ξ − λr * > 0. From the definitions of ξ and λ and the rate of

interest should be small, it is reasonable to require ξ > λr * . The solution
of the linear differential equation is given by28
b(t ) = (b(0 ) − b* )e − (ξ − λr )t + b* , (6.3.13)

*
28 It should be noted that in an important paper, Fischer and Frenkel (1972)

demonstrates that an initially capital-scarce country will first acquire debt as it ac-
cumulates capital, then will begin to reduce its foreign liabilities, and may eventu-
ally become a net creditor to the rest of the world. Nevertheless, saving in their
work is not derived from optimizing behavior.
where
λw0 − r01 / β
b* ≡ .
ξ − λr *
As ξ − λr * > 0, we conclude that as t → + ∞, b(t ) → b* . In the long

term, the system approaches its equilibrium position. Figure 6.3.1 depicts
the foreign asset dynamics with different initial conditions. We see that if
the initial foreign asset is above the equilibrium level, it decreases over
time, and vice versa.
b
b(t )
equilibium
b(t )
Fig. 6.3.1. Convergence towards the equilibrium point
Lemma 6.3.1
Assume ξ − λr * > 0. The dynamic system has a unique stable equilibrium
point.
As ξ − λr * > 0 , the sign of b* is the same as that of λw0 − r01/ β . From

w0 = (1 + r * )r01/ β + βAr0α / β , we see that the equilibrium value of b* is posi-
tive if
αξ (6.3.14)
r* > − βδ k ,
λ
where we also use r0 = αA / (r * + δ k ). We conclude that if the propensity
to save is high, it needs higher level of the interest rate to satisfy (6.3.14).
Inequality (6.3.14) implies that in the long term, whether or not the econ-
omy owns wealth employed by other countries is independent of its pro-
ductivity parameter A.
We simulate the model to illustrate how the equilibrium values are af-
fected by parameters. First, we examine the impact of r * on the equilib-
rium values. We specify the other parameters as follows
α = 0.35, A = 1, λ = 0.7, δ k = 0.05. (6.3.15)
1.5 c
b λ
0.02 0.04 0.06 0.08 0.1 0.12 0.14 1.45
-2
1.4
-4
1.35
-6
0.02 0.04 0.060.08 0.1 0.12 0.14 λ
-8 1.25
a) the foreign assets b) the per-capita consumption level
Fig. 6.3.2. The impact of the international interest rate, 0 < r * < 0.15
We now allow λ to vary, with r * = 0.03 and the values of the other pa-
rameters specified as (6.3.15), we have the effects of change in the propen-
sity to save as in Fig. 6.3.3.
α = 0.35, A = 1, λ = 0.7, δ k = 0.05. (6.3.15)
As the propensity to save rises, both the foreign assets and the consump-
tion level increase. It should be noted that in an autarky economy, a rise in
the propensity to reduce per-capita consumption level when the propensity
to save is high. As the economy in trade is faced with a fixed rate of inter-
est, accumulated wealth will not reduce the return rate from wealth as in
the autarky case.29
8 1.7
6
1.6
4
2 1.5
0.3 0.4 0.5 0.6 0.7 0.8 0.9 1.4

-2
-4
-6 0.3 0.4 0.5 0.6 0.7 0.8 0.9
a) the foreign assets b) the per-capita consumption level

Fig. 6.3.3. The impact of the propensity to save, 0.1 ≤ λ ≤ 0.9
29 The costs due to depreciation is paid by producers.

6.3.3 Autarky Interest Rates and the Trade Pattern
We are concerned with an open economy where the rate of interest is fixed
in international market. In order to describe impact of trade on the national
economic growth, it is proper to compare two extreme types of economies
– a completely open economy and an isolated economy with the same
preference and technology.30 The key concept for the comparison is the au-
tarky real interest rate, that is, the rate of interest that prevails in an econ-
omy barred from international borrowing and lending.
As the two economies have similar variables, if x is a variable value in
the open economy, then x̂ stands for the corresponding variable value in
the autarky economy. We assume that the two economic systems have the
same preference and technology, which are specified as in (6.3.10). From
Sect. 6.3.3, we know that the dynamics of the open economy are described
by
f (t ) = Ak α (t ), k = r01 / β , w = βAr0α / β , U (t ) = c ξ (t )s λ (t ),
y (t ) = w0 + (1 + r * )b(t ), c(t ) = ξy (t ), s = λy (t ), a (t ) = k (t ) + b(t ),
b(t ) = (b(0 ) − b* )e − (ξ − λr )t + b* , (6.3.16)

*
where r0 = αA / (r * + δ k ) and w0 = (1 + r * )r01/ β + βAr0α / β .

From Sect. 6.3.2, we know that the dynamics of the autarky economy
are described by
fˆ (t ) = Akˆα (t ), rˆ(t ) = αAkˆ − β (t ) − δ k , wˆ (t ) = βAkˆα (t ),
yˆ (t ) = Akˆ α (t ) + δkˆ(t ), cˆ(t ) = ξyˆ (t ), sˆ(t ) = λyˆ (t ),
1/ β
 λA  − βξ k t λA 
kˆ(t ) =  kˆ β (0) − e +  ,
 ξ k  ξ k  (6.3.17)
where ξ k ≡ 1 − λδ > 0. The equilibrium value of kˆ(t ) is given by

kˆ = (λA / ξ ) .
1/ β
k
First, we are interested in comparing the equilibrium values of the two

systems. As
30 As trade will affect an economy’s preference and technology, validity of this
comparison is limited.
αξ k αξ − βλδ k
rˆ = − δk = ,
λ λ
we see that rˆ − r * > (< ) 0 if αξ / λ > (< ) r * + βδ k , that is
α
> (< ) λ.
r + α + βδ k
*
We conclude that for the autarky economy’s equilibrium rate of interest

to be higher than the internationally fixed interest rate (i.e., rˆ > r * ), we
should require that the economy’s propensity to save is “properly” small or
the international interest rate is small. In the remainder of this section, our
discussion is limited to the case of
α > λ (r * + α + βδ k ).
Under this condition, we have rˆ > r * . Under α / (r * + α + βδ k ) > λ , we
have
λw0 − r01 / β ((α + r * + βδ k )λ − α )r01 / β
b* = = < 0.
ξ − λr * α (ξ − λr * )
The equilibrium value of foreign assets is negative because of the low
propensity to save. From rˆ > r * , r = αAk − β − δ k and rˆ = αAkˆ − β − δ k , we
see that the capital intensity of the open economy is higher than the capital
intensity of the autarky economy, i.e., k > k̂ . We have f > fˆ and w > ŵ.
From
y = (1 + r * )r01 / β + βAr0α / β + (1 + r * )
((α + r *
+ βδ k )λ − α )r01 / β
,
α (ξ − λr * )
α /β 1/ β
 λA   λA 
yˆ = A  + δ   ,
 ξk   ξk 
we have
y − yˆ
= (1 + r *
) +
(r * + δ k )β +
r01 / β α
(1 + r ) ((α + r + βδ k )λ − α ) ξ k ~ β (r * + δ k ) ~
*
r ~ r
*
− − δr = − ,
α (ξ − λr )*
λ α (ξ − λr ) λ
* (6.3.18)
r ≡ (λ (r * + δ k )/ αξ k ) < 1 (under α / (r * + α + βδ k ) > λ ). We

in which ~
1/ β
see that in general, we cannot judge the sign of y − ŷ. As

( )
c − cˆ = ξ y − yˆ , the impact of trade on the long-term consumption is
ambiguous.
Lemma 6.3.2
If α / (r * + α + βδ k ) > (< ) λ , then the autarky economy’s equilibrium rate
of interest is higher (lower) than the internationally fixed interest rate. The
capital intensity, per-capita output and wage rate in the trade economy are
higher (lower) than the corresponding variables in the autarky economy.
We now simulate the model to illustrate behavior of the economy. First,

we examine effects of the international interest rate. We specify the other
parameters as in (6.3.15). As r * rises, the difference between the interna-
tional interest rate and the interest rate in the autarky system rises. When
r * reaches near 0.094, the difference is changing its sign from negative to
positive. We see that free trade will always benefit the economy in terms
of (long-term) per-capita consumption.
0.06 0.25
0.04 r * − rˆ 0.2
0.02
0.15
0.02 0.04 0.06 0.08 0.1 0.12 0.14
-0.02
0.1
c − cˆ
-0.04
-0.06 0.05
-0.08
0.02 0.04 0.06 0.08 0.1 0.12 0.14
a) the interest rates b) per-capita consumption levels
Fig. 6.3.4. The differences in the two economies as r * changes, 0 < r * < 0.15
We now allow λ to vary, with r * = 0.05 and the values of the other pa-
rameters specified as (6.3.15), we have the effects of change in the propen-
sity to save as in Fig. 6.3.5. As the propensity to save rises, the difference
6.4 Growth and Agglomeration of a Small-Open Multi-Regional Economy 203
between the international interest rate and the interest rate in the autarky
system rises. When r * reaches near 0.76, the difference is changing its
sign from negative to positive. We see that free trade benefits the economy
in terms of (long-term) per-capita consumption.
0.6
0.3 0.4 0.5 0.6 0.7 0.8 0.9 0.5
-0.2
-0.4
0.4 c − cˆ
0.3
-0.6
r * − rˆ 0.2
-0.8
0.1
-1
0.3 0.4 0.5 0.6 0.7 0.8 0.9
a) the interest rates b) per-capita consumption levels
Fig.6.3.5 The differences in the two economies as τ changes, 0 < τ < 0.9
6.4 Growth and Agglomeration of a Small-Open Multi-

Regional Economy
Extending the model in Sect. 6.3 to a multi-regional economy, we examine

economic growth of a multi-regional small open economy in a perfectly
competitive economy.31 The national economy consists of multiple regions
and each region has one production sector and one housing sector. House-
holds move freely among regions, equalizing utility level among regions
by choosing housing, goods and saving. A region’s amenity is endogenous,
depending on the region’s output and population. We explicitly solve the
dynamics of the multi-regional economy. The system has a unique stable
equilibrium point. We simulate the motion of the model and examine ef-
fects of changes in the rate of interest, the preference, and amenity parame-
ters. We show, for instance, that a productivity improvement in the region
with lowest productivity reduces the GDP and GNP and a rise in the pref-
erence for large cities may accelerate agglomeration of the population and
economic activities into a region with high productivity.
In his Interregional and International Trade published in 1933, Bertil
Ohlin argues that regional economics and international economics should
be studied together as they share the same research objective. Neverthe-
less, regional aspects of economics had been largely neglected in (main-
31 This section is based on Zhang (2008a).

streams of) economics until new economic geography has recently ob-
tained much attention.32 A main purpose of economic geography is to ex-
plain the empirical fact that economic activity and population distribution
are not spatially random. It is important to give a micro-economic founda-
tion for studying clustering of people and firms using a general equilibrium
framework. Although many papers and books have been recently pub-
lished in the field of new economic geography, almost all these works have
been concerned with imperfect competition and have neglected capital ac-
cumulation.33 The purpose of this section is to develop a general equilib-
rium framework with multiple regions and capital accumulation under per-
fect competition. Different from the new economic geography which has
been mainly concerned with monopolistic competition, scale economies,
and transport costs in economic geography, this model studies perfection
competition, amenity, and technological differences (with constant returns
to scale).34 We show how different regions in an open economy interaction
with each other with capital accumulation and differences in amenity, fac-
tor endowments and productivity. Although some attempts have been
made to apply neoclassical growth theory to address spatial growth issues,
these models do not take account of land and regional differences in amen-
ity, which are generally considered as important factors of economic geog-
raphy.35 The objective of this section is to study growth of a small open
economy with economic geography. There are some economic models
which deal with growth and capital accumulation of small open econo-
32 We refer two comprehensive surveys on the literature to Henderson and Thisse
(2004) and Capello and Nijkamp (2004).

33 See Zhang (2003a) and Baldwin and Martin (2004) for the literature on the
topic. Obviously, capital accumulation and capital mobility are important vari-
ables for explaining spatial dynamics. Clustering of people into a single metropoli-
tan area like Tokyo or Shanghai can hardly be explained without taking capital as
endogenous variables. As argued by Zhang (2005a, 2006a), capital accumulation,
which is the key aspect of the neoclassical growth theory and is obviously a key
dimension of modern economic evolution, is largely neglected in new growth the-
ory as well as new economic theory.
34 A comprehensive model of economic geography should take account of not
only scale economies and transport costs (like in Krugman’s models), but also
amenity and factor endowment differences (like in Glaeser’s approach and this
model). In this stage, we are concentrated on perfect competition, amenity, factor
endowments and productivity differences among regions).
35 Extending neoclassical growth theory to spatial economics is made by, for in-
stance, Richardson (1977), Henderson (1985), and Henderson et al. (1995).

mies.36 As pointed out by Baldwin and Martin (2004: 2675-6), “Many of

the most popular economic geography models focus on labor. … These are
unsuited to the study of growth.” Capital accumulation is seldom modeled
with land use pattern and land markets in the literature of geographical
economics. Fujita and Thisse (2002: 389) state the current situations of
spatial economic growth as follows: “Clearly, space and time are intrinsi-
cally mixed in the process of economic development. However, the study
of their interaction is a formidable task. … Not surprisingly, therefore, the
field is still in its infancy, and relevant contributions have been few.” This
section attempts to make a contribution to economic growth with space by
developing an economic growth model with economic geography, basing
on the neoclassical growth theory within the context of growth theory of
small open economies. Moreover, as far as the interregional economic is-
sues are concerned, the model in this section is similar to the GTAP model
which is a multiregion, multisector, computable general equilibrium
model, with perfect competition and constant returns to scale (see, for in-
stance, McDougall, 2002). Attempts have been made to extend the stan-
dard static GTAP model to dynamic model.37 There are many other models
developed by regional scientists. For instance, some models based on the
input-output system or/and the gravity theory are proposed to examine in-
terregional trade patterns.38 Nevertheless, our model differs from these ap-
proaches in that we model behavior of households differently.
6.4.1 The Multi-Region Trade Model with Capital Accumulation
Most aspects of the model are the same as the model in Sect. 6.3, except
that we add housing sector and refine national economy into multiple re-
gions. The system consists of multiple regions, indexed by j = 1, ..., J .
Perfect competition is assumed to prevail in good markets both within each
region and among the regions, and commodities are traded without any
barriers such as transport costs or tariffs. The labor markets are perfectly
competitive within each region and among regions. Let prices be measured
in terms of the commodity and the price of the commodity be unity. We
denote wage and interest rates by w j (t ) and r j (t ) , respectively, in the
36 Refer to, for instance, Obstfeld and Rogoff (1999), Lane (2001), Koolmann
(2001, 2002), Benigno and Benigno (2003), and Galí and Monacelli (2005), for
the literature on economics of open economies.
37 This approach is represented by Ianchovichina and McDougall (2001).
38 See, for instance, Isard (1953), Hewings and Jensen (1986), Batten (1982),
Boomsma and Oosterhaven (1992), and Canning and Wang (2005).

j th region. The interest rate is identical throughout the national economy,

i.e.
rj (t ) = r * ,
where r * is the rate of interest fixed in the international market. We as-

sume a homogenous population. A person is free to choose his residential
location. We assume that any person chooses the same region where he
works and lives. Each region has fixed land. Land quality, climates, and
environment are homogenous within each region, but they vary among re-
gions. We neglect transportation cost of commodities between and within
regions. The assumption of zero transportation cost of commodities im-
plies price equality for the commodity among regions. As amenity and
land are immobile, wage rates and land rent may not be equal among re-
gions.
We introduce
N  the given population of the economy;

L j  the given (residential) area of region j;
~
K (t ) and A(t )  the capital stocks employed by and the total wealth of
the national economy at t ;
F j (t )  the output levels of region j ’s production sector at time t ;
K j (t ) and N j (t )  the levels of capital stocks and labor force employed
by region j ’s production sector;
c j (t ) and s j (t )  the per-capita consumption level of commodity and
saving made by per capita in region j;
l j (t ) and R j (t )  the lot size per household in region j and region j ’s
land rent.
Behavior of producers
We assume that there are only two productive factors, capital, K j (t ) ,
and labor, N j (t ), at each point of time t. The production functions are
given by
F j (K j (t ), N j (t )), j = 1, L, J ,
where F j is the output of region j. Assume F j to be neoclassical. We

have
F j (t ) K j (t ) (6.4.1)
f j (t ) = f j (k j (t )), f j (t ) ≡ , k j (t ) ≡ .
N j (t ) N j (t )
Markets are competitive; thus labor and capital earn their marginal prod-
ucts, and firms earn zero profits. The rate of interest, r * , and wage rates,
w j (t ), are determined by markets. Hence, for any individual firm r * and
w j (t ) are given at each point of time. The production sector chooses the
two variables, K j (t ) and N j (t ), to maximize its profit. The marginal con-
ditions are given by
r * + δ kj = f j' (k j ), w j (t ) = f j (k j ) − k j f j' (k j ), (6.4.2)
where δ kj are the depreciation rate of physical capital in region j . As r *

is fixed, from r * + δ kj = f j' and w j = f j − k j f j' we obtain that both k j (t )
and w j (t ) are functions of r * as
k j = φkj (r * ), w j = φwj (r * ). (6.4.3)
We see that k j and w j are invariant in time. It is straightforward to

show dφkj / dr * = 1 / f j" < 0 and dφwj / dr * = − φkj < 0 . As the rate of in-
terest rises, both the capital densities and the wage rates fall.
Behavior of consumers
Each worker may get income from land ownership, wealth ownership
and wages. In order to define incomes, it is necessary to determine land
ownership structure. It can be seen that land properties may be distributed
in multiple ways under various institutions. To simplify the model, we ac-
cept the assumption of “absentee landownership” which means that the in-
come of land rent is spent outside the economic system. A possible case is
that the land is owned by the government.39 Households rent the land in
39 Another two popular assumptions in the literature of spatial economics are

the equally shared landownership and the public ownership. In the former, land is
owned equally by all households in the system. Zhang (2007a) also studies the dy-
namics for the equally shared landownership. In the latter, for instance as accepted
in Kanemoto (1980), the government rents the land from the landowners at certain
rent and sublets it to households at the market rent, using the net revenue to subsi-
dize city residents equally. Zhang (1998b, 2008b) constructs multi-regional
growth models, which are similar to this model but for a closed economy. It
competitive market and the government uses the income for military or
other public purposes. Consumers make decisions on choice of lot size,
consumption levels of services and commodities as well as on how much
to save.
Let a~ j (t ) stand for the wealth owned by a household in region j. The
household in region j obtains income
y j (t ) = r * a~ j (t ) + w j , j = 1, L, J , (6.4.4)
from the interest payment, r *a~ j (t ), and the wage payment, w j . The dis-
posable income is equal to
yˆ j (t ) = y j (t ) + a~ j (t ). (6.4.5)
At each point of time, a consumer distributes the total available budget

among housing, l j (t ), saving, s j (t ) , consumption of goods, c j (t ) . The
budget constraint is given by
R j (t )l j (t ) + c j (t ) + s j (t ) = yˆ j (t ) = r * a~ j (t ) + w j + a~ j (t ). (6.4.6)
At any time, consumers have three variables to decide. A consumer de-

cides how much to consume housing, to consume goods and to save. Equa-
tion (6.4.6) means that consumption and savings exhaust the consumers’
disposable personal income.
We assume that utility level, U j (t ) , that the consumers obtain is de-
pendent on the consumption level of commodity, c j (t ) , and the saving,
s j (t ) . The utility level of the consumer in region j , U j (t ) , is specified as
follows
U j (t ) = θ j (t )l ηj 0 (t )c ξj 0 (t )s λj 0 (t ), η 0 , ξ 0 , λ0 > 0 , (6.4.7)
in which η 0 , ξ 0 , and λ0 are a typical person’s elasticity of utility with re-

gard to lot size, commodity and savings in region j . We call η 0 , ξ 0 , and
λ0 propensities to consume lot size, to consume goods, and to hold wealth
(save), respectively.
In (6.4.7), θ j (t ) is called region j ’s amenity level. The concept of
amenity measures a region’s attractiveness for households. Amenities are
should be noted that we can refine the model by introducing urban structures
(Zhang, 1996, 2007c).
affected by infrastructures, regional cultures and climates.40 People cluster

together for different reasons. For instance, people like to socially interact
with each other. This implies that a large population of the region is attrac-
tive. A region with large population offers more opportunities for em-
ployment. Good climates make a region attractive as residential location.
As argued by Glaeser et al. (2001), consumption amenities have increas-
ingly played important role in economic geography. Public services, acces-
sibilities, local transportation systems, pollution, and human relations such
as discrimination all involve externalities and affect amenities. We incor-
porate amenity into the consumer location decision by assuming that
amenity is an endogenous variable.41 The regional population dynamics is
influenced by many changing characteristics of environmental quality such
as air quality, levels of noise pollution, open space, and other physical and
social neighborhood qualities at each location. Environmental quality can
be reflected in part by its effect on the location choice of individuals.
Many kinds of externalities may actually exist at any location. Some may
be historically given, such as historical buildings and climate; others such
as noise and cleanness, may be endogenously determined by the location
of residents. Households may prefer a low-density residential area to a
high one, as there tend to have more green, less noise, more cleanness and
more safety in a low-density area. Nevertheless, there are other factors,
such as social interactions, which may make high-density area attractive.
We assume that amenity is affected by production and consumption activi-
ties. We specify θ j as follows
θ j (t ) = θ j F ja (t )N bj (t ), j = 1, L, J ,
where θ j (> 0) , a and b are parameters. We don’t specify signs of a

and b as economic activities and population may have either positive or
negative effects on regional attractiveness. As F j = f j N j , we can rewrite
the above equations as follows
θ j (t ) = θ j f ja (t )N aj + b (t ), j = 1, L, J . (6.4.8)
40 See, for instance, Kanemoto (1980), Diamond and Tolley (1981), Blomquist et
al. (1988), and Andersson et al. (2003).
41 This section does not take account of externalities for producers. Firms often
prefer to locate close to other firms. An explicit introduction of externalities will

make the spatial structure far more complicated. In the literature of spatial eco-
nomics, various externalities have been analyzed (see, Henderson, 1974; Upton,
1981; and Abdel-Rahman, 2004).
Maximizing U j (t ) subject to the budget constraints (6.4.6) yields
l j (t ) R j (t ) = ηyˆ j (t ) , c j (t ) = ξyˆ j (t ) , s j (t ) = λyˆ j (t ) , (6.4.9)
in which
1
η ≡ ρη 0 , ξ ≡ ρη 0 , λ ≡ ρη 0 , ρ ≡ .
η 0 + ξ 0 + λ0
According to the definitions of s j (t ), the wealth accumulation of the
representative person in region j is given by
a~& j (t ) = s j (t ) − a~ j (t ) . (6.4.10)
As households are assumed to be freely mobile among the regions, it is

reasonable to consider that households migrate where utility is higher. Un-
der the assumptions that households can move freely and rapidly, the util-
ity level of people should be equal, irrespective of in which region they
live, i.e.
U j (t ) = U m (t ) , j , m = 1, L, J . (6.4.11)
We neglect possible costs for migration. In reality, even to change a

house in a small town costs. Although it is not difficult to introduce migra-
tion costs into the model, it will become far more difficult to explicitly get
analytical results. Instead of wage equalization (which is often used as the
equilibrium mechanism of population distribution), we assume that con-
sumers obtain the same level of utility in different regions as the equilib-
rium mechanism of population distribution among the regions. Although
the condition of utility equalization is often used in the literature of urban
economics,42 the assumption of utility equalization is rarely used in the lit-
erature of economic dynamics as the temporary equilibrium condition of
population distribution. It is argued that this assumption is more reasonable
than the assumption of wage equalization in interregional analysis.
The total capital stocks employed by the economy is equal to the sum of
the capital stocks employed by all the regions. That is
J J (6.4.12)
K (t ) = ∑j =1
K j (t ) = ∑ k (t )N (t ).
j =1
j j
42 Fujita (1989) provides some models with the assumption of equalizing utility
levels among households in different locations.

The total wealth of the national economy is the sum of the wealth
owned by all the households
~ J
(6.4.13)
A(t ) = ∑ a~ (t )N (t ).
j j
j =1
We introduce B(t ) as the value of the economy’s net foreign assets at t .

The income from the net foreign assets, E (t ), which may be either posi-
tive, zero, or negative, is equal to r * B(t ). The national industrial output is
equal to the national net saving. That is
~ J
(6.4.14)
S (t ) + C (t ) − A(t ) − r * B(t ) + ∑δ kj K j (t ) = F (t ),
j =1
where
J J J
C (t ) ≡ ∑ c j (t )N j (t ), S (t ) ≡ ∑ s j (t )N j (t ), F (t ) ≡ ∑ F j (t ).
j =1 j =1 j =1
The assumption that labor force and land are fully employed is repre-
sented by
J
(6.4.15)
∑ N (t ) = N , l (t )N (t ) = L ,
j =1
j j j j j = 1, L, J .
We have thus built the multi-regional model of a small open economy

with capital accumulation.
We now explain trade balance in the model. According to the definitions
of the national wealth, the capital stocks employed by the economy and the
net foreign assets, we have
~
A(t ) = K (t ) + B(t ).
Similar to the variable, B(t ), we introduce B j (t ) as the value of region

j ’s net external assets at t . We have
B j (t ) = (a~ j (t ) − k j )N j (t ).
We have
J
B (t ) = ∑ B j (t ).
j =1
From Eqs. (6.4.4), we obtain the national current income, Y (t ), as fol-

lows
Y (t ) ≡ ∑ y j (t )N j (t ) = ∑ (r * a~ j (t ) + w j )N j (t ).
J J
j =1 j =1
From Eqs. (6.4.2) and K (t ) = K (t ) + B(t ), we have
Y (t ) ≡ ∑ y j (t )N j (t ) = ∑ (r * a~ j (t ) + w j )N j (t ).
J J
j =1 j =1
where we also use Eqs. (6.4.12), (6.4.13) and (6.4.15). From this equation
and Eq. (6.4.16), we have
J
Y (t ) = F (t ) − ∑δ kj K j (t ) + r * B (t ).
j =1
The national current income is equal to the sum of the economy’s net
output
J
F (t ) − ∑δ kj K j (t ),
j =1
and the country’s interest earned on foreign assets, r * B(t ). The gross na-
tional product (GNP) is measured as the sum of the value of the net output
produced within its borders and net international factor payments. The
GNP is given by F (t ) + E (t ). We introduce
G (t ) ≡ F (t ) + E (t ).
Similarly, region j ’s gross regional product (GRP), G j (t ), is given by
G j (t ) ≡ Fj (t ) + r * B j (t ).
The output produced within the country’s geographical borders is called

gross domestic product (GDP), The GDP is given by F (t ). A country’s
current balance at time t is the change in the value of its net claims over
the rest of the world – the change in its net foreign assets. If B& (t ) > 0 , the
economy as a whole is lending (in this case we say that the current account
balance is in surplus); if B& (t ) < 0 , the economy as a whole is borrowing
(the current account balance is in deficit); and if B& (t ) = 0 , the economy as
a whole is neither borrowing nor lending (the current account balance is in

balance).
Finally, we describe trade among regions. In the rest of this section, we
omit t in expressions, wherever without causing confusion. First, we cal-
culate
F − (R l + c + s − a~ )N − δ K = r * B ,
j j j j j j j kj
(6.4.17)
j j
where we use
R j l j + c j + s j = ra~ j + w j + a~ j , Fj = (r * + δ kj )K j + w j N j .
That is
F j = (R j l j + c j + s j − a~ j )N j + δ kj K j + r * B j .
The regional output, F j , is used for housing, R j l j N j , consumption,

c j N j , net saving, (s j − a~ j )N j , the depreciation of capital, δ kj K j , and the
region’s interest payment for the capital owned by the other regions or for-
eign countries, r * B j . We express Eq. (6.4.17) as follows
(F j − R j l j N j − c j N j − δ kj K j ) + (s j N j − a~ j N j − r * B j ) = 0 ,
where trade balance, F j − R j l j N j − c j N j − δ kj K j , is expressed as net pro-

duction minus consumption. If this term is positive, then the region is an
exporter, which corresponds on the capital account side to a positive,
s j N j − a~ j N j − r * B j , the wealth accumulation minus interest payment re-
ceived.
6.4.2 The Interregional Dynamic Behavior
Multi-regional dynamic system is seemingly complicated. Nevertheless, its

motion is given by a set of (unconnected) linear differential equations. The
following lemma, which is proved in Appendix A.6.3, shows how we can
determine the motion of all the variables in the dynamic system.
Lemma 6.4.1
The variables, k j , w j and f j , are uniquely determined as functions of
r * . The motion of the levels of the per-capita wealth is given by
λw j (6,4,18)
a~ j (t ) = a~ j (0)e −λ t + * , j = 1, L, J ,
*
λ
in which λ* ≡ 1 − λ − λr * . The other variables are uniquely determined by
the following procedure: yˆ j (t ) = (1 + r * )a~ j (t ) + w j , j = 1, ..., J →
g j yˆ ηj (t )N
N j (t ) = , j = 1, ... , J ,
∑ g yˆ η (t )
J
j =1 j j
where
a / (η − a − b ) 1 / (η − a − b )
 fj   θ j Lηj  ξ +λ
g j ≡     , η ≡ ,
 θ Lη  η −a−b
 f1   1 1 
→ F j (t ) = f j N j (t ) → F (t ) = ∑ j F j (t ) → K (t ) = ∑ j k j N j (t ) →
~ ~
A(t ) = ∑ j a~ j (t )N j (t ) → B(t ) = A(t ) − K (t ) → G (t ) = F (t ) + r * B(t ) →
B j (t ) = (a~ j (t ) − k j )N j (t ) → l j (t ) = L j / N j (t ) → R j (t ) = ηyˆ j (t ) / l j (t ) →
c j (t ) and s j (t ) by Eqs. (6.4.9).
As η + ξ + λ = 1, we see that if η + ξ > r *λ , then λ* > 0 . As it is rea-

sonable to assume the rate of interest, r * , to be small, the requirement of
η + ξ > r *λ is generally acceptable. As λ* > 0 , from Eqs. (6.4.18) we
see that
a / (η − a − b ) 1 / (η − a − b ) (6.4.19)
 fj   θ j Lηj  ξ +λ
g j ≡     , η ≡ ,
 θ Lη  η −a−b
 f1   1 1 
as t → ∞ . The dynamic system has a unique equilibrium point and the
equilibrium point is stable. In summary, we have the following theorem.
Theorem 6.4.1
The dynamic system has a unique stable equilibrium point.
From Eqs. (6.4.19), the wealth of a household in region j in equilib-

rium is positively related to the wage rate, w j , the rate of interest, r * , and
propensity to save, λ . The disposable income is also positively related to
w j , r * , and λ . We note that the sign of the parameter, η , is important
for determination of the population distribution. The sign of η is the same

as that of η − a − b . If a ≤ 0 and b ≤ 0 , which implies that both the out-
put level and the region’s population have negative effects on the region’s
amenity level, then we definitely have η > 0 . If η > 0 , then an increase
in the region’s residential area, or/and per-capita output level, or/and the
per-capita wealth attracts more people to the region. In the case of a = 0 ,
the condition becomes η < b , which implies that the amenity level is posi-
tively related to the region’s population and the impact of the population
on the amenity is stronger than the housing condition on the utility level.
We now explain behavior of the model. In the remainder of this section,
we are concerned with a three-region economy, i.e., J = 3 . For illustra-
tion, we specify the production functions as follows
F j (t ) = A j K αj (t )N βj (t ), α + β = 1, α , β > 0 ,
where A j is region j ’s productivity. We have f j = A j k αj . By Eqs.

(6.4.2), we solve
1/ β
 αA 
kj =  * j  , f j = A j k αj , w j = βf j .
r + δ 
 kj 
Region j ’s capital intensity, k j , per-capita output level, f j , and wage
rate, w j , are invariant in time and are dependent on the rate of interest in
the international market and the region’s productivity. As the rate of inter-
est rises, k j , f j and w j fall. According to Lemma 6.4.1, we can deter-
mine k j (t ) and yˆ j (t ). We examine how the population distribution is af-
fected by different factors. To simulate the model, we specify the
parameter values as follows
r * = 0.04 , N = 10 , α = 0.3 , a = 0 , b = − 0.1,
 A1  1.5   θ1   4  η 0   0.07   L1   3 
               
 A2  = 1.3  ,  θ 2  =  3 .8  ,  ξ 0  =  0.10  ,  L2  =  4  ,.
A   1       λ   0.83   L   6
 3    θ 3   4.3   0    3  
 δ k1   0.05  (6.4.20)
   
 δ k 2  =  0.06 
 δ   0.05 
 k3   
The rate of interest is fixed at 4 per cent and the population is 10 . Re-
gion 1 has the highest level of productivity. Region 2 ’s level of productiv-
ity is the second, next to region 1’s. We term region 1 as the coastal re-
gion (CR), region 2 the inner region (IR), and region 3 the hinterland
region (HR). It should be remarked that although the specified values are
not based on empirical observations, the choice does not seem to be unre-
alistic. For instance, some empirical studies on the US economy demon-
strate that the value of the parameter, α , in the Cobb-Douglas production
is approximately equal to 0.3. With regard to the technological parame-
ters, what are important in our interregional study are their relative values.
This is similarly true for the specified differences in land and amenity pa-
rameters among regions.
First, we calculate the time-independent variables
k1 = 9.966 , k 2 = 6.988 , k3 = 5.584 , f1 = 2.990 , f 2 = 2.330 ,
f 3 = 1.625 , w1 = 2.093 , w2 = 1.631, w3 = 1.173.

Region 1’s per-capita capital level, per-capita output level, and wage
rate are higher than the other two regions’ corresponding variables. Figure
6.4.1 plots the motion of the time-dependent variables. The initial condi-
tions are specified as
a~ (0 ) = a~ (0) = a~ (0) = 6 .
1 2 3
The initial per-capita wealth are equal in the three regions. As shown in
Fig. 6.4.1, the variables approach their equilibrium values.
The initial values of the per-capita wealth, k j (0), are smaller than their
equilibrium values. Figure 6.4.1a shows that the wealth levels of the
households in all the regions increase over time. From Fig. 6.4.1b and 1c,
the CR’s population and output level rise and the other two regions’ popu-
lation and output levels fall. The GDP, F , rises over time. The GNP and
the CR’s GRP rise and the other two regions’ GRPs fall. The net foreign
assets, B(t ), rise. The current account balance, B& (t ), is in surplus over
time. The per-capita consumption levels rise. The lot size in region 1 falls
and the land rent rises. The lot sizes in the other two regions rise and the
land rents fall.
12 25
11
k2
6
N1 20 F F1
10 k1 15
4
9
8
N2 10
7
k3 2
5 F2
N3 t
5 10 15 20 25 30t 5 10 15 20 25 30 5F310 15 20 25 30 t
~ (t )
(a) a (b) N j (t ) (c) F (t ) and F j (t )
j
25
G B'
3
20 G1 20 B
'
15 10 B1 2 B 1
10
B2
G2 25B330 t
1
5 5 10 15 20 B2'
-10 t
5G310 15 20 25 30 t B3' 5 10 15 20 25 30
(d) G (t ) and G j (t ) (e) B(t ) and B j (t ) (f) B' (t ) and B j (t )
8 2.5
1.4 c1 2 R1
1.2
c2 6
l3 1.5
4
t 2
l2 1 R2
5 10 15 20 25 30 l1 0.5
c3 20 25 30 t
0.8
5 10 15 20 25 30 t 5 10 15
R3
(g) c j (t ) (h) l j (t ) (l) R j (t )
Fig. 6.4.1. The motion of the national economy
6.4.3 The Rate of Interest and Interregional Dynamics
The previous section plots the motion of the variables. This section exam-
ines how the rate of interest affects the national economy. As we have ex-
plicitly solved the model, it is straightforward to make comparative dy-
namic analysis. First, we examine the case that all the parameters, except
the rate of interest, r * , are the same as in (6.4.20). We study what will
happen to the dynamics of the economic system if the rate of interest is
changed as follows43
43 As we have explicitly solved the dynamics, we can also carry out compara-
tive dynamic analysis by assuming that the rate of interest varies in time, r * (t ).
r * = 0.04 ⇒ 0.03.
The rate falls from 4 % to 3 % in the international market. We intro-
duce a variable, ∆x(t ), to stand for the change rate of the variable, x(t ), in
percentage due to changes in the parameter value. That is
x(t ; a ) − x(t ; a0 )
∆x(t ) ≡ ×100 ,
x(t ; a0 )
where x(t ; a ) stands for the value of the variable, x(t ), with the parameter
value, a , at time t and x(t ; a0 ) stands for the value of the variable, x(t ),
with the parameter value, a0 , at time t .
The effects on k j , f j and w j are given as follows
∆k1 = 18.325 , ∆k 2 = 16.243 , ∆k3 = 18.325 , ∆f1 = 5.177 ,

∆f 2 = 4.619 , ∆f 3 = 5.177 , ∆w1 = 5.177 , ∆w2 = 4.619 ,
∆w3 = 5.177 .
As the rate of interest is reduced in the international market, the capital
intensities, per-capita output levels and wage rates are increased. The capi-
tal cost reduction increases the capital intensities.
Figure 6.4.2 plots the effects of the change in the rate of interest. Figure
6.4.2a shows that the wealth of the households in all the regions rise ini-
tially and then fall. In the long term, the wealth of a typical household in
any region will be reduced. From Eqs. (6.4.18), we see that a reduction in
r * increases the wage rate and increases the parameter, λ* . Initially, the
increases in the wealth due to the wage income increases are larger than
the losses in the wealth due to the reduction in λ* , the net results increase
the wealth. Nevertheless, as time passes, the losses due to the reduction in
λ* become larger. From Fig. 6.4.2b and 2c, both the CR’s population and
output level rise. The other two regions’ population fall but their output
levels are increased. The GDP rises over time. The GNP and the three re-
gions’ GRPs rise. The net foreign assets, B(t ), rise in the long term. The
current account balance, B& (t ), is in surplus over time. The lot size in re-
gion 1 falls and the land rent rises. The lot sizes in the other two regions
rise and their land rents rise.
2 7
∆k1 6 ∆F1
0.5
∆k2 1 ∆ N1 5
t 5 10 15 20 25 30
t 4 ∆F
5 10 15 20 25 30 -1 3
-0.5 -2 ∆N 3 2 ∆F2
-1 -3
1
∆F3
∆k3 ∆N 2 5 10 15 20 25 30 t
(a) ∆k j (t ) (b) ∆N j (t ) (c) ∆F (t ) and ∆F j (t )
6 t 1
0.5 ∆B
5 10 15 20 25 30 '
-2.5
4 ∆G1 -5 ∆B3 ∆B '
2 ∆B2 3
∆G
-7.5 5 10 15 20 25 30 t
-10 -0.5
2 ∆G2 -12.5 ∆B1 ∆B '
∆G3 -15
∆B
-1
5 10 15 20 25 30 t -17.5 -1.5
∆B1'
(d) ∆G (t ) and ∆G j (t ) (e) ∆B (t ) and ∆B j (t ) (f) ∆B' (t ) and ∆B j (t )
4 3
∆c1 3 ∆l2 2 ∆R1
0.5 1
2
5 15 20 25 30 t
10∆c 1 ∆l3 5 10 15 20 25 30
t
2 -1
-0.5
5 10 15 20 25 30t -2 ∆R3
-1
∆c3 -1
-2
∆ l1 -3
-4
∆R2
(g) ∆c j (t ) (h) ∆l j (t ) (l) ∆R j (t )
Fig. 6.4.2. A fall in the rate of interest
6.4.4 Preference Change and Interregional Dynamics
This section examines how changes in the preference affect the national
economy. First, we examine effects of a fall in the propensity to save,
specified as follows: λ0 = 0.83 ⇒ 0.80 . We note that the preference will
not affect the capital intensities, k j , per-capita output levels, f j , and
wage rates, w j . Hence, we will not mention these variables in this section.
The simulation results are plotted in Fig. 6.4.3. Figure 6.4.3a shows that
the wealth of the households in all the regions fall. From Fig. 6.4.3b and
3c, both the CR’s population and output level fall. Some people move
away from the CR and they migrate either to the IR or to the HR. As the
propensity to save falls, the propensities to consume goods and housing are
relatively increased. This results in that the CR becomes less attractive be-
cause of its high land rent. As the two other regions’ populations are in-
creased and the per-capita output levels are not affected by the preference
change, the CR’s output falls and the other two regions’ output levels rise.
The national output level falls as the propensity to save falls. The GNP and
the CR’s GRP fall and the other two regions’ GRPs rise. The net foreign
assets, B(t ), fall. The current account balance, B& (t ), is in deficit. The lot
size in region 1 rises and the land rent rises initially and then falls. The lot
sizes in the other two regions fall and their land rents rise. The per-capita
consumption levels rise initially mainly because the propensity to consume
goods rises and the disposable income does not fall much; but the per-
capita consumption levels falls because the per-capita wealth is reduced as
a consequence in the fall in the propensity to save.
30 t 3
5 10 15 20 25 3 ∆F3
-1 ∆N 3
-2 ∆k1 ≥ ∆k2 ≥ ∆k3
2
∆N 2 2
∆F2
1 1
-3
∆F
-4 5 10 15 20 25 30t 5 10 15 20 25 30t
∆N1 ∆F1
~ (t )
(a) ∆a j (b) ∆N j (t ) (c) ∆F (t ) and ∆F j (t )
∆B3 ∆B53' 10
∆G3 30t
3
5 10 15 20 25 15 20 25 30t
2 -1 ∆B2 -0.1 ∆B2'
∆G2 -2
1
-3 ∆B1 -0.2 ∆B1'
t -0.3
5 10 15 20 25 30 -4
∆B ∆B '
-1
∆G1 ∆G -5
(d) ∆G (t ) and ∆G j (t ) (e) ∆B(t ) and ∆B j (t ) (f) ∆B ' (t ) and ∆B j (t )
3
∆c1 ≥ ∆c2 ≥ ∆c3 ∆ l1 t 3
∆R3
2 5 10 15 20 25 30 2
1
-1
1 ∆R2
-2
∆ l2 t
t 5 10 15 20 25 30
5 10 15 20 25 30 -3
∆l 3 -1 ∆R1
(g) ∆c j (t ) (h) ∆l j (t ) (l) ∆R j (t )
Fig. 6.4.3. A fall in the propensity to save
We now examine effects of a rise in the propensity to consume housing,

specified as follows: η 0 = 0.07 ⇒ 0.1. The variables, k j , f j and w j are
noted affected by the preference change. Hence, we will not mention these
variables in this section. The simulation results are plotted in Fig. 6.4.4.
Figure 6.4.4a shows that the wealth of the households in all the regions
fall. An increase in the propensity to consume housing implies a relative
decline in the propensity to save. The relative decline in the propensity to
save explains the decreases in the per-capita wealth. As housing becomes
relatively more important for residents, people move away from the CR
and migrate to the IR and the HR. The consumption levels in the three re-
gions are reduced. From Fig. 6.4.4b and 4c, both the CR’s population and
output level rise. Some people move away from the CR and they migrate
either to the IR or to the HR. The other variables change as in the case of
the decrease in the propensity to save.
t 50 50
-2.5
-5
5 10 15 20 25 30 40 ∆N 3 40
-7.5 ∆k1 ≥ ∆k2 ≥ ∆k3 30
∆N 2 30 ∆F3
-10
-12.5
20
10
20
10
∆F2
∆F
10 15 20 25 30 t
-15
-17.5 5 10 15 20 25 30t 5
-10
∆N1 -10 ∆F1
~ (t )
∆B3 t ∆5B3' 10' t

40
30
∆G3 -5
5 10 ∆B25
15 20
2
30 -0.25 ∆B2 15 20 25 30
-0.5
20 ∆G2 -10 -0.75
-1 ∆B1'
10
-15 ∆B1 -1.25
5 10 15 20 25 30
t ∆B -1.5
-10 ∆G1 ∆G -20 ∆B '
10 70
-2.5 5 10 15 20 25 30 t ∆ l1 60 ∆R2
-5 5 10 15 20 25 30
t 50 ∆R3
-7.5 ∆c1 ≥ ∆c2 ≥ ∆c3 -10 40
-10
-12.5 ∆l2 30
20
-15
-20
10 ∆R1
-17.5 -30 ∆l3 t
5 10 15 20 25 30
(g) ∆c j (t ) (h) ∆l j (t ) (l) ∆R j (t )
Fig. 6.4.4. A rise in the propensity to consume housing
6.4.5 Amenity and Interregional Dynamics
This section examines how changes in the parameters in the amenity func-
tions, θ j (t ) = θ j N bj . First, we examine effects of a fall in the parameter,
b , as follows
b = − 0.1 ⇒ − 0.05 .
A decrease in the parameter value may result from that, for instance,
people like more to live in large cities. Although cities have disamenities,
cities also offer a great variety of life styles and many work opportunities.
It is significant to examine how this parameter affects regional agglomera-
tion. The variables, k j , f j and w j are not affected by the preference
change.
The simulation results are plotted in Fig. 6.4.5. The per-capita wealth
and consumption levels are not affected by the parameter change. As peo-
ple like more to live with other people in the same region, people immi-
grate to the CR from the IR and HR. As the parameter is increased, people
tend to agglomerate into regions with high productivity. This parameter
may help us understand why people tend to be concentrated in a few met-
ropolitan areas, for instance, in Japan. As b rises, the CR’s output level is
increased mainly due to the increase in the labor force and the output lev-
els in the other two regions fall. As more people move to the region with
the highest productivity, the national output level rises.
1 ∆F1
10 ∆ N1 10
t
0.5 5 10 15 20 25 30t 5 10 15 ∆20
F 25 30
∆k j = 0 t
-10
-20
-10
-20
5 10 15 20 25 30 -30 ∆N 2 -30 ∆F2
-0.5 -40
-50 ∆N 3 -40
-50
-1 -60 -60 ∆F3
~ (t )
∆G1 0.5
10 2 ∆B1' ≥ ∆B '
-10 5 10 15 ∆G25 30t
20 1 ∆B1 5 10 15 20 25 30 t
-20 ∆B -0.5
-30 ∆G2 5 10 15 20 25 30t -1
-40
-50
-1 ∆B3 -1.5 ∆B3' ≥ ∆B2'
-60 ∆G3 -2 ∆B2 -2
(d) ∆G (t ) and ∆G j (t ) (e) ∆B (t ) and ∆B j (t ) (f) ∆B ' (t ) and ∆B j (t )
1
125 10 ∆R1
0.5 100 ∆ l2 5 10 15 20 25 30 t
∆c j = 0 75 ∆l3 -10
-20
5 10 15 20 25 30 t 50 -30 ∆R2
-0.5 25
t
-40
∆R3
10 15 ∆
20l1 25 30
-50
-1 5 -60
(g) ∆c j (t ) (h) ∆l j (t ) (l) ∆R j (t )
Fig. 6.4.5. The preference for living in the large region is increased
We now examine effects of changes in the CR’s amenity parameter, θ1 .

We specify the change as follows: θ1 = 4 ⇒ 4.2 . A change in the pa-
rameter does not affect k j , f j , w j , a~ j and c j . As shown in Fig. 6.4.6,

the effects are similar to those caused by the rise in b as shown in Fig.
6.4.5. Although the effects are similar in the two cases, the changes in the
two parameters may be caused by different mechanisms. For instance,
changes in b may be caused by the population’s attitude towards urban
life; changes in θ1 may be caused by an improvement in the CR’s infra-
structures.
1
10 ∆ N1 10 ∆F1
0.5
∆k j = 0 ∆F
t t
5 10 15 20 25 30 t 5 10 15 20 25 30 5 10 15 20 25 30
-0.5 -10 -10
∆ N 2 = ∆N 3 ∆F2 = ∆F3
-1 -20 -20
(a) ∆a~ j (t ) (b) ∆N j (t ) (c) ∆F (t ) and ∆F j (t )
1
10 ∆G1 ∆B1 ∆B t 0.5
0.4
∆B1' ≥ ∆B '
5 ∆
10G 15 20 25 30
t -1
5 10 15 20
∆B3
25 30 0.3
0.2
-10 ∆B2 0.1
∆G2 = ∆G3 -2 ∆B53' ≥
10 ∆15
B2' 20 25 30
t
-20 -0.1
1
0.5
20 ∆l2 = ∆l3 10 ∆R1
10
t t
5 10∆c
15j =
20 025 30 t 5 10 15 20 25 30
-0.5 5 10 15 20 25 30 -10
-10 ∆R2 = ∆R3
-1 ∆ l1 -20
(g) ∆c j (t ) (h) ∆l j (t ) (l) ∆R j (t )
Fig. 6.4.6. A rise in the CR’s amenity parameter, θ1
6.4.6 Productivity and Interregional Dynamics
This section examines how changes in the regions’ productivities affect the
national economy. First, we examine effects of a rise in the CR’s produc-
tivity, specified as follows: A1 = 1.5 ⇒ 1.7 . The effects on the capital in-
tensities, k j , per-capita output levels, f j , and wage rates, w j , are given
as follows
∆k1 = ∆f1 = ∆w1 = 19.579 , ∆k j = ∆f j = ∆w j = 0 , j = 2 , 3 .
The capital intensity, per-capita output level, and wage rate of the CR
are increased and the corresponding variables in the IR and HR are not af-
fected. The simulation results for the time-dependent variables are plotted
in Fig. 6.4.8. Figure 6.4.8a shows that the wealth of the households in the
CR is increased and the variables in the IR and HR are not affected. From
Fig. 6.4.8b and 8c, both the CR’s population and output level rise. The
populations and output levels in the other two regions are reduced as some
people from these regions immigrate to the CR. The net effect on the na-
tional output is positive. The trade balance is worsened initially but soon
improved. The lot size in region 1 falls and the land rent rises. The lot
sizes in the other two regions rise and their land rents fall.
20 40 ∆F1
15
∆k1 ∆ N1
30t ∆F
20
10 5 10 15 20 25
-20 5 10 15 20 25 30 t
5 -20
∆ k 2 = ∆k 3 = 0 -40
∆N 2 = ∆ N 3 -40 ∆F2 = ∆F3
5 10 15 20 25 30t
~ (t )
∆G1 2
40
5 ∆B 1 ∆B1' ≥ ∆B '
20 ∆B1 ∆B3
∆G t 5 10 15 20 25 30t 5 10 15 20 25 30 t
-20
5 10 15 20 25 30 -5 ∆B2 -1 ∆B3' ≥ ∆B2'
-2
-40
∆G2 = ∆G3 -10
-3
120 40
15 ∆c1 100 20
∆R1
80
10 60 ∆l2 = ∆l3 5 10 15 20 25 30
t
40 -20
5 20
t -40
∆c10
2 = 15
∆c20
3 t -20 5 10 15 20 25 30 ∆R2 = ∆R3
5 25 30
∆ l1
(g) ∆c j (t ) (h) ∆l j (t ) (l) ∆R j (t )
Fig. 6.4.7. An improvement in the CR’s productivity, A1
We now study effects of a rise in the HR’s productivity, specified as fol-

lows: A3 = 1 ⇒ 1.3. The effects on the capital intensities, k j , per-capita
output levels, f j , and wage rates, w j , are given as follows
∆k j = ∆f j = ∆w j = 0, j = 1, 2 , ∆k3 = ∆f 3 = ∆w3 = 45.471.
As in the previous case, only the variables in the HR are affected. Al-
though the effects to similar to those in the previous case, it should be
noted that the national output level is reduced in the long term. As the
HR’s productivity is increased, its wage rate is increased and the region
becomes more attractive. People immigrate to the IR from the CR and IR.
As the HR’s productivity after the change, A3 = 1.3 , is still lower than the
CR’s productivity, A1 = 1.5 , the net result of the reallocation of the popu-
lation reduces the national output level.
40 600 ∆F3 10 ∆F
30 ∆k3 500
t
20
400
300 ∆N 3 -10
5 10 15 20 25 30
200
10 100 -20
∆k1 = ∆k2 = 0 t 5 10
∆15N120= 25
∆N30
2 t -30 ∆F1 = ∆F2
5 10 15 20 25 30
~ (t )
(a) ∆a j (b) ∆N j (t ) and ∆F3 (t ) (c) ∆F (t ), ∆F1 (t ) and ∆F2 (t )
600 5 4
500 2.5 ∆B ∆B3 t
400 ∆G3 5 10 15 20 25 30
3
300 -2.5
-5 ∆B2 2
200
100
-7.5 ∆B1 1
∆B ' ∆B3'
∆G -10
t
= ∆25G230 t
5 10 ∆15 -12.5
G1 20 ∆B52' 10∆B15' 20 25 30
(d) ∆G (t ) and ∆G j (t ) (e) ∆B(t ) and ∆B j (t ) (f) ∆B' (t ) and ∆B j (t )

1
40 40 600
∆c3 20 ∆ l1 = ∆ l 2 500
30
20 -20 5 10 15 20 25 30
400
300
∆R3
-40 200
10
∆c1 = ∆c2 = 0 -60 100
∆R1 = ∆R2 t
5 10 15 20 25 30
t -80 ∆l3 t 5 10 15 20 25 30
(g) ∆c j (t ) (h) ∆l j (t ) (l) ∆R j (t )
Fig. 6.4.8. An improvement in the HR’s productivity, A3
By the way, we can also take other forms of technological changes in

the system. A most common way is to assume that technological changes
are exogenous and time dependent, as specified as follows
A j (t ) = A0 j exp(g j t ), j = 1, 2 , 3 ,
where A0 j are the initial levels of region j ’s productivity and g j is the

growth rate of productivity. We can simulate the model as before. As little
new insights can be obtained for the type of technological change, we omit
further examination.44
6.4.7 Conclusions
This section proposed an economic growth model of a multi-regional small

open economy in a perfectly competitive economy. The national economy
consists of multiple regions and each region has one production sector and
one housing sector. Following the traditional literature of small open
economies, we assume that the rate of interest is fixed in international
market. The production side is the same as in the neoclassical growth the-
ory. Different from, for instance, the Solow growth model and the Ramsey
model, we used a utility function, which determines saving and consump-
tion with utility optimization without leading to a higher dimensional dy-
namic system like by the traditional approaches. Households move freely
among regions, equalizing utility level among regions by choosing hous-
ing, goods and savings. A region’s amenity is endogenous, depending on
the region’s output and population. The dynamics of J -regional national
economy is controlled by a J -dimensional differential equations system.
We explicitly solved the dynamics of the multi-regional economy. The
system has a unique stable equilibrium point. We simulated the motion of
the model and examined effects of changes in the rate of interest, the pref-
erence, and amenity parameters.
The comparative dynamic analysis provides some important insights.
For instance, if productivity improvement occurs in the region with the
highest productivity, the national output rises; but if productivity im-
provement occurs in the region with the lowest productivity, the national
output falls. This hints on the possibility that if the central government im-
proves a technologically less advanced region, the national output may ac-
tually fall. We also show that amenities may strongly affect agglomeration
of people and economic activities. It should be remarked that from the em-
pirical study on wage determination with a large panel of French workers,
Combes et al. (2003) have found that individual skills account for a large
fraction of existing spatial wage disparities with strong evidence of spatial
sorting by skills and endowments only appear to play a small role. As far
44 See, Zhang (2005a), for various sources of knowledge creation, diffusion and
utilization and how different aspects of technological changes can be introduced

into economic growth theory.
6.5 On the Alternative Utility Function 227
as relations between wage disparity and endowments in small open

economies are concerned, our model gives similar results. It remains to
prove whether this property of economic development can be observed
under more general conditions. We may extend and generalize the model
in different ways. We may analyze behavior of the model with other forms
of production or utility functions. There are multiple production sectors
and households are not homogenous. Any extension will cause some ana-
lytical difficulties because of the nature of regional dynamics. Moreover, it
is known that issues related to tax competition among regions has increas-
ingly caused interests in economic geography.45 We can extend the dy-
namic equilibrium framework proposed in this section to deal with these
issues. As mentioned before, the new economic geography has mainly
concerned with monopolistic competition, scale economies, and transport
costs in economic geography.
6.5 On the Alternative Utility Function
As a concluding remark, we discuss the theoretical basis for the utility

function used in this chapter.46 We assume that at any point of time the
consumer has preferences over alternative bundles of commodities, which
can be divided into goods, services, and time distribution of the consumer.
The behavioral rule consists of maximization of these preferences under
budgets restrictions of finance, or time, or human capital, or energy.
A commodity is characterized by its location, date at which it is avail-
able and its price. At each point of time, the consumer is faced with a
commodity bundle consisting of (finite) real numbers
{x (t )}, j = 1, 2 , L, m ,
j
indicating the quality of each commodity. The commodity space consists

of commodity bundles. Here, we omit issues related to spatial location. Let
us denote the price of commodity j by p j (t ). For simplicity, we omit
time index of x and p except in some circumstances. Both commodity
vector x, and price vector p , can be represented by points in Euclidean
45 See, for instance, Andersson and Forslid (2003), Baldwin and Krugman (2004),
Bayindir-Upmann and Ziad (2005), and Borck and Pflüger (2006).
46 This is section is referred to Zhang (2005a: Chap. 2). The discussion on the re-
lationship between the preference structure and utility function is actually based on
Barten and Böhm (1982).
space R m , i.e., x ∈ R m and p ∈ R m . The value of the commodity bundle

at any point of time is given by p(t )x(t ) = ∑ j p j (t )x j (t ) . The consumption
set, denoted by X , consists of all consumption bundles, which are possi-
ble. Let us assume that the consumer’s choices are restricted by the fact
that the value of his consumption should not exceed his income w(t ), at
each point of time. The budget set
β ( p , x , t ) ≡ {x ∈ X px ≤ w},
is the set of possible consumption bundles whose value does not exceed
the income.
The consumer has tastes and desires. They are important in analyzing
why the consumer chooses a bundle from the consumption set. Mathemati-
cally, we represent the preference structure by the consumer’s preference
relation, f t , at each point of time which is a binary relation on X . For
any two bundles, x(t ) and y (t ), x∈X and y ∈ X , x f y means that x is
at least as good as y at time t. Before discussing the relation between the
preference relation and utility functions, we introduce the following axi-
oms.
Axiom 1 (Reflexibility)
For all x ∈ X , x f x , i.e., any bundle is as good as itself.
Axiom 2 (Transitivity)
For any three bundles, x , y , z in X such that x f y and y f z it is
true that x f z .
Axiom 3 (Completeness)
For any two bundles x and y in X , x f y or y f z .
Axiom 4 (Continuity)
For every x ∈ X the upper contour set {y ∈ X y f x} and the lower con-
tour set { y ∈ X | x f y} are closed relative to X .
A preference relation f which satisfies the first three axioms is a com-

plete preordering on X and is called a preference order. A bundle x is
said to be strictly preferred to a bundle y , i.e., x f y iff x f y and not
y f x . A bundle x is said to be indifferent to a bundle y, i.e., x ~ y iff
Appendix 229
x f y and y f x . The indifference relation defines an equivalent relation

on X , i.e., ~ is reflexible, symmetric, and transitive. We always assume
that X includes at least two bundles x' and x" such that x' f y". In order
to solve the problem of the representability of a preference relation by a
numerical function, we introduce the concept of utility function.
Definition 6.5.1
Let X denote a set and f t a binary relation on X at time t . Then a func-
tion u from X into real R is a representation of f , i.e., a utility function
for the preference relation f , if, for any two points x and y,
ut ( x) ≥ ut ( y ) iff x f t y at point of time t .
It seems that Pareto was the first to recognize that arbitrary increasing
transformation of a given function would result in identical maximization
of a consumer. From the above definition we see that for any utility func-
tion ut and any increasing transformation f : R → R the function
vt = f o ut is also a utility function for the same preference relation f .
The following theorem is referred to Debreu (1959) or Rader (1963).
Theorem 6.5.1
Let X denote a topological space with a countable base of open sets and
f a continuous preference order defined on X , i.e., a preference relation
that satisfies Axioms 1-4. Then there exists a continuous function u .
The above theorem shows that under certain conditions the concepts of
utility and of the underlying preferences may be used interchangeably to
determine demand at any point of time.
Appendix
A.6.1 Growth of a Small Overlapping-Generations Economy
This section introduces a typical model of a small overlapping-

generalizations (OLG) economy. The model is proposed by Galor (1994).47
47 It should be noted that Galor also examines the case when there are tariffs.
The model is built for an economy of perfect competition with an infinite

horizon. In every period two, consumption and investment goods, are pro-
duced with two factors, capital and labor in the world. The labor force,
N (t ), of the country grows at a fixed rate, n , that is
N (t + 1) = (1 + n ) N (t ).
For simplicity, assume that the small open economy specializes in pro-
ducing the investment good. The output produced in every period is used,
partly as capital in next period production processes while the rest is ex-
ported and traded freely in return for the consumption good.
Production of the investment good in the small economy occurs within a
period according to the following neoclassical production function:
F (t ) = F (K (t ), N (t )), alternatively
K (t )
f (t ) = f (k (t )), k (t ) ≡ ,
N (t )
where K (t ) and N (t ) are respectively the capital stock employed by the
production sector and the labor force of the economy. Assume that the rate
of capital depreciation is zero. Choose the investment good as the nu-
meraire. The marginal conditions are
r (t ) = f ' (k (t )), w(t ) = f (k (t )) − k (t ) f ' (k (t )), (A.6.1.1)
where r (t ) and w(t ) are the prevailing wage and the interest rates, respec-
tively at t .
Individuals are identical in the system over time and each individual
lives only two periods. In the first period individuals work and earn w(t )
and in the second they are retired. Individuals born at t are characterized
by their intertemporal utility function u (ct (t ), ct (t + 1)), where ct (t ) is the
consumption of period t . Assume that u is twice continuously differenti-
able and strictly quasi-concave, defined over the consumption set R+2 . It is
also required Du >> 0 , ∀ c ∈ R+2+ , and for ct (t ), ct (t + 1) > 0 ,
lim u1 (ct (t ), ct (t + 1)) = ∞ , lim u1 (ct (t ), ct (t + 1)) = 0 .

ct (t )→ 0 ct (t )→∞
Young individuals at time t supply their unit-endowment of labor ine-

lastically and allocate the resulting income w(t ) between first period con-
sumption, ct (t ), and savings St (t ). The budgets over two periods are thus
given by
Appendix 231
p(t )ct (t ) + S (t ) ≤ w(t ),
1 + r (t + 1) S (t ) (A.6.1.2)
ct (t + 1) = .
p(t + 1)
Individuals maximize u (ct (t ), ct (t + 1)) subject to the above constraints.

The problem has a unique solution for strictly positive prices. Let p(t ) be
fixed in the world market and constant over time. Then, we can express the
solution as
 w(t )   w(t )  (A.6.1.3)
ct (t ) = ct  , r (t + 1) , S t (t ) = w(t ) − pct  , r (t + 1) ,
 p   p 
where ∂S / ∂r ≥ 0 and ∂S / ∂w > 0 .
If neither international lending nor borrowing is allowed, the stock of
capital changes according to
K (t + 1) = N (t ) S t (t ) = F (t ) + K (t ) − X (t ), (A.6.1.4)
where X (t ) is the economy’s export at t . The trade balance is guaranteed

by
X (t ) = p[N (t − 1)ct −1 (t ) + N (t )ct (t )]. (A.6.1.5)
We have thus described the model. Under certain conditions the dy-
namic system has a unique (locally) stable equilibrium. We will not illus-
trate the dynamic analysis of the discrete system as almost all the dynamic
models in this book are in continuous time.
A.6.2 Habits and Current Account Dynamics
Many empirical studies have identified the following stylized facts about
current experiences (Ikeda and Gombi, 1998): (i) adverse productivity
shocks improve the current account; (ii) savings and investment display a
positive correction in the short- and long-run; and (iii) temporary increases
in fiscal spending deteriorate the current account whereas permanent ones
exert at most weaker negative effects on it. To explain these findings,
much attention in theoretical literature has been paid to the intertemporal
aspects of savings, investment, and the current account (Sen, 1994;
Obstfeld and Rogoff, 1995). This section introduces a small country model
proposed by Ikeda and Gombi (1998) to analyze the equilibrium dynamics
of savings, investment and the current account and to explain the stylized
facts just mentioned.
The model is constructed for a small open economy populated with infi-
nitely lived identical agents. There is a composite traded good that can be
used for consumption and investment. The good is taken as numeraire.
Given the market wage rate, w(t ), households supply one unity of labor at
each point of time t and hold non-human wealth, a(t ), in the form of
bonds, b(t ), and equities. Bonds can be either purchased or issued freely at
a constant interest rate, r , in the international market. To describe habit
formation of households, introduce z (t ) the time- t consumption habit, i.e.,
the average of past consumption rates defined by
z (t ) = ∫ c(t )exp(− α (t − s)) ds ,

t
−∞
or equivalently
z& (t ) = α (c(t ) − z (t )), (A.6.2.1)
where α is the discount rate for past consumption rates, and c(t ) is the
consumption rate. The consumers’ lifetime utility is specified as
∞
U0 = ∫ [u (c(t ), z(t )) + v(g (t ))]exp(− θt ) dt ,

0
where g (t ) represents government services. It is assumed that v is con-

cave in g (t ) and u satisfies: (1) uc > 0 ; (2) u z ≤ 0 ; (3) uc + u z > 0; (4)
u is concave in (c, z ); (5) lim c →0 uc (c, z ) = ∞ uniformly in z ; and (6)
lim c →0 [uc (c, c ) + u z (c, c )] = ∞ .
Let x(t ) stand for lump-sum tax payments to the government. Given the
initial conditions (a(0 ), z (0 )), consumers choose {c(t ), z (t ), a(t )} to maxi-
mize U 0 subject to the following budget constraint
a& (t ) = ra(t ) + w(t ) − c(t ) − x(t ), (A.6.2.2)
and the non-Ponzi game condition. Together with the transversality condi-
tions for λ (t ) and ξ (t ), the optimal conditions are given by
u z (c, z ) = λ (t ) − αξ (t ),
ξ&(t ) = (θ + α )ξ (t ) − u (c, z ),
z
Appendix 233
λ& (t ) = (θ − r )λ (t ), (A.6.2.3)
where λ (t ) (≥ 0) and ξ (t ) (≤ 0) are respectively the shadow price of sav-

ing and the shadow price of habit formation. Assume θ = r in the rest of
this section (which implies λ& (t ) = 0 ). This assumption will bring the
model the zero root property that the steady state depends on the initial
condition (Sen and Turnovsky, 1990), even though it is frequently ac-
cepted in the literature.
The representative firm maximizes the present value of its future net
cash flows, choosing labor, N (t ), and rate of net investment, I (t ). Ne-
glecting depreciation of physical capital, we have K& (t ) = I (t ), where
K (t ) is the capital stock. Assume that the government levies a tax on equi-
ties at constant rate τ ≥ 0 . The arbitrage-free rate of return on equities is
equal to r + τ . The government maximizes
∞
V0 = max ∫ [AF (K , N ) − wN − I (1 + φ (I / K ))]exp[− (r + τ )t ]dt ,

0
where AF (K , N ) is the production function which is linearly homogene-

ous in N (t ) and K (t ) with productivity parameter A and Iφ (I / K ) de-
notes the capital adjustment cost function satisfying
 I   I   I 
φ (0 ) = 0, φ '   > 0, 2φ '   + φ "  > 0 .
K K K
Together with, the normalization N (t ) = 1, K& (t ) = I (t ), and the trans-
versality condition for K (t ), the optimal conditions are
AFN (K , 1) = w(t ),
I  I I 
1 + φ   + φ '   = q(t ),
K K K
  I   I 
2
q& (t ) = (r + τ )q (t ) −  AFK (K ,1) +   φ '   ,

  K   K 
where q(t ) is the shadow price of investment. From the second equation,
we solve
I (t ) = η (q(t ))K (t ), η (1) = 0, η ' (q ) > 0 .

The dynamics are thus given by
K& (t ) = η (q(t ))K (t ),
[
q& (t ) = (r + τ )q(t ) − AFK (K ,1) + η 2φ ' (η ) . ] (A.6.2.4)
Governments
The government’s budget is assumed to be balanced at any point of
time, i.e.
g (t ) = x(t ) + τV (t ),
where V (t ) is equities at time t .
Steady state and stability

The dynamics of ( z (t ), ξ (t ), K (t ), q(t )) are given by Eqs. (A.6.2.4) and
z& (t ) = α (c(t ) − z (t )),
ξ&(t ) = (θ + α )ξ (t ) − u z (c, z ).
It can be shown that the dynamic system exhibits saddle point stability.
A.6.3 Proving Lemma 6.4.1
We now prove Lemma 6.4.1. First, we note that k j , w j and f j (k j ) are de-
termined as functions of r * , which is fixed in the international market.
Hence, we treat them as constants in the dynamic analysis. Substituting
Eqs. (6.4.8), c j = ξyˆ j and s j = λyˆ j in Eqs. (6.4.9) and l j = L j / N j into
the utility functions, we have
U j = ρ ξ 0 + λ0θ j f ja Lηjξ ξ λλ N aj +b −η yˆ ξj + λ , j = 1, L , J .
Inserting the above equations in Eqs. (6.4.11), we get

η
 yˆ j  (A.6.3.1)
n j = g j   , j = 2, L, J ,
 yˆ1 
Appendix 235
where g j and η are defined in Lemma 6.4.1 and
N j (t )
n j (t ) ≡ .
N1 (t )
From the population constrain in (6.4.15), we have
N
N1 = .
∑
J
1+ j =2
nj
From this equation and Eqs. (A.6.3.1), we determine the population dis-
tribution as functions of ŷ j as follows
g j yˆ ηj N
Nj = , j = 1, ... , J ,
∑
J
g yˆ η
j =1 j j
in which g1 = 1. From Eqs. (6.4.4) and (6.4.5), we obtain
yˆ j = (1 + r * )a~ j + w j , j = 1, L, J . (A.6.3.2)
As r * and w j are independent of t , we see that ŷ j in region j is line-

arly related to a~ j and is independent of any other time-dependent vari-
ables.
From s j = λyˆ j in (6.4.9) and Eqs. (6.4.10), we have
a~& j = λyˆ j − a~ j , j = 1, 2 , L, J . (A.6.3.3)
Substituting Eqs. (A.6.3.2) into Eqs. (A.6.3.3) yields

a~& j = λw j − (1 − λ − λr * )a~& j , j = 1, L, J . (A.6.3.4)
As each equation is unconnected to the rest of the equations, it is

straightforward to show that the solutions of Eqs. (A.6.3.4) are given by
Eqs. (6.4.18).
A.6.4 The Keynesian Consumption Function and the OSG

Approach
The Keynesian theory of consumption is that current real disposable in-

come is the most important determinant of consumption in the short run.
Many attempts were made to correlate aggregate consumption expendi-
tures over time with aggregate disposable income and other variables. The
traditional Keynesian consumption function posits that consumption is de-
termined by current disposable income, i.e.
C (t ) = a + bY (t ), a > 0 , 0 < b < 1,
where a and b are constant, C (t ) is real consumption at time t , and Y (t )
is real disposable income (which is the same as the current income in our
model), which equals GNP minus taxes. It can be seen that if we swap the
real disposable income in the Keynesian model with the disposable per-
sonal income in our model in Sect. 6.1,
The parameter, b , is the marginal propensity to consume, which meas-
ures the increase in consumption in association with per unit increase in
disposable income. The intercept, a , measures consumption at a zero level
of disposable income.
Consumer spending
450 line where income = spending
consumption
spending is assumed to rise but less quickly

than income
Real disposable income

Fig. A.6.4.1. The Keynesian consumption function
Because of the intercept, the Keynesian consumption is not a propor-

tional relationship between consumption and income. The ratio of con-
sumption to income is termed the average propensity to consume (APC),
i.e.
C a
APC = =b+ .
Y Y
Appendix 237
The average propensity to consume declines as income increases. The

average propensity to consume is greater than the marginal propensity to
consume, by the amount of a /Y . The ratio of saving to income is termed
the average propensity to save (APS), i.e.
Y −C a
APS ≡ =1− b − .
Y Y
We have
APC + APS = 1.
As Y increases, the average propensity to save rises.
The OSG model with the Cobb-Douglas utility function determines the
relationship between consumption and disposable personal income
C (t ) = ξYˆ (t ) = ξY (t ) + ξK (t ).
We now connect the two theories by treating a in the Keynesian model
as a wealth-related variable. If we assume that the intercept a is depend-
ent on wealth and marginal propensity to propensity, b , is related to the
propensity to consume, ξ , in the following way
a = ξK (t ), b = ξ ,
then the Keynesian consumption function is identical to the consumption
function in the OSG model. We may call our consumption function as a
generalized Keynesian consumption function. We can define the APC and
APS, denoted by c (t ) and s (t ), respectively, for the OSG model in the
same way as in the Keynesian consumption function. In the OSG model
C ξ (Y + K ) K
c (t ) = APC ≡ = =ξ +ξ ,
Y Y Y
S − K λY − δK K
s (t ) = APS ≡ = =λ −ξ ,
Y Y Y
where we use ξ + λ =1. It should be noted that according to the definition
of the APS
S (t ) − K (t ) K& (t )
s (t ) = APS ≡ = .
Y (t ) Y (t )
The APC in the OSG model rise as wealth increases or as current in-
come declines; The APS in the OSG model rise as wealth falls or as cur-
rent income rises. It should be noted that APC + APS = 1. It is possible

for the APS to be negative in the OSG model.
It should noted that the life cycle hypothesis has also played an impor-
tant role in analyzing households’ The hypothesis was developed by Irving
Fisher and Roy Harrod, before later being extended by Ando and Modi-
gliani (1963).48 It assumes that individuals come a constant percentage of
the present value of their life income. This is dictated by preference and
income. The hypothesis is to explain the empirical work on consumption
function.49 It has been observed that the relationship between consumption
and current income would be nonproportional and the intercept of con-
sumption function is not constant over time. As stated out by Modigliani
(1966), “The point of departure of the life cycle model is the hypothesis
that consumption and saving decisions of households at each point of time
reflect a more or less conscious attempt at achieving the preferred distribu-
tion of consumption over the life cycle, subject to the constraint imposed
by the resources accruing to the household over its lifetime.” Consumption
depends not just on current income but also on long-term expected earn-
ings over their lifetime. Zhang (2005a) shows how the OSG model can be
related to this hypothesis.50
A.6.5 The Solow Growth Model and the OSG Approach
The Solow growth model, often also called the neoclassical growth model,
is a work horse of economic growth theory. Most neoclassical models are
extensions and generalizations of the pioneering works of Solow and Swan
in 1956.51 The behavior of the production sector is the same as in the OSG
model in Sect. 6.1.52 Nevertheless, the Solow model assumes that the
agents regularly set aside some fairly predictable portion ŝ of its output
for the purpose of capital accumulation; hence
48 See also Modigliani and Brumberg (1954) and Modigliani (1986).

49 This section is referred to Froyen (1999: 282-286).
50 Zhang (2005a) also discussed the permanent income hypothesis developed by
Friedman (1957) and possible relations between the permanent income hypothesis
and the OSG approach.
51 Solow (1956) and Swan (1956). The Solow model is often called the Solow-
Swan model because Swan’s work is similar to Solow’s seminal paper.

52 The description of behavior of producers and production sectors follows the
traditional approach (e.g., Burmeister and Dobell, 1970; Azariadis, 1993; and
Zhang, 1999).
Appendix 239
k&(t ) = sˆf (k (t )) − (n + δ k )k (t ).
We see that the differential equation for per-worker-capital accumula-
tion in the Solow model is mathematically identical to the capital accumu-
lation equation in the OSG model defined by Eq. (1.1.12) in Sect. 6.1
k&(t ) = λf (k (t )) − (ξ + n )k (t ),
if we specify U = c ξ s λ . The Solow model and the OSG model have the
same dynamic properties – the system has a unique stable equilibrium. But
the OSG model holds that the saving rate is time-dependent; the Solow
model predetermines the saving rate.
We now show that under certain circumstances the OSG model can ex-
plain what the Solow model forecasts. The OSG model endogenously de-
termines saving and consumption. For simplicity, we let δ k = 0 . The
OSG’s capital accumulation is given
K& (t ) = λF (t ) − ξK (t ). (A.6.5.1)
In the OSG model, the APS is given by

λF (t ) + λK (t ) − K (t )
s (t ) = .
F (t )
We are interested in when s (t ) in the OSG model equals the predeter-
mined saving rate ŝ in the Solow model, i.e.
λF (t ) + λδK (t ) − δK (t ) (A.6.5.2)
= ŝ .
F (t )
If the propensity to save λ is considered as an endogenous variable, the
above equation holds if
K (t ) (1 − sˆ )δ (A.6.5.3)
λ (t ) = sˆ + (1 − sˆ )δ = sˆ + (< 1).
F (t ) + δK (t ) f (k (t )) / k (t ) + δ
As ξ (t ) + λ (t ) = 1, ξ (t ) is also a function of k / f (k ). If the propensity

to save is related to the ratio of capital per capita and output per capita as
in Eq. (A.6.5.7), then s (t ) in the OSG model is constant and is equal to the
saving rate, ŝ , in the Solow model. Inserting Eq. (A.6.5.7) into Eq.
(A.6.5.1) yields
K& (t ) = λ (t )F (t ) − (ξ (t ) + λ (t )δ k )K (t ) =
λ (t )(F (t ) + δK (t )) − K (t ) = sˆF (t ) − δ k K (t ).
We see that under Eq. (A.6.5.7) the evolution of capital in the OSG model
is identical to that in the Solow model.
Theorem A.6.5.1
Let the production sectors be identical in the OSG model and the Solow
model. If the saving rate, ŝ, in the Solow model and the propensity to save
λ (t ) in the OSG model satisfy Eq. (A.6.5.8), then the OSG model is identi-
cal to the Solow model in terms of the saving rate (out of current income), the
consumption rate, the interest rate, the wage rate, output, income, consump-
tion, and saving.
7 One-Sector Global Growth Models with Capital
Accumulation
As Findlay (1984) pointed out, one topic that was almost entirely absent
from the pure theory of international trade was any consideration of the
connection between economic growth and international trade in classical
literature of economic theory. Almost all the trade models developed be-
fore the 1960s are static in the sense that the supplies of factors of produc-
tion are given and do not vary over time; the classical Ricardian theory of
comparative advantage and the Heckscher-Ohlin theory are static since la-
bor and capital stocks (or land) are assumed to be given and constant over
time. Trade models with capital movements are originated by MacDougall
(1960) and Kemp (1961), even though these models were limited to static
and one-commodity frameworks. A dynamic model, which takes account
of accumulating capital stocks and of growing population within the Heck-
scher-Ohlin type of model is initially developed by Oniki and Uzawa and
others, in terms of the two-country, two-good, two-factor model of trade.
The Oniki-Uzawa model is developed within the framework of neoclassi-
cal growth theory. The model is primarily concerned with the process of
world capital accumulation and distribution with demands and supplies.
Eaton (1987) proposed a dynamic two-sector, three-factors model of inter-
national trade. The dynamic specification of the model is based on
Samuelson’s overlapping generations model. The dynamic model at each
point of time t proposed by Eaton is identical to the three-factor, two-
commodity model examined in a static context by Jones, Samuelson and
Mussa.1 The model tries to extend the Heckscher-Ohlin theory to include
endowments of factor as endogenous variables. In this model land and
capital serve not only as factors of production but also as assets which in-
dividuals use to transfer income from working periods to retirement. The
model shows that changes in the terms of trade and in the endowments of
fixed factors do not necessarily have the same effects on factor prices and
on the composition of output as they do in a static framework. Some re-
sults obtained from the specific-factors model about the relationships be-
1 See, for instance, Jones (1971), Samuelson (1971) and Mussa (1974).
242 7 One-Sector Global Growth Models with Capital Accumulation
tween commodity prices and factor prices, factor endowments and factor
rewards, and factor endowments and the pattern of production are not held
in the dynamic model. For instance, a permanent increase in the relative
price of one commodity does not necessarily lower the steady-state income
of the factor specific to the industry producing the other commodity.
Obstfeld examines the saving behavior of a small economy facing a certain
world real interest rate.2 Obstfeld proposes a dynamic Heckscher-Ohlin
model with internationally mobile capital and overlapping generations of
infinitely-lived agents. The model focuses on the effects of government
debt and spending shocks. Devereux and Shi (1991) develop a trade model
which includes intertemporal consumption-saving decisions with the use
of recursive preferences.3 These preferences make it possible to analyze
heterogeneity in a representative-agent infinite horizon model with well-
defined steady states. The key factors driving the steady state are the con-
vergence of national rates of time preference with one another and the
monotonical relationship between consumption and the real interest rate at
the steady state. This implies that each country’s share of total world out-
put depends only on its degree of impatience and not on country-specific
factors. From this model it concludes that the more patient country has a
higher steady-state consumption level and will be a steady-state external
creditor.
We analyze trade issues within the framework of a simple international
macroeconomic growth model with perfect capital mobility. Most aspects
of production sectors in our model are similar to the neoclassical one-
sector growth model. It is assumed that there is only one (durable) good in
the global economy under consideration. Households own assets of the
economy and distribute their incomes to consume and save. Our model, as
far as trade and global growth are concerned, is influenced by the neoclas-
sical trade theory with capital accumulation. Section 7.1 discusses the na-
ture of the economic relations between the advanced and less developed
regions of the world economy, or the North and South as it has become
customary to call refer to them. The formal framework, initiated by
2 Obstfeld (1981). See also Sect. 2.10 for a small open economy described within
the OSG framework.

3 There are also some models with capital and agglomeration (see, for instance,
Baldwin, 1992, 1999; Baldwin and Krugman, 2004; and Baldwin and Martin,
2004). It should be remarked that in the early 1990s, Zhang (for instance, 1991a,
1991b) proposed interregional and interregional models with both capital and
knowledge, while in the new economic geography there are dynamic models ei-
ther with capital accumulation or technological change, but not both, with micro
behavioral foundation.
7.1 A Growth Model with Trade Between North and South 243
Findlay (1980), is a synthesis of Solow-Swan’s neoclassical growth model

(for the North), Lewis’s dual-economic model (for the South), and John-
son’s trade model as a linkage between the North and the South. Section
7.2 builds a dynamic one-commodity and two-country trade model to ex-
amine interdependence between trades and global growth. We analyze
trade issues within the framework of a simple international macroeco-
nomic growth model with perfect capital mobility. Section 7.3 extends the
model in Sect. 7.2, introducing a few new features to the analytical frame-
work. We construct a dynamic one-commodity and multiple-country trade
model to examine interdependence between trade and global growth with
sexual division of labor. The section proposes the multi-country model
with endogenous labor supply, sexual division of labor, and capital accu-
mulation.
7.1 A Growth Model with Trade Between North and South
This section discusses the nature of the economic relations between the
advanced and less developed regions of the world economy, or the North
and South as it has become customary to call refer to them. It is often ar-
gued that the movement of the terms of trade between two regions is a key
index of the distribution of the benefits from the international division of
labor and the development prospects of the South. We now introduce a
formal framework, set up by Findlay (1980), within which diverse argu-
ments are sorted out and assessed. The model is a synthesis of Solow-
Swan’s neoclassical growth model (for the North), Lewis’s dual-economic
model (for the South), and Johnson’s trade model as a linkage between the
North and the South (Lewis, 1954; Johnson, 1967b).
First, we consider the North. Assume that it produces a single commod-
ity, called manufactures, which can be used either for consumption or in-
vestment. A constant fraction of output is saved and invested. Markets are
perfectly competitive and labor and capital are always fully employed. The
population grows at a constant rate and technology progresses also at a
fixed rate in the labor-augmenting type. The portion of output in the North
which is not saved is spent either on manufactures or on another homoge-
nous commodity, called primary products, produced in the South. Primary
products constitute the sole output of the South. The production of primary
products uses labor and capital as inputs. Capital consists of a stock of
manufactures. Labor is in perfectly elastic supply from a ‘hinterland’ out-
side the model at a fixed wage rate in terms of primary products. Perfec-
tion competition leads to the point at which marginal productivity of labor
is equal to the fixed real wage. Total employment at any instant is deter-
mined by the quantity of capital available. It is assumed that a constant
fraction of profits are saved and all wages are consumed. Consumption ex-
penditure is spent on manufactures and primary products with the propor-
tions depending on relative prices. Assume that there is no lending so that
trade is always balanced.
We now describe the basic structure of the model. The constant return-
to-scale production function for primary products and the profit-
maximization condition in the South are
f S = f S (k S ), f S (k S ) − f S ' (k S )k S = w , f S ' (k S ) > 0 , f S " (k S ) < 0 ,
where f S stands for output per worker of primary products in the South,
k S capital-labor ratio, and w fixed wage. The above equations uniquely
determine k S as a function of w . Since capital consists of a stock of
manufactures and output of a flow of primary products, the rate of profit in
the South is
ρ = θf S ' (k S ),
where θ is the terms of trade (manufactures per unit of primary products)
to be determined. The common growth rate of total capital, output, and
employment in the South is g = σρ , where σ is constant fraction of
profit saved in the South. At steady-state equilibrium the growth rates of
the North and the South are equal. As the growth rate of the North is fixed
at n , from g = σρ and ρ = θf S ' (k S ) the condition g = n yields
n
θ= .
σf S ' (k S )
The production function, YN , and population, N N , for the North are
YN = f N (k N )N N , N N = N 0 e nt .
Assume that the import demand function of the North is
∂I N (7.1.1)
I N = m[θ , (1 − s ) f N (k N )]N N , < 0,
∂θ
where I N is total imports in the North, s is constant fraction of income
saved in the North, and m is per capita imports of the North. We assume
that the elasticity of m with respect to per capita consumption (1 − s ) f N is
equal to unity. The import demand function for the South is
 1  (7.1.2)
I S = θσf S ' k S + µ  , w + (1 − σ ) f S ' k S  N S ,
 θ 
where I S is total imports in the South, the expression in brackets is the
sum of per capita imports for investment and consumption, respectively.
Per capita import demand for consumption purposes is µ , with
∂µ / ∂ (1 / θ ) < 0 and the elasticity with respect to per capita consumption,
w + (1 − σ ) f S ' k S , is equal to unity. Southern employment is determined
by k S N S = K S . In the absence of international capital movements the
trade balance must be zero, θI N = I S . Introduce λ ≡ N S / N N . From
θI N = I S and Eqs. (7.1.1) and (7.1.2), we solve
λµ
θ= .
m − λσf S ' k S
Together with θ = n / σf S ' (k S ), the above equation yields

θm
λ= .
µ + nk S
The ratio of total income in the two regions is
YS θf S (k S )λ
= .
YN f N (k N )
The basic dynamics are given by
λ& (t ) = [σf S ' (k S )θ (λ , k N ) − n]λ ,
k&N (t ) = sf N (k N ) − nk N .
We have thus built the model. It can be shown that the system has a unique sta-
ble equilibrium as illustrated in Fig. 7.1.1.
7.2 A Two-Country Trade Model with Capital

Accumulation
Irrespective of analytical difficulties involved in analyzing two-country,

dynamic-optimization models with capital accumulation, many efforts
have been made to examine the impact of savings, technology and various
policies upon trade patterns within this framework. For instance, Frenkel
and Razin (1987) used a two-country and two-period model to analyze the
effects of various fiscal policies, even though their model ignores capital
accumulation. In Ikeda and Ono (1992), an optimal multi-country model
was constructed to analyze dynamic trade patterns, even though the model
ignores capital growth by assuming a constant capital supply. This section
makes another contribution to the literature by proposing a dynamic trade
model with capital growth under the assumption that the households make
decisions on savings on the basis of their attitudes towards wealth at each
point of time. That is, rather than using the concept of the subjective dis-
count rate, we solve the problem of endogenous savings by treating wealth
similarly to a consumption good in household decision making. This
greatly reduces difficulties involved in the dynamic analysis of traditional
two-country trade models with endogenous capital accumulation.
k&N = 0
λ& = 0
kN
Fig. 7.1.1. A Stable equilibrium point
This section develops a dynamic one-commodity and two-country trade

model to examine interdependence between trades and global growth. We
analyze trade issues within the framework of a simple international macro-
economic growth model with perfect capital mobility. We show that our
analytical framework greatly reduces difficulties involved in the dynamic
analysis of traditional two-country trade models with endogenous capital

accumulation.4
7.2.1 The Trade Model
In describing economic production, we follow the neoclassical trade

framework. It is assumed that the countries produce a homogenous com-
modity. Most aspects of production sectors in our model are similar to the
neo-classical one-sector growth model. The system consists of two coun-
tries, indexed by j = 1, 2. Only one good is produced in the system. Per-
fect competition is assumed to prevail in good markets both within each
country and between the countries and commodities are traded without any
barriers such as transport costs or tariffs. We assume that there is no mi-
gration between the countries and the labor markets are perfectly competi-
tive within each country. Each country has a fixed labor force, N j ,
( j = 1, 2 ). Let prices be measured in terms of the commodity and the price
of the commodity be unity. We denote wage and interest rates by w j (t )
and rj (t ), respectively, in the j th country. In the free trade system, the in-
terest rate is the same throughout the world economy, i.e., r (t ) = r j (t ).
First, we describe behavior of the production sections. We use produc-
tion functions to describe the physical facts of a given technology. Let
K j (t ) stand for the capital stocks owned by country j. Let E (t ) stand for
the capital stocks which are employed by country 1 but owned by country
2. When E (t ) > (<) 0 , country 1 ( 2 ) uses country 2 ’s (1’s) capital. The
production functions are specified as follows
F1 (t ) = A1 (K1 (t ) + E (t )) 1 N1β1 , F2 (t ) = A2 (K 2 (t ) − E (t )) 2 N 2β 2 ,
α α
where α j + β j = 1, j = 1, 2. Markets are competitive; thus labor and capi-

tal earn their marginal products, and firms earn zero profits. The rate of in-
terest, r (t ) , and wage rates, w j (t ) , are determined by markets. The mar-
ginal conditions are given by
4 This section is based on Zhang (2006a: Sect. 8.3). Zhang extends the model to
any number of countries with any number of types of households. In the next sec-
tion, we will represent a trade model of multiple economies with endogenous la-
bor supply and sexual division of labor.
r + δ k = α1 A1 (K1 (t ) + E (t )) N1β1 = α 2 A2 (K 2 (t ) − E (t ))
− β1 −β2
N 2β 2 ,
w1 (t ) = β1 A1 (K1 (t ) + E (t )) 1 N1−α1 ,
α
w2 (t ) = β 2 A2 (K 2 (t ) − E (t )) 2 N 2−α 2 , (7.2.1)
α
where δ k is the depreciation rate of physical capital. We assume that the

depreciation rate is identical between the economies.
We now describe behavior of consumers. Let k j (t ) stand for the per
capita wealth in country j. That is, k j = K j / N j . A consumer of country
j obtains the current income
y j (t ) = r (t )k j (t ) + w j (t ), j = 1, 2 , (7.2.2)
from the interest payment, rk j , and the wage payment, w j . The disposable
income is given by
yˆ j (t ) = y j (t ) + k j (t ). (7.2.3)

point of time, a consumer distributes the total available budget between
saving, s j (t ), and consumption of goods, c j (t ). The budget constraint is
given by
c j (t ) + s j (t ) = yˆ j (t ) = rk j (t ) + w j (t ) + k j (t ). (7.2.4)
The utility function is specified as follows

ξ λ
U j (t ) = c j j (t ) s j j (t ), ξ j , λ j > 0, ξ j + λ j = 1,
Maximizing U j subject to the budget constraints (7.2.4) yields
c j (t ) = ξ j yˆ j (t ), s j (t ) = λ j yˆ j (t ). (7.2.5)

typical household in country j is given by
k& j (t ) = s j (t ) − k j (t ). (7.2.6)
The total capital stocks employed by the production sectors is equal to

the total wealth owned by all the countries. That is
2
(7.2.7)
K (t ) = ∑ k j (t )N j .
j =1
The world production is equal to the world consumption and world net
saving. That is
2
C (t ) − S (t ) − K (t ) + ∑δ kj K j (t ) = F (t ),
j =1
where
2 2 2
C (t ) ≡ ∑ c j (t )N j , S (t ) ≡ ∑ s j (t )N j , F (t ) ≡ ∑ F j (t ).
j =1 j =1 j =1
We have thus built the model which explains the endogenous accumula-
tion of capital and the international distribution of capital in the world
economy in which the domestic markets of each country are perfectly
competitive, international product and capital markets are freely mobile
and labor is internationally immobile. We now examine the properties of
the system.
7.2.2 Behavior of the Dynamic System
From the condition that the world economy has the equal interest rate
throughout, we get
α1 F1 α 2 F2
= .
K1 + E K2 − E
From this equation and Eqs. (7.2.1), we obtain
K 2 − E = υ ( K 1 + E )θ , (7.2.8)
in which
1/ β 2
α  N2 β
υ ≡  2  , θ ≡ 1 < 1.
 α1  β2
θ
N1
In the remainder of this section, for convenience of discussion we re-

quire θ ≤ 1, i.e., β1 ≤ β 2 . This requirement will not affect our discussion.
Introducing x ≡ K1 + E , we may rewrite Eq. (7.2.8) as follows
Φ( x ) ≡ x + υxθ − K = 0, 0 < x < K . (7.2.9)
We now show that for any positive K > 0, the equation, Φ (x ) = 0 , has
a unique positive solution.
The function, Φ , has the following properties
dΦ
Φ(0) < 0, Φ(K ) > 0, > 0,
dx
for all x. This implies that Eq. (7.2.9) has a unique positive solution
x = Λ ( K ) > 0.
For instance, in the case of θ = 1, we have
K
Λ( K ) = .
1+υ
In the case of θ = 1 / 2, we have
2
 ν 2 
1/ 2
υ 
x =  + K  −  .
 4  2 
We thus solve E as a unique function of K j as follows
E = Λ ( K ) − K1 . (7.2.10)
Substituting Eq. (7.2.10) and r in Eqs. (7.2.1) into Eqs. (7.2.2) yields
Y j ( K1 , K 2 ) = g j ( K1 , K 2 ), j = 1, 2, (7.2.11)
where Y j = y j N j and
α 1 K1 + β1Λ
g1 ( K 1 , K 2 ) ≡ N1β1 − δ k K1 ,
Λβ1
α 2 K2 + β2 K − β2Λ
g 2 ( K1 , K 2 ) ≡ N 2β1 − δ k K 2 .
( K − Λ) β 2
From Eqs. (7.2.6), we have
K& j = λ jY j − ξ j K j , j = 1, 2. (7.2.12)
At equilibrium, we have
λ jY j = ξ j K j , j = 1, 2. (7.2.13)
From Eqs. (7.2.11) and (7.2.13), we directly solve K j as functions of

K as follows
β1Λ β Λθ (7.2.14)
K1 = , K2 = 2 ,
φ1 (Λ ) φ2 (Λ )
in which
δ 1Λβ1 δ 2υ β 2 Λβ1 (7.2.15)
φ1 (Λ ) ≡ − α1 , φ2 (Λ ) ≡ − α2,
λ1 N1β1 λ2 N 2β 2
where δ j ≡ ξ j + (1 − δ k )λ j . As K j ≥ 0, j = 1, 2 , it is necessary to require
φ j ≥ 0. Define
Λ 0 ≡ min{Λ φ j ( Λ) = 0, Λ > 0, j = 1, 2}. (7.2.16)
It is obvious that such a positive Λ 0 exists. As φ j are increasing in Λ,

we see that Λ is meaningful only when Λ > Λ 0 .
To guarantee K ≥ K j , j = 1, 2, where K = Λ + υΛθ , we introduce
β1 β 2υΛθ −1 (7.2.17)
Λ1 ≡ max{Λ | = 1 + υΛθ −1 , = 1 + υΛθ −1 , Λ > Λ 0 }.
φ1 (Λ ) φ2 (Λ )
It is easy to show the existence of such a positive Λ1 . Adding the two
equations in Eqs. (7.2.14) yields
β1 β 2υΛθ −1 (7.2.18)
Φ * (Λ) ≡ + − 1 − υΛθ −1 = 0,
φ1 (Λ ) φ2 (Λ)
where we use K = K1 + K 2 and K = Λ + υΛθ . As Φ * (Λ 0 )>0 and

Φ * (Λ1 ) < 0, we see that there is at least one positive Λ 0 < Λ < Λ1 such
that Φ * (Λ ) = 0.
 β1 
E = 1 − Λ .
 φ1 (Λ) 
The sign of 1 − β1 / φ1 (Λ ) determines the direction of trade flow. As we

cannot explicitly solve Eq. (7.2.18), it is not easy to explicitly interpret the
economic meanings of the sign.
We have thus shown how to solve the equilibrium problem. The proce-
dure is as follows: Λ by Eq. (7.2.18) → K j by Eqs. (7.2.14) →
K = K1 + K 2 → Y j by Eqs. (7.2.11) → E by Eq. (7.2.10) →
F1 = A1 (K1 + E ) 1 N1β1 → F2 = A2 (K 2 − E ) 2 N 2β 2 → r and w j by Eqs.
α α
(7.2.10) → C j and S j by Eqs. (7.2.16).

We provide the conditions for the uniqueness of equilibrium and for
stability. Summarizing the above discussion, we have the following
lemma.
Lemma 7.2.1
The dynamic system has at least one equilibrium point. In the case of
θ = 1, the system has a unique solution. In the case of θ < 1, if Λ1 ≤ Λ 2 ,
where Λ 2 is the solution of 1 − θ = 1 / φ2 (Λ ), the system has a unique equi-
librium point.5
7.2.3 Some Special Cases
We now examine the trade patterns when the parameters are taken on
some special values. In this section, we assume N1 = N 2 .
Case 1 the identical production function

First, we are concerned with the case that the two countries have identi-
cal production function, i.e., θ = 1. In this case, the system has a unique
equilibrium point. From the definitions of φ1 (Λ ) and φ2 (Λ ) ) in Eqs.
(7.2.15), we see that if δ 1 / λ1 > δ 2 / λ2 , i.e., ξ1 / λ1 > ξ 2 / λ2 , then
φ1 (Λ) > φ2 (Λ ), for any Λ > Λ 0 . We require ξ1 / λ1 > ξ 2 / λ2 in the follow-
ing discussion.
On the other hand, in the case of θ = 1 and N1 = N 2 , we can rewrite
(7.2.18) as
1 1 2 (7.2.19)
+ = ,
φ1 (Λ) φ2 ( Λ) β
5 The stability condition is given in Zhang (2006a: Sect. 8.3).

where we use υ = 1 and β = β1 = β 2 . From φ1 (Λ ) > φ2 (Λ) and Eq.

(7.2.19), we have
2 1 1 2
< + = .
φ1 ( Λ) φ1 (Λ ) φ2 (Λ ) β
Hence, we have 1 / φ1 (Λ) < 1. As K1 = β1Λ / φ1 (Λ), we have K1 / Λ < 1.
With Λ = K1 + E , we conclude that E > 0. In the case of θ = 1 and
υ = 1, Λ ( K ) = K / 2, i.e., K1 + E = K / 2. This implies that K1 < K 2 . As
S j = δ k K j at equilibrium, we have S1 < S 2 . From Eq. (7.2.8), we get
F1 = F2 and w1 = w2 . We have
Y1 − Y2 = − 2rE < 0.
We conclude that Y1 − Y2 is less than zero. It is easy to check that
 δ /λ ρ  δ
C1 − C 2 =  K1 − 2 2 2 K 2  1 − δ k ( K1 − K 2 ) < 0 ,
 δ 1 / λ1 ρ1  λ1 ρ1
where we use
δ 2 / λ2 ρ 2 δ1
< 1, > δk .
δ 1 / λ1 ρ1 λ1 ρ1
Summarizing the above discussion, we have the following corollary.
Corollary 7.2.1
Let θ = 1, N1 = N 2 and ξ1 / λ1 > ξ 2 / λ2 . Then, the system has a unique
equilibrium point at which E > 0, K1 < K 2 , S1 < S 2 , F1 = F2 , w1 = w2 ,
Y1 < Y2 and C1 < C 2 .
The condition, ξ1 / λ1 > ξ 2 / λ2 , implies that country 1 has lower propen-

sity to hold wealth than country 2 . The difference in the preferences de-
termines that country 1 employs country 2' s capital in production even
though the two countries have identical production function and labor
force.
Case 2 the identical preference

Let the two countries have an identical utility function, i.e., ξ1 = ξ 2 and
λ1 = λ2 . We require θ < 1, i.e., β1 < β 2 and α 2 < α1 . From the definition
of υ and Eqs. (7.2.15), we have
α 2φ1 (Λ )
φ2 (Λ ) = ,
α1
for any Λ > Λ 0 . Using this relation and Eq. (7.2.18), we have
β1 β 2υΛθ −1  α1 β 2υΛθ −1  β1
1 + υΛθ −1 = + = 1 + 
φ1 (Λ) φ2 (Λ)  α 2 β1φ2 (Λ )  φ1 (Λ )
β1 (7.2.20)
> (1 + υΛθ −1 ) .
φ1 (Λ )
From (7.2.20), we directly have
φ1 (Λ) > β1 .
We thus have K1 / Λ > 1, i.e., E < 0. Country 1’s capital is employed by
country 2 .
Corollary 7.2.2
Let θ < 1 and ξ1 / λ1 = ξ 2 / λ2 . Then, the system has a unique equilibrium
point at which E > 0.
As θ < 1 implies that the marginal productivity of capital in country 1

is higher than that in country 2 , the conclusion is reasonable under the
condition that the two countries have the identical preference and labor
force.
Similarly, we may examine other cases. For instance, it is easy to check
that if θ < 1 and ξ1 / λ1 > ξ 2 / λ2 , then E < 0. But it is difficult to deter-
mine the sign of E in the case of θ > 1 and ξ1 / λ1 > ξ 2 / λ2 . The above
discussion implies that trade patterns are determined by combinations of
preferences and production functions of various countries. It is difficult to
get general explicit conclusions even when we use simple production and
utility functions.
7.3 A Multi-Country Growth Model with Labor Supply and Capital 255
7.3 A Multi-Country Growth Model with Labor Supply and

Capital
This section extends the model in Sect. 7.2, introducing a few new features
to the analytical framework. We construct a dynamic one-commodity and
multiple-country trade model to examine interdependence between trade
and global growth with sexual division of labor. Over the years there have
been a number of attempts to modify neoclassical consumer theory to deal
with economic issues about endogenous labor supply, family structure,
working hours and the valuation of traveling time with endogenous sexual
division of labor and consumption.6 It has become apparent that gender is
an important macroeconomic variable and that gender relations can affect
national growth and international economic trade. Nevertheless, one might
argue that the contemporary economics has failed to develop analytical
frameworks to properly introduce sexual division of labor into interna-
tional trade models with capital accumulation. Some empirical studies
have been conducted on comparing sexual division of labor and gender
wage gaps among countries.7 For instance, in a study on international
comparison of the gender pay gap in 10 industrialized economies, Blau
and Kahn (1996) examined the role of education and labor skills in influ-
encing the gender gap. Among other important conclusions, they conclude,
for instance, that the US gender gap is higher than in most other countries
like Sweden and Australia mainly because the larger penalty in the US for
those with low skill levels or employed in low-wage sectors. In another
study on gender inequality and economic growth, Seiguido (2000) exam-
ines empirically the determinants of economic growth for a set of semi-
industrialized export economies. The paper shows that gender inequality
which contributes to women’s relatively lower wages was a stimulus to
growth via the effects on exports during 1975-95. Although some empiri-
cal studies have considered gender as an important explanatory variable as
the determinants of economic growth, it may be argued that theoretical re-
search on international trade is seldom concerned with economic growth
and trade with gender. The research presented here is an effort to fill this
lacuna. This section is organized as follows. Section 7.3.1 defines the
multi-country model with endogenous labor supply, sexual division of la-
6 For instance, Becker (1965, 1976, 1981), Chiappori (1988, 1992a, 1992b, 1997),
Browning and Chiappori (1998), Gomme et al. (2001), Campbell and Ludvigson
(2001), Galor and Weil (2000), and Tassel (2004).
7 See, for instance, Becker (1985), Becker et al. (1990), Becker and Tomes
(1986), O’Neill and Polachek (1993), McCall (1998), Lam (1988), Ertürk and Dar-
ity (2000), Persson and Jonung (1997, 1998), and Seiguido (2000).
bor, and capital accumulation. Section 7.3.2 shows that the dynamics of
the world economy with J countries can be described by J -dimensional
differential equations. Section 7.3.3 simulates the motion of the 3-country
world economy. Section 7.3.4 examines the effects of changes in different
countries’ population, productivity, propensities to save and to use leisure
time, and human capital of men and women upon the world economic dy-
namics. Section 7.3.5 concludes the section. It should be remarked that as
we provide a computational procedure for any number of economies and
the production functions in the procedure are in general forms, we can
simulate the world economy with any number of economies with any form
of production functions. It is possible to extend the model in different di-
rections. We may consider that each economy has multiple sectors. There
are heterogeneous types of households in each country. It is straightfor-
ward to develop the model in discrete time. We may analyze behavior of
the model with other forms of production or utility functions.
7.3.1 The Multi-Country Trade Model with Capital Accumulation
The global economic system consists of multiple countries, indexed by

j = 1, ..., J . Only one good is produced in the system. Perfect competi-
tion is assumed to prevail in good markets both within each country and
between the countries, and commodities are traded without any barriers
such as transport costs or tariffs. We assume that there is no migration be-
tween the countries and the labor markets are perfectly competitive within
each country. For simplicity, we assume that country j has N̂ j identical
families. Each family consists of four members - father, mother, son and
daughter. The total population of country j is equal to 4 Nˆ j . It is assumed
that only the adults may work. The young people get educated before they
get married and joint the labor market. We assume that the husband and
wife pass away at the same time. When the parents pass away, the son and
the daughter respectively find their marriage partner and get married. The
properties left by the parents are shared equally among the male and fe-
male children. The children are educated so that they have the same human
capital as their parents. When a new family is formed, the young couple
joins the labor market and has two children. As all the families are identi-
cal, the family structure is invariant over time under these assumptions.
There is sexual division of labor in the family. The children consume
goods and accumulate knowledge through education. The parents do home
work and find job for family’s living.
Let prices be measured in terms of the commodity and the price of the
commodity be unity. We denote interest rates by rj (t ) in the j th country.
In the free trade system, the interest rate is identical throughout the world
economy, i.e., r (t ) = r j (t ). We introduce the following variables:
m  subscript indexes for sex; m = 1 , male, m = 2 , female;

N j (t )  the total labor supply in country j at time t ;
N jm (t )  the total labor supply of sex m in country j ;
T jm (t ) and Tˆjm (t )  the working and leisure time of sex m in country j ;
Fj (t )  country j ’s output;
w jm (t )  the wage rate per unity of working time of sex m in country j .
The labor supplies N jm (t ) and N j (t ) are defined as follows
N jm (t ) = h jmT jm (t )Nˆ j , N j (t ) = N j1 (t ) + N j 2 (t ),
j = 1, L , J , m = 1, 2 ,
where h jm are human capital index of country j ’s sex m . For simplicity
of analysis, we assume that the labor supply of each sex is linearly related
to its working time. Although it is reasonable to assume that the labor sup-
ply may exhibit certain nonlinear relationship with working time (for in-
stance, over-working may reduce productivity per unity of time), we are
only concerned with the above forms. The human capital levels h jm are as-
sumed to be constant.
First, we describe behavior of the production sections. Production sec-
tors use capital and labor. Production sectors sell their product to house-
holds or to other sectors and households sell their labor and assets to pro-
duction sectors. Factor markets work well; factors are inelastically
supplied and the available factors are fully utilized at every moment. Sav-
ing is undertaken only by households, which implies that all earnings of
firms are distributed in the form of payments to factors of production. We
omit the possibility of hoarding of output in the form of non-productive
inventories held by households. All savings volunteered by households are
absorbed by firms. We require savings and investment to be equal at any
point of time. We use production functions to describe the physical facts of
a given technology. We assume that there are only two productive factors,
capital, K j (t ), and labor, N j (t ), at each point of time t . The production
functions are given by
F j (K j (t ), N j (t )), j = 1, L, J ,
where F j (t ) are the output of country j at time t . Assume F j (t ) to be

neoclassical. We have
F j (t ) K j (t )
f j (t ) = f j (k j (t )) , f j (t ) ≡ , k j (t ) ≡ .
N j (t ) N j (t )
ucts, and firms earn zero profits. The rate of interest, r (t ), and wage rates,
w j (t ), are determined by markets. Hence, for any individual firm r (t ) and
w jm (t ) are given at each point of time. The production sector chooses the
two variables, K j (t ) and N j (t ), to maximize its profit. The marginal con-
r + δ kj = f j' (k j ), w jm (t ) = h jm w j (t ), (7.3.1)
where δ kj is the depreciation rate of physical capital in country j and
w j (t ) ≡ f j (k j ) − k j f j' (k j ).
Let kˆ j (t ) stand for the per-family wealth in country j . Country j ’s
per-family current income, y j (t ), from the interest payment, r (t )kˆ j (t ), and
the wage payment, w j1 (t )T j1 (t ) + w j 2 (t )T j 2 (t ), is given by
y j (t ) = rkˆ j + w j1T j1 + w j 2T j 2 = rkˆ j + (h j1T j1 + h j 2T j 2 )w j . (7.3.2)
The per-family disposable income of family j is defined as the sum of

the current income and the wealth available for purchasing consumption
goods and saving
yˆ j (t ) = y j (t ) + kˆ j (t ) =
(1 + r (t ))kˆ j (t ) + w j1 (t )T j1 (t ) + w j 2 (t )T j 2 (t ), j = 1, L , J . (7.3.3)

point of time, a family would distribute the total available budget among
savings s j (t ) and consumption of goods c j (t ). The budget constraint is
given by
c j (t ) + s j (t ) = yˆ j (t ). (7.3.4)
Let T0 denote the total available time. The time constraint requires that
the amounts of time allocated to each specific use add up to the time avail-
able
T jm (t ) + Tˆjm (t ) = T0 , j = 1, L, J , m = 1, 2 . (7.3.5)
Substituting (7.3.5) into the budget constraints (7.3.3) yields

w j1 (t )Tˆj1 (t ) + w j 2 (t )Tˆj 2 (t ) + c j (t ) + s j (t ) = yˆ j (t ) ≡
(1 + r (t ))kˆ j (t ) + h jT0 w j (t ), (7.3.6)
where h j ≡ h j1 + h j 2 .
At each point of time, households decide the four variables subject to
the disposable income. We assume that utility level U j (t ) is dependent on
the leisure times, Tˆj1 (t ) and Tˆj 2 (t ), the consumption level of commodity,
c j (t ), and the savings, s j (t ), as follows
U j (t ) = Tˆj1 j1 (t )Tˆj 2 j 2 (t )c j j (t )s j j (t ),
σ σ ξ λ
σ j1 , σ j 2 , ξ j , λ j > 0 , σ j1 + σ j 2 + ξ j + λ j = 1,
(7.3.7)
where σ j1 , σ j 2 , ξ j and λ j are respectively country j ’s propensities to
use the husband’s leisure time, to use the wife’s leisure time, to consume
goods and services, and to hold wealth. Maximizing U j subject to the
budget constraints (7.3.6) yields
w j1 (t )Tˆj1 (t ) = σ j1 yˆ j (t ), w j 2 (t )Tˆj 2 (t ) = σ j 2 yˆ j (t ), (7.3.8)
c j (t ) = ξ j yˆ j (t ), s j (t ) = λ j yˆ j (t ).
By Eqs. (7.3.1) and (7.3.8), we have

Tˆj1 (t ) σ j1h j 2
= .
Tˆj 2 (t ) σ j 2 h j1
The ratio of the husband and the wife’s leisure time (or home production
time) is positively related to the wife’s level of human capital and the fam-
ily’s propensity to use the husband’s leisure time and negatively related to
the husband’s level of human capital and the family’s propensity to use the
wife’s leisure time. We also see that that the ratio of the husband and the
wife’s leisure time is constant. Evidently, this is due to the specified Cobb-
Douglas form, fixed human capital, and fixed preference parameters. To
explain endogenous changes of time distribution, we may introduce
mechanisms for endogenous changes of human capital or preferences.
According to the definitions of s j (t ), the per-family’s wealth accumula-
tion in country j is given by
& (7.3.9)
kˆ j (t ) = s j (t ) − kˆ j (t ), j = 1, L, J .

J J J
(7.3.10)
K (t ) = ∑ K j (t ) = ∑ k j (t )N j (t ) = ∑ kˆ j (t )Nˆ j ,
j =1 j =1 j =1
where K (t ) is the total capital stock of the world economy.

saving. That is
J
(7.3.11)
C (t ) + S (t ) − K (t ) + ∑ δ kj K j (t ) = F (t ),
j =1
where
J J J
C (t ) ≡ ∑ c j (t )Nˆ j , S (t ) ≡ ∑ s j (t )Nˆ j , F (t ) ≡ ∑ F j (t ) .
j =1 j =1 j =1
We have thus built the model which explains the endogenous capital ac-
cumulation and sexual division of labor, the international distribution of
capital in the world economy in which the domestic markets of each coun-
try are perfectly competitive, international product and capital markets are
freely mobile and labor is internationally immobile.
We now examine trade balances among countries. First, we calculate
( ) ( ) ( )
F j − c j + s j − k j Nˆ j − δ kj K j = r K j − kˆ j Nˆ j = r N j k j − kˆ j Nˆ j ,
where we use
2
c j + s j = rkˆ j + ∑ w jmT jm + kˆ j ,
m =1
F j = (r + δ kj )K j +
2
∑w
m =1
jm T jm Nˆ j .
That is
( ) (
F j = c j + s j − kˆ j Nˆ j + δ kj K j + r k j N j − kˆ j Nˆ j . )
The national output is used for the consumption ( c j Nˆ j ), the net saving
( )
( s j − kˆ j Nˆ j ), the payment for the depreciation of capital employed by the
economy ( δ kj K j ), and the payment for the net foreign capital employed by
( )
the economy ( r k j N j − kˆ j Nˆ j ). If k j N j − kˆ j Nˆ j > (<) 0 , we say that
country j is in trade deficit (trade surplus). If k j N j − kˆ j Nˆ j = 0 , country
j is in trade balance. We introduce variables to measure trade balances
( )
E j (t ) ≡ kˆ j Nˆ j − k j N j , Eˆ j (t ) ≡ kˆ j Nˆ j − k j N j r . (7.3.12)
If Eˆ j (t ) > ( =, <) , we say that country j ’s trade is in surplus (balance,

deficit). We now examine the properties of the system.
7.3.2 The World Economic Dynamics
This section shows that the dynamics of the world economy can be ex-
pressed as J − dimensional differential equations. First, from Eqs. (7.3.1)
we obtain
f j' (k j ) = f1' (k1 ) − δ j , j ≡ 2, L, J , (7.3.13)
where δ j ≡ δ k 1 − δ kj . If f1' (k1 ) − δ j > 0 for all j = 2 , L, J and given

k1 (t ) > 0 , then the equations determine unique relations between k j and
k1 , denoted by
k j = φ j (k1 ), j = 1, L, J , (7.3.14)
where φ1 (k1 ) = k1 . From Eqs. (7.3.13), we have

dk j
f j" (k j ) = f1" (k1 ), j = 2 , L, J .
dk1
As f j" (k j ) ≤ 0 , j = 1, L, J , we see that dk j / dk1 ≥ 0 , j = 2 , L, J . That

is, φ j' (k1 ) ≥ 0 . Hence, for any given k1 (t ) > 0 , we uniquely determine
k j (t ), j = 2 , L, J as unique functions of k1 (t ). From Eqs. (7.3.1), we de-
termine the wage rates as functions of k1 (t ) as follows
w jm (t ) = φˆ jm (k1 ) ≡ h jmφˆ j (k1 ), j = 1, L, J , (7.3.15)
where
φˆ j (k1 ) ≡ f j (φ j (k1 )) − φ j (k1 ) f j' (φ j (k1 )).
By r + δ kj = f j' (k j ) in (7.3.1), we also express r (t ) as a function of

k1 (t ) as
r (t ) = φˆ0 (k1 ) ≡ f1' (k1 ) − δ k 1 . (7.3.16)
Insert (7.3.15) and (7.3.16) into (7.3.6)
( )
yˆ j (t ) = 1 + φˆ0 (k1 ) kˆ j (t ) + h jT0φˆ j (k1 ), j = 1, L, J . (7.3.17)
We see that yˆ j (t ) can be expressed as functions of kˆ j (t ) and k1 (t ). Sub-

stituting (7.3.17) into w jmTˆjm = σ jm yˆ jm yields
( )
T jm (t ) = Λ jm k1 , kˆ j ≡ σˆ jm −
(
1 + φˆ0 (k1 ) σ jm ˆ
kj ,
)
φˆ (k ) jm 1 (7.3.18)
j = 1, L, J , m = 1, 2 ,
where we use Eqs. (7.3.1) and (7.3.5) and
  φˆ j1 + φˆ j 2  
σˆ jm ≡ 1 −  σ T .
  φˆ  jm
 0
  jm  
The variables σˆ jm are constant. For gender m to work outside, we
should require σˆ jm > 0 . For illustration, let m = 2 . Then
  h j1  
σˆ j 2 = 1 − 1 + σ j 2 T0 .
  h j 2  
 
If
1 h j1
−1≤ ,
σ j2 hj2
then country j ’s women will not work outside irrespective of the family’s
economic conditions. As we are interested in sexual division of labor in the
world, we require
1 h jm '
−1> , m , m' = 1, 2 , m ≠ m' , j = 1, L, J .
σ jm h jm
This means that any gender in any country may work outside. By Eqs.
(7.3.18), we can express T (t ) as functions of kˆ (t ) and k (t ) as well.
jm j 1
We can rewrite Eq. (7.3.10) as

J 2 J
∑ k (t )Nˆ ∑ h
j =1
j j
m =1
jm T jm (t ) = ∑ kˆ j (t )Nˆ j .
j =1
Insert (7.3.14) and (7.3.18) into the above equation, we solve kˆ1 (t ) as
( { }) σ k
kˆ1 (t ) = Λ k1 , kˆ ≡ 0 1 −
Λ 0 (k1 )
1 
( ) ,
J 2
∑ n j kˆ j − φ j (k1 )∑ h jm Λ jm k1 , kˆ j
Λ 0 (k1 ) j = 2  m =1 (7.3.19)
{ } (
where kˆ(t ) ≡ kˆ2 (t ), L, kˆJ (t ) and )
Λ 0 (k1 ) ≡ 1 + (σ 11 + σ 12 ) 1 + φˆ0 (k1 ) ( )φˆ k(k ) ,
1
1 1
Nˆ j
σ 0 ≡ h11σˆ11 + h12σˆ12 , n j ≡ , j = 1, L , J .
Nˆ 1
We see that country 1’s per-family wealth kˆ1 (t ) can be expressed as a

unique function of country 1’s capital intensity and the other countries’
{ }
per-family wealth k̂ (t ) at any point of time. By Eqs. (7.3.17)-(7.3.19), we
see that yˆ j (t ) can be expressed as functions of k̂ (t ) and k1 (t ). It is { }
straightforward to show that all the variables can be expressed as functions
{ }
of k̂ (t ) and k1 (t ). We now show that the dynamics of the world economy
can be described by J -dimensional differential equations.
First, substitute s j (t ) = λ j yˆ j (t ) in (7.3.8) and (7.3.17) into the wealth
accumulation Eqs. (7.3.9)
&
( )
kˆ1 = λ1 − 1 + λ1φˆ0 (k1 ) kˆ1 + λ1h1T0φˆ1 (k1 ),
(7.3.20)
&
1( { }) (
ˆ k , kˆ ≡ λ − 1 + λ φˆ (k ) kˆ + λ h T φˆ (k ),
kˆ j = Λ j j j 0 1 j j j 0 j 1 )
j = 2, L, J . (7.3.21)
The right-hand sides of Eqs. (7.3.20) and (7.3.21) are functions of
{k̂ (t )} and k (t ).
1
Insert Eq. (7.3.19) into Eq. (7.3.20)

& ~
( { }) ( ) ( { })
kˆ1 = Λ1 k1 , kˆ ≡ λ1 − 1 + λ1φˆ0 (k1 ) Λ k1 , kˆ + λ1h1T0φˆ1 (k1 ).
(7.3.22)
Taking derivatives of Eq. (7.3.19) with respect to t yields

(7.2.23)
&  Λ jm 
( { })
J 2
&
Ψ k1 , kˆ k&1 = Λ 0 kˆ1 + ∑ n j kˆ j 1 − φ j (k1 )∑ h jm ,
j =2  m =1 ∂kˆ j 
in which Λ'0 and φ j' are derivatives of the functions Λ 0 and φ j with re-
spect to k1 and
( { })  ∂Λ jm 
J 2 2
Ψ k1 , kˆ ≡ σ 0 − ΛΛ'0 + ∑ φ ∑ h '
j jm Λ jm + φ j ∑ h jm n j .
∂k1 
j =2  m =1 m =1
We will not explicitly express these derivatives and partial derivatives

as they are straightforward to obtain but their expressions are tedious. In-
serting Eqs. (7.3.21) and (7.3.22) in Eq. (7.3.23), we get
~
( { })
Λ Λ k , kˆ
k&1 = 0 1 1 +
( { })
Ψ k1 , kˆ
1
(k , {kˆ})1 − φ (k )∑ h Λ jm 
J 2
Ψ (k , {kˆ})
∑ n Λˆ j j 1 j 1 jm .
∂k j 
(3.3.24)
1 j =2  m =1
{ }
We see that k&1 is a function of k1 (t ) and kˆ(t ) . In summary, we obtain
the following lemma.
Lemma 7.3.1
The dynamics of the world economy is given by the J − dimensional dif-
ferential Eqs. (7.3.21) and (7.3.24) with k (t ) and kˆ (t ), j = 2, L , J , as
1 j
the variables. For any given positive values of k1 (t ) and k j (t ) at any point
of time, all the other variables are uniquely determined by the following
procedure: kˆ1 (t ) by (7.3.19) → k j (t ), j = 2, L , J j = 2 　
, L, J by
~
(7.3.14) → T jm (t ) by (7.3.18) → Tˆjm (t ) T jm (t ) = T0 − T jm (t ) →
f j (t ) = f j (k j ) → r (t ) and w jm (t ) by (7.3.1) → yˆ j (t ) by (7.3.17) →
c j (t ) s j (t ) N j (t ) = ∑m h jm Nˆ jT jm (t ) →
2
and by (7.3.8) →
K j (t ) = k j (t )N j (t ) → F j (t ) = N j (t ) f j (t ) .
Although we may analyze behavior of the J − dimensional differential

equations, it is difficult to explicitly interpret results. Following the com-
puting procedure given in Lemma 7.3.1, we simulate the model to illus-
trate motion of the system.
7.3.3 Simulating 3-Country Model with the Cobb-Douglas

Production Functions
For illustration, we will follow the procedure given in Lemma 7.3.1 to

simulate motion of the trade system. We specify the production functions
as follows
F j (t ) = A j K j j (t )N j j (t ), α j + β j = 1, α j , β j > 0 , (7.3.25)
α β
where A j are country j ’s productivity and α j are positive parameters.

α
From f j = A j k j j , and Eqs. (7.3.13) and (7.3.14), we have
−1 / β j
 α 1 A1k1− β1 − δ j 
k j (t ) = φ j (k1 ) ≡   , j = 2 , L, J .
 α j Aj  (7.3.26)
 
It is straightforward to obtain
w jm (t ) = φˆjm (k1 ) = h jm β j A jφ j j (k1 ),
α
r (t ) = φˆ0 (k1 ) = α1 A1k1− β1 − δ k 1 . (7.3.27)
&
An equilibrium point is given by setting k&1 = 0 and kˆ j = 0 . By Eqs.
(7.3.22) and (7.3.23), an equilibrium point is given by
(λ 1 ) ( { })
− 1 + λ1φˆ0 (k1 ) Λ k1 , kˆ + λ1h1T0φˆ1 (k1 ) = 0 , (7.3.28)
(λ j )
− 1 + λ jφˆ0 (k1 ) kˆ j + λ j h jT0φˆ j (k1 ) = 0, j = 2, L, J . (7.3.29)
From (7.3.29), we solve
− λ j h jT0φˆ j (k1 ) (7.3.30)

kˆ j = , j = 2, L, J .
λ j − 1 + λ jφˆ0 (k1 )
We thus can consider kˆ j , j = 2 , L , J as functions of k1 . From

(7.3.18), (7.3.19) and (7.3.30), we have
σ 0 k1 1 J 2
Λ(k1 ) = + ∑ n jφ j (k1 )∑ h jmσˆ jm −
Λ 0 (k1 ) Λ 0 (k1 ) j =2 m=1
1 J 
1 + φ j (k1 )∑
(
2 1 + φˆ (k ) h σ )  (7.3.31)
∑
Λ 0 (k1 ) j =2 
0 1
φˆjm (k1 )
jm jm
n j kˆ j .
m=1

As Λ is a function of k1 , from (7.3.27) we see that an equilibrium

value of k1 is determined as a positive solution of the following equation
( )
Ω(k1 ) ≡ λ1 − 1 + λ1φˆ0 (k1 ) Λ(k1 ) + λ1h1T0φˆ1 (k1 ) = 0 . (7.3.32)
Equation (7.3.32) determines the equilibrium value of k1 and Eqs.

(7.3.29) determine the equilibrium values of kˆ j , j = 2 , L, J . Equilib-
rium values of the other variables are determined by following the proce-
dure in Lemma 7.3.1.
To simulate the model, we specify the parameter values as follows
 A1   8   Nˆ 1   2   α 1  1 / 3   δ k 1   0.07 
               
 A2  =  4 ,  Nˆ 2  =  3 ,  α 2  =  0.3 ,  δ k 2  =  0.06  ,
 A  1  ˆ     α   0 .3   δ   0.05 
 3    N 3  10   3    k3   
 h11   8   h12   5   λ1   0.58   σ 11   0.13 

               
 h21  =  5 ,  h22  =  3 ,  λ2  =  0.48  ,  σ 21  =  0.13  ,
 h   3  h   2  λ   0 .4   σ   0.18 
 31     32     3    31   
 σ 21   0.13 
   
 σ 22  =  0.15  , T0 = 1.
 σ   0.2 
 32   
Country 1 has the highest level of productivity and highest propensity to
save. Its population size is smallest. Country 2 ’s level of productivity is
the second, next to country 1 ’s. Its propensity to save is higher than coun-
try 3 but lower than country 1. Country 3 has the largest population and
the lowest levels of productivity and propensity to save. Its propensity to
use leisure is the highest. For convenience, we call countries 1, 2 , and 3
respectively as developed, industrializing and developing economies. The
developing country’s man has the highest propensity to stay at home and
the men of the developed and industrialized economies have the same level
of the propensity to stay at home. The developing country’s women have
the highest propensity to work at home and the industrializing economy’s
women has higher propensity to stay at home than the developed econ-
omy’s. The human capital level of the developed economy’s men is high-
est; the next are the human capital levels of the industrializing economy’s
men and the developed economy’s women. The developing economy’s
women has the lowest human capital level.
We now show that the dynamic system has a unique equilibrium point.
As λ j + ξ j + σ j1 + σ j 2 = 1, we have
ξ1 = 0.16, ξ 2 = 0.24, ξ 3 = 0.22 .

The developed economy’s propensity to consume is lowest and the in-
dustrializing country’s propensity to consume is highest.
To find out equilibrium points, we need to solve the equation

Ω(k1 ) = 0 . We plot the function Ω(k1 ) as in Fig. 7.3.1. The equation,
Ω(k1 ) = 0 , has three positive solutions
k1 = 1.28 , k1 = 2.12 , k1 = 49.24 .
It can be shown that only the equilibrium point, k1 = 49.24 , is meaning-

ful, as the rest two solutions are not meaningful in the sense that per-
family wealth of some country(s) becomes negative. Hence, the equation,
Ω(k1 ) = 0 , has a unique meaningful solution k1 = 49.24 .
Ω(k1 ) Ω(k1 )
200
40
150
100 30
50 20
2 4 6 8 10 12 14 k1 10
-50
-100
k1
30 40 50
a) multiple solutions for 0 ≤ k1 ≤ 15 b) a unique solution for k1 ≥ 15
Fig. 7.3.1. The existence of positive solutions of Ω(k1 ) = 0
By Eqs. (7.3.30), we solve the equilibrium values of kˆ j . Following {}

Lemma 7.3.1, we get the equilibrium values of all the other variables. We
list the simulation results as follows
 f1  19.31  k1   49.24   c1   53.04 
           
r = 0.048 ,  f 2  =  6.93  ,  k 2  =  16.28 ,  c2  =  13.49  ,
 f   1.56   k   3.77   c   1.22 
 3    3    3  
 F1  169.39   C1  106.07   Kˆ 1   519.60 

           
 F2  =  72.62  ,  C 2  =  40.50  ,  Kˆ 2  =  112.39  ,
 F   26.91   C   12.18   ˆ   
 3    3    K 3   35.71 
 w11  108.15   Tˆ11   0.54  (7.3.33)

       
 w12   67.60   Tˆ12   0.86 
ˆ    kˆ1   259.80 
 w   24.25      
 21  =  ,  T21  =  0.42  ,  kˆ2  =  37.46  ,
 w22   14.55   Tˆ22   0.81  ˆ  
    ˆ     k3   3.57 
 
 w31   3.11   T31   0.51 
 w   2.08   Tˆ   0.86 
 32     32   
where Kˆ j ≡ kˆ j Nˆ j . We see that the per-family levels of wealth and con-

sumption and wage rate in the developed economy are much higher than
the corresponding variables in the developing economy. The differences
result from the developed country’s higher levels of productivity and hu-
man capital and high propensity to save. The women of the developed and
developing economies have the longest leisure time and the men of the in-
dustrializing economy work the longest hours. The developed economy’s
men do not work many hours as the industrializing economy’s men, but
more hours than the developing economy’s men. The women of the indus-
trializing economy also work more hours than the women of the other two
economies.
The global income and wealth distribution of the world economies is
given by
) ) )
 N1   13.3%   F1   63.0%   W1   63.3% 
)    )     )   
 N 2  =  20%  ,  F2  =  27.0%  , W2  =  27.1%  ,
 )  
N 66. 7 %   F)   10.0%   W)   9.6% 
  3    3    3  
) )
 C1   66.6%   Kˆ 
)    ) 1   77.8% 
 Kˆ  =  16.8%  ,
 C 2  =  25.5%  ,
 )    )2   
 K 3   5.4% 
ˆ 
 C3   7.7%    (7.3.34)
)
where a variable x j with circumflex, x j , denotes country j ’s share of the
corresponding variable in the world economy. The developed economy’s
share of the world population is 13.3% , the industrializing economy’s
share of the world population is 20% , and that of the developing econ-
omy is 66.7% . Irrespective of its small population size, the global shares
of the output, wage income, consumption and wealth of the developed
economy are respectively 63.0% , 63.3% , 66.6% , and 77.8% . The de-
veloping economy has 66.7% of the world population, its global shares of
the output, wage income, consumption and wealth are respectively only
10% , 9.6% , 7.7% , and 5.4% .
We calculate the national trade balances at equilibrium as follows
 E1   87.72   Eˆ1   4.18 

       
 E2  =  − 58.27  ,  Eˆ 2  =  − 2.78  . (7.3.35)
 E   − 29.45   ˆ   
 3    E3   − 1.40 
We see that the industrializing and developing economies are in trade
deficit and the developed country is in trade surplus.
We just examined the equilibrium structure of the global economy. It is
important to follow the motion of the global economy when it starts from a
state far away from equilibrium. As we have shown by Lemma 7.3.1 how
to follow the dynamic processes, it is straightforward to simulation the mo-
tion. We simulate the model with the parameter values specified as in
(7.3.33) and the following initial conditions
k1 (0) = 45 , kˆ2 (0) = 40 , kˆ3 (0) = 2 . (7.3.36)
The simulation results are plotted in Fig. 7.3.2. We observe that the
variables approach to their equilibrium values in the long term. Depending
on the initial conditions, these variables may experience different paths of
economic development. We now examine how changes in he parameters
will affect paths of economic development and equilibrium values of the
variables.
7.3.4 Comparative Dynamic Analysis of the 3-Country Model
First, we examine the case that all the parameters, except the developed
economy’s productivity, A1 , are the same as in (7.3.33). We increase the
productivity level, A1 , from 6 to 7 . The simulation results are demon-
strated in Fig. 7.3.3. In the plots, a variable ∆x j (t ) stand for the change
rate of the variable x j (t ) in percentage due to changes in the parameter
value from A10 ( = 6 in this case) to A1 ( = 7 ). That is
0.055
15 f1 0.054
0.053
10 0.052 r
0.051
5 f2 5 10 15 20
t
f3 0.049
t 0.048
5 10 15 20
a) the per-work-time output b) the rate of interest
250
100 w11 k̂1
80 200
60 w12 150
40 100
w21 50 k̂2
20 w22
w31 t t
5 10w32 15 20 5 k̂3 10 15 20
c) the wage rates d) the per-family wealth
Tˆ12 50 c1
0.8
Tˆ Tˆ22
40
32
0.7 30
0.6 20
Tˆ11
t 10 c2
Tˆ31 5 10 Tˆ 15
21
20
5 10
c3 15 20
t
e) the leisure time f) the per-family consumption levels
0.6 )
4 F1
0.5
Ê1
2 0.4
0.3
t
)
5 10 15 20 0.2 F2
-2 Ê3 0.1 )
Ê2 F3 t
5 10 15 20
g) the trade balances h) the shares of global product

Fig. 7.3.2. The motion of the global economy
x j (t ; A1 ) − x j (t ; A10 ) (7.3.37)
∆x j (t ) ≡ × 100 ,
x j (t ; A10 )
where x j (t ; A1 ) stands for the value of the variable x j with the parameter
value A1 at time t and x j (t ; A10 ) stands for the value of the variable x j
with the parameter value A10 at time t . We will use the symbol ∆ with
the same meaning when we analyze other parameters.
From Fig. 7.3.3a, we see that the per-work-time output level in the de-
veloped economy rises over time; the per-work-time output levels of the
other two economies fall down initially but rise after a few periods of time.
In the new equilibrium all the per-work-time output levels rise due to the
improved productivity. As demonstrated in Fig. 7.3.3b, the rate of interest
falls. The wage rate of the developed economy is increased all the time;
the wage rates in the other two economies fall down initially and raise in
the long term. In the new equilibrium, all the wage rates are increased. The
per-family wealth of the developed economy rises. The per-family wealth
levels of the other two economies are slightly affected by the developed
economy’s productivity improvement in the long term. The consumption
exhibits a similar change pattern to that of wealth. Figure 7.3.3e shows that
the leisure times in the developing and industrializing economies initially
increase and then slightly fall down. The leisure times of men and women
in the developed economy fall. From Fig. 7.3.3g, we note that the devel-
oped economy’s trade balance deteriorates first and then becomes im-
proved. The industrializing economy’s trade balance improves initially and
deteriorates later on. The developing economy’s trade balance is slightly
affected. The developed economy’s share of the global output is increased
and the other countries’ shares decline.
We illustrate the effects of change in the developing economy’s produc-
tivity in Fig. 7.3.4. The per-work-time output level in the developing econ-
omy rises over time; the per-work-time output levels of the other two
economies fall down slightly. The rate of interest rises. The wage rate of
the developing economy rises; the wage rates in the other two economies
fall down. The per-family wealth level of the developing economy is in-
creased; the per-family wealth level of the developed economy rises tem-
porarily and then falls down; the industrializing economy’s per-family
wealth falls slightly. The consumption exhibits a similar change pattern to
that of the wealth. Figure 7.3.4g shows that the leisure times in the devel-
oped and industrializing economies rise and the leisure times of the devel-
oping economy falls initially and then rises slightly. Figure 7.3.4e shows
that both the developed and the industrializing economies’ trade balances
improve; the developing economy’s trade balance deteriorates as its pro-

ductivity is improved. In Fig. 7.3.5, we further demonstrate that the living
conditions in terms of the per-family wages, consumption levels, and
wealth lose as the developing economy improves its productivity.
25
20
∆ f1 30
15
20
10
5 10 ∆r
∆f 2 t
5 10 15 20 t
-5 ∆f 3 5 10 15 20
25 ∆w1 25
20 20
15 ∆k̂1
15
10
10
5
5
∆w2 t
-5 ∆w3
5 10 15 20
∆k̂ 2 5 10 15 20
t
∆k̂3
4 25
20
2
∆Th 2 ∆c1
t 15
5 10 15 20
-2 ∆Th3 10
-4 5
-6 ∆Th1 ∆c2 t
5 10 ∆c3 15 20
60 10 )
∆Ê240 ∆F1
t
20 5 10 15 20
∆Ê3 -10 )
t ∆F3
10 15 20 )
∆Ê1 -20 -20 ∆F2
Fig. 7.3.3. The developed economy increases its productivity ( A1 : 6 ⇒ 7 )

175 12
150 ∆f 3
10
125
8
100
6
∆r
75
50 4
25 2
∆f1 , ∆f 2 t t
5 10 15 20 5 10 15 20
175 175
150
∆w3 150 ∆k̂3
125 125
100 100
75 75
50 50
25 ∆w1 , ∆w2 25 ∆k̂1
t t
5 10 15 20 ∆k̂ 2 5 10 15 20

175
∆c3
∆Tˆ11 , ∆Tˆ12
10 150
5 125
t 100
∆-5Tˆ21 , ∆Tˆ225 10 15 20
75
-10 50
-15 ∆Tˆ31 , ∆Tˆ32 25 ∆c1
t
5 ∆c2 10 15 20
200
)
∆Ê1 100 ∆F3
150
t
∆Ê2 10 15 20 100
-100
50
)
-200
∆Ê3 ∆F2 t
)5 10 15 20
-300 ∆F1
Fig. 7.3.4. The developing economy increases its productivity ( A3 : 1 ⇒ 2 )

20 12
t
5 10 15 20 15 10
-0.5 8
-1 10 ∆k̂1 6
5
4 ∆c1
-1.5 ∆w21 , ∆w22 2
-2 ∆w11 , ∆w12 5 ∆k̂ 210 15 20
t
5 ∆c210 15 20
t
a) the wage rates b) the wealth level c) the consumption levels
Fig. 7.3.5. The richer economies lose in the long term ( A3 : 1 ⇒ 2 )
We now allow the developed economy’s propensity to save to change.

For λ j + ξ j + σ j1 + σ j 2 = 1 to hold, we specify the following preference
changes as follows:
∆λ j (7.3.38)
∆σ j1 = ∆σ j 2 = ∆ξ j = − ,
3
where ∆ stands for the amount of change. We limit our comparative dy-
namic analysis to the above patterns of preference change. Indeed, it is im-
portant to examine different patterns of preference changes. The effects of
an increase in the developed economy’s propensity to save are plotted in
Fig. 7.3.6. The per-work-time output levels of all the three economies rise
over time. Also the wage rates and per-family wealth levels of the three
economies all rise. The per-family consumption levels of the three econo-
mies rise. The leisure times of all the groups are reduced. Figure 7.3.6g
shows that both the developed economy’s trade balance improves; the in-
dustrializing and developing economies’ trade balances deteriorate. We
conclude that an increase in the developed economy’s propensity to save
will benefit the developing economy, except that the workers of the devel-
oping economy work longer hours.
We illustrate the effects of change in the developing economy’s propen-
sity to change in Fig. 7.3.7. The per-work-time output levels and wage
rates of the three economies are increased. The rate of interest falls. The
developing economy’s per-family wealth level rises and the other two
economies’ per-family wealth levels are slightly affected. The leisure
times of men and women in the developing economy fall first and then
rise. The industrializing economy’s trade balance deteriorates. The devel-
oped economy’s trade balance improves first and then deteriorates. The
developing economy’s trade balance deteriorates first and then improves.
The share of the developing economy’s output in the global economy rises
first and then actually falls down.
∆ f1 t
1
∆f 3 5 10 15 20
-1
0.8
∆f 2 -2
0.6
-3
0.4
-4
0.2
-5
∆r
t
5 10 15 20 -6
∆w11 , ∆w12 5
1
0.8
4 ∆k̂1
∆w31 , ∆w32
0.6 3
0.4 ∆w21 , ∆w22 2
0.2 1 ∆k̂3
5 10 15 20
t ∆k̂ 2 t
5 10 15 20
t 2
5 10 ∆Tˆ3115
, ∆Tˆ32 20
-0.2
1.5 ∆c1
-0.4 ∆Tˆ21 , ∆Tˆ22
-0.6 1 ∆c3
-0.8
0.5
-1 ∆c 2
-1.2 ∆Tˆ11 , ∆Tˆ12 t
5 10 15 20
2
∆Ê1 )
0.5
1 ∆F1
t
) t
10 15 20 5 ∆ F 10 )
15 20
3
-1
-0.5 ∆F2
∆Ê3
-1
-2
-1.5
-3
∆Ê2
Fig. 7.3.6. The developed economy increases its propensity to save
0.4
∆f 3 t
∆ f1 ∆f 2 5 10 15 20
0.3 -0.5
0.2 -1
0.1
-1.5 ∆r
-2
t
5 10 15 20
0.4 ∆w31 , ∆w32

20 ∆k̂3
∆w11 ,
0.3 ∆w12 ∆w21 , ∆w22
15
0.2
10
0.1 5
∆k̂1
t t
5 10 15 20 ∆k̂ 2 5 10 15 20
∆Tˆ11 , ∆Tˆ12 ∆Tˆ21 , ∆Tˆ22

5 10 15 20
t
6 ∆c3
-2 ∆Tˆ32
4
-4
2
-6 ∆T̂31 ∆c1
t
5 10 15 20
-8
-2
∆c2
25 8
20
∆Ê3
6 )
15 ∆F3
10 4
5 2)
∆Ê210 15 20
t
∆F2 t
-5 ) 5 10 15 20
∆Ê1 ∆F1
Fig. 7.3.7. The developing economy increases its propensity to save
We now examine effects of change in different countries’ population.

First, we allow the developed economy’s population to rise. The effects are
illustrated as in Fig. 7.3.8. The per-work-time output levels and the wage
rates in the three economies are increased. The rate of interest falls down.
The per-family wealth of the developed economy falls down initially and
then rises permanently; the per-family wealth levels of the industrializing
and developing economies rise. The consumption exhibits a similar change
pattern to that of wealth. Figure 7.3.4e shows that the leisure times of all
the groups in the global economy are reduced. The developed economy’s
trade balance improves, the other two economies’ trade balances deterio-
rate. The share of the developed economy’s output in the global economy
rises and the shares of the other two economies fall.
We illustrate the effects of change in the developing economy’s popula-
tion as in Fig. 7.3.9. We see that the world economy suffers with regard to
the economic variables (except the leisure times) in per-family terms as the
developing economy increases its population.
We now examine effects of change in the human capital level of the
women in the developed economy. The effects are illustrated as in Fig.
7.3.10. The per-work-time output levels of the three economies are in-
creased. The wage rate of the developed economy’s women is greatly in-
creased and the other groups’ wage rates are affected only slightly. The
rate of interest falls down. The per-family wealth of the developed econ-
omy rises and the other economies’ per-family wealth levels rise slightly.
The leisure time of the developed economy’s men rises and that of the
women falls. The leisure times of men and women in the other economies
are only slightly affected. The consumption exhibits a similar change pat-
tern to that of wealth. The developed economy’s trade balance improves;
the other two economies’ trade balances deteriorate. The shares of the de-
veloped and developing economies’ outputs in the global economy rise
and the share of the industrializing economy falls.
We now allow the human capital level of the developing economy’s
men to rise. The effects are illustrated as in Fig. 7.3.11. The per-work-time
output levels of the three economies are reduced. The rate of interest rises.
The wage rate of the developing economy’s men is increased and the other
groups’ wage rates are affected only slightly. The per-family wealth of the
developing economy rises and the other economies’ per-family wealth lev-
els change slightly. The leisure time of the developing economy’s men
falls and that of the women rises. The leisure times of men and women in
the other economies are only slightly affected.
Finally, we examine effects of changes in the propensities to use leisure
time. For illustration, We require
∆σ j1 = − ∆σ j 2 , ∆ξ j = ∆λ j = 0
0.35 ∆ f1 5 10 15 20
t
0.3
0.25 ∆f 3 ∆f 2 -0.5
0.2
-1
0.15
0.1 -1.5
0.05 ∆r
t -2
5 10 15 20
0.35 ∆w31 , ∆w32 ∆k̂3

0.3
∆w11 , ∆w12 0.2
0.25 ∆k̂ 2 t
∆w21 , ∆w22 5 10 15 20
0.2 -0.2
0.15
-0.4 ∆k̂1
0.1
0.05 -0.6
t -0.8
5 10 15 20
t
5 10 ∆Tˆ , 15∆Tˆ32 20 0.2 ∆c3
31
-0.1 ∆c2
∆Tˆ21 , ∆Tˆ22 t
-0.2 5 10 15 20
-0.3 -0.2 ∆c1
-0.4 ∆Tˆ11 , ∆Tˆ12
-0.4
-0.5
0.75 4
∆Ê1 )
0.5 2 ∆F1
0.25
t t
10 15 20 5 10 15 20
-0.25 -2
-0.5 ∆Ê3 -4
-0.75 ) )
-1 ∆Ê2 -6 ∆F2 , ∆F3

Fig. 7.3.8. The developed economy’s population rises
t
5 10 15 20
0.6
-0.02
∆r
-0.04
-0.06 0.4
-0.08
0.2
-0.1 ∆f 2
-0.12 ∆f1 t
∆f 3 5 10 15 20
t 0.6
5 10 15 20
-0.02 0.5
-0.04 0.4
-0.06 0.3 ∆k̂1
-0.08 0.2
∆w11 , ∆w12 0.1
-0.1 ∆w21 , ∆w22 ∆k̂1 t
-0.12 5 10 15 20
∆w31 , ∆w32 -0.1
∆k̂3
0.35
0.3 0.3
∆Tˆ11 , ∆Tˆ12
0.25
0.2
0.2
∆c1
0.15 0.1
0.1
∆Tˆ21 , ∆Tˆ22 5∆c2
t
0.05 10 15 20
∆Tˆ31 , ∆Tˆ32 t -0.1
5 10 15 20 ∆c3
5
∆Ê1 8 )
2.5 ∆F3
6
10∆ Ê2
t
15 20
-2.5 4
-5 2
)
-7.5 ∆F2 t
-10 ∆Ê3 ) 5 10 15 20
∆F1
Fig. 7.3.9. The developing economy’s population rises
0.15 ∆f1 5 10 15 20
t
0.125
∆f 3 ∆f 2 -0.2
0.1
-0.4
0.075
0.05 -0.6
∆r
0.025
-0.8
t
5 10 15 20
20
∆w12 ∆k̂1
15 6
10 4
5 2
∆w11 , ∆w21 , ∆w22 , ∆w31 , ∆w32 ∆kˆ2 , ∆kˆ3
t t
5 10 15 20 5 10 15 20
7.5 ∆c1
5 ∆T̂11 6
2.5
t 4
5 10 15 20
-2.5 ∆Tˆ21 , ∆Tˆ22 , ∆Tˆ31 , ∆Tˆ32
-5 2
-7.5
-10 ∆T̂12 ∆c2 , ∆c3 t
5 10 15 20
4 )
5 ∆F3
2.5 2 )
∆Ê1 ∆F1
t t
10 15 20
-2.5 ∆Ê2 5 10 15 20
-2
-5
-7.5 -4 )
∆Ê3 ∆F2
-10 -6

Fig. 7.3.10. Women’s human capital is improved in the developed economy
t
5 10 15 20 2
-0.1
1.5 ∆r
-0.2 1
-0.3 0.5
-0.4 ∆f1
∆f 3 t
∆f 2 5 10 15 20

20
30 ∆w31 ∆k̂3
25 15
20
15 10
10
5
5
∆w11 , ∆w12 , ∆w21 , ∆w22 , ∆w32 ∆k̂1
t t
5 10 15 20 5 ∆k̂ 2 10 15 20
20 20
15 ∆c3
10 ∆Tˆ32 15
5 ∆Tˆ11 , ∆Tˆ12 10
t
∆Tˆ21 , ∆Tˆ22
5 10 15 20
-5 5
-10
-15 ∆T̂31 ∆c2 t
∆c15 10 15 20
20
10 ∆Ê1 30
)
t 20
∆F3
10 15 20
∆Ê-10
2
-20 10
-30 )
-40 ∆)F25 10 15 20
t
∆Ê3 ∆F1
Fig. 7.3.11. Men’s human capital is improved in the developing economy
This implies that if men’s propensity to use leisure rises in a country,

then the women’s propensity to use leisure will be reduced the same
amount, and vice versa. We allow the women’s propensity to use leisure
time to fall in the developed economy. The effects are illustrated as in Fig.
7.3. 12. The per-work-time output levels and wage rates of the three
economies are increased. The rate of interest falls. The per-family wealth
and consumption levels are all reduced in the long time. The women’s lei-
sure time in the developed economy is reduced and that of the men is in-
creased. The leisure times of the other groups in the global economy are
slightly affected. The developed economy’s trade balance improves; the
other two economies’ trade balances deteriorate. The shares of the devel-
oped and industrializing economies’ outputs in the global economy fall
and the share of the developing economy rises.
t
-0.02
5 10 15 20
0.6
∆r
-0.04
-0.06 0.4
-0.08
-0.1 ∆f1 0.2
-0.12 ∆f 2
∆f 3 5 10 15 20
t
t 0.6
5 10 15 20
-0.02 0.5
-0.04 0.4
-0.06 0.3 ∆k̂1
-0.08 0.2
-0.1 ∆w , ∆w12 0.1
11
-0.12 ∆w21 , ∆w22 5∆k̂ 2 10 15 20
t
∆w31 , ∆w32 -0.1
∆k̂3
7.5
5 ∆T̂11 0.3
2.5 0.2
∆5Tˆ21 , ∆10Tˆ22 , ∆15
Tˆ31 , ∆T20
ˆ t
32 0.1 ∆c1
-2.5
t
-5
∆5c2 10 15 20
-7.5 ∆T̂12 -0.1
∆c3
5 )
2.5
∆Ê1 8
∆F3
6
t
-2.5
10 ∆Ê2 15 20
4
-5 2 )
∆F2
-7.5 t
∆Ê3 ) 5 10 15 20
-10
∆F1
Fig.7.3.12. Women’s propensity to use leisure time is reduced in the developed
8 Growth, Trade Patten and Structure
The two-by-two H-O model has been a fundamental general framework in

trade theory for a long time. As demonstrated in Chap. 2, it is difficult to
analyze behavior of the static H-O model even with Cobb-Douglas produc-
tion and utility functions. The current state of the literature is described by
Doi et al. (2007: 390-1) as follows: “Innumberable articles and volumes
have been published to extend the O-H model to various directions in such
a way that many important realistic issues like increasing returns, external-
ities, market imperfections, non-traded goods and trade policies … are in-
corporated into it. However, there are only few contributions that extend
the H-O model to explain the pattern of trade and the long-run world
growth rate jointly in an unified framework.”1 Indeed, formal trade theory
has not succeeded in handling with issues related to growth and economic
structures. The one-sector trade model is not sufficient to study dynamic
processes of division of labor and interdependence between division of la-
bor, knowledge and efficiency. It is necessary to extend the one-sector
economy into multiple ones. It may be argued that the main task of eco-
nomics is to explain how economic structures are determined over time
and space.2 Since the pioneering works of Leontief,3 numerous theoretical
studies on economic structure have been published.4 But formal trade the-
ory has not yet succeeded in providing satisfactory frameworks for analyz-
ing international trades with capital and knowledge accumulation.
Chapter 7 assumes that the world has only one production sector and
produces a single product. This chapter is concerned with dynamic rela-
tions between growth, economic structure and trade patterns in a two-
1 Although Doi et al. (2007) formulate a two-country endogenous growth model
to explain joint determination of long-run trade patterns and world growth rates,
the model is still based on the Ramsey approach in explaining consumer behavior.
The Ramsey approach for the two economies results in a four dimensional prob-
lem. We will use the classical Oniki-Uzawa model to illustrate a simpler problem.
2 For instance, Rostow (1960), Kuznets (1963, 1966), and Lewis (1955).
3 Leontief (1941, 1966).
4 See, for instance, Sraffa (1960), Nikaido (1968), Morishima (1964, 1969),
Brody (1970), Pasinetti (1981, 1993), and Arthur et al. (1991).

286 8 Growth, Trade Patten and Structure
country world economy. Section 8.1 studies the standard trade model in
neoclassical growth theory proposed by Oniki and Uzawa. The model exam-
ines interactions between the process of capital accumulation and the pattern
of international trade. It is presented in terms of the standard two-country,
two-commodity, two-factor model of international trade. Section 8.2 proposes
a trade model with economic structures and endogenous saving, synthesizing
the Oniki-Uzawa model and the one-sector growth trade model proposed in
Sect. 7.1. Section 8.3 studies a two-country trade model in which economic
product in each country is classified into goods and services. Section 8.4 con-
cludes the chapter. Section A.8.1 extends the two-country model in Sect. 8.3
to any number of countries. Section A.8.2 presents a two-country optimal
model, extending and generalizing the Oniki-Uzawa trade model.
8.1 Oniki-Uzawa’s Trade Model with Capital Accumulation
It has become evident that it is difficult to model international trade with

capital accumulation in a multi-country global economy. The standard
trade model in neoclassical growth theory is by Oniki and Uzawa in 1965.5
The model examines interactions between the process of capital accumula-
tion and the pattern of international trade. It is presented in terms of the
standard two-country, two-commodity, and two-factor model of interna-
tional trade. The world economy consists of two countries, which are en-
gaged with the trade of two commodities, consumption goods and invest-
ment goods.6 As shown in Chap. 2, given technology and preferences of
consumers in both countries, the volume and terms of trade and the pattern
of specification depend on the quantities of productive factors endowed in
both countries. The comparative advantages of countries vary over time as
factors are changeable over time.
5 Before Oniki and Uzawa published their important model, many authors had
examined effects of growth on international trade (e.g., Bensusan-Butt, 1954;

Black, 1956; Bhagwati, 1958a; Johnson, 1958 and 1962; Takayama, 1964). A dis-
crete two-sector trade growth model in the OLG framework is proposed by
Mountford (1999).
6 The two-country model is an extension of Uzawa’s two-sector growth model
(Uzawa, 1961). The model has been extended, mainly within the overlapping-
generations framework. See Zhang (2005a) for the recent literature of the two-
sector model for closed economies.
8.1.1 The Model with Fixed Saving Rates and Identical

Production Functions
The basic assumptions are the same as in the 2 × 2 × 2 model developed in

Sect. 2.6. There are two countries, called Home and Foreign. Perfect com-
petition prevails within each country and between countries. There is no
transaction cost. Assume that there are two production factors, capital and
labor; quantities of factors are identical in both countries. Each commodity
is produced by combining labor and capital. Labor grows at a fixed rate in
each country. Consumption goods are instantaneously consumed and in-
vestment goods are accumulated as capital stock. Capital, once invested,
and labor are both internationally immobile but domestically completely
mobile. First, assume that technologies are identical in both countries. Let
N (t ) stand for the total labor supply at time t respectively in Home and
Foreign; then we have
N& (t ) = nN (t ),
where n is the fixed population growth rate, which is assumed to be equal
in both countries.7
Let subscript indexes, i and c , stand respectively for consumption
goods (sector) and investment goods (sector). We use symbols, F j , K j ,
N j and X j to denote the amount of output, capital, labor, and with regard
to sector j, j = i , c. Assume that the production functions,
F j (K i (t ), N i (t )), are neoclassical. In each country the aggregate quantity
of capital, K& (t ), evolves according to
K& (t ) = Yi (t ) − δ k K (t ), (8.1.1)
where Yi (t ) is the quantity of gross investment which is equal to the coun-

try’s product and export of investment good, that is
Yi (t ) = Fi (K i (t ), N i (t )) + X i (t ). (8.1.2)
7 It would make almost no difference without considering non-zero population

growth rate as the economic system is neoclassical. When the population growth
rates differ between the two countries and labor is internationally immobile, in
general the model with exogenous growth population rates tends to result in mis-
leading results in very long-term analysis.
Similarly, the total supply of consumption good, Yc (t ), is given by
Yc (t ) = Fc (K c (t ), N c (t )) + X c (t ). (8.1.3)
The available quantities of capital and labor satisfy

K i (t ) + K c (t ) ≤ K (t ), N i (t ) + N c (t ) ≤ N (t ). (8.1.4)
Let p(t ) represent the price of the investment good in terms of the con-
sumption good. The marginal conditions are given
∂Fi ∂F
p(t ) ≤ r (t ), p(t ) i ≤ w (t ),
∂K i ∂N i
∂Fc ∂Fc (8.1.5)

≤ r (t ), ≤ w (t ),
∂K c ∂N c
where w (t ) and r (t ) the wage and rental rate in Home and Foreign. In
(8.1.5), inequality is replaced by equality if the corresponding output is
positive. Because of the neoclassical assumptions, the relations (8.1.5) are
satisfied with equality.
We assume that the payment of foreign trade always balances for each
country, i.e.
X c (t ) + p (t )X i (t ) = 0 . (8.1.6)
The gross national product, Y (t ), is equal to the value of the domestic

outputs, namely
Y (t ) = Yc (t ) + p(t )Yi (t ) = Fc (t ) + p(t )Fi (t ). (8.1.7)
Assume that each country saves a constant fraction of its gross national
product and consumes the rest; namely
p(t )Yi (t ) = s Y (t ), (8.1.8)
where s are the constant saving rates in Home and Foreign. The sum of
net imports for each good over the world is zero
~
X j (t ) + X j (t ) = 0 , j = i , c . (8.1.9)
We have thus built the model. We now examine behavior of the model.
8.1.2 The Reciprocal Demand Functions
We now try to find the reciprocal demand function, which relates the de-
mand for net imports of goods by each country with the relative price pre-
vailing in the world market. We will omit time in expression and are only
concerned with Home as the corresponding variables for Foreign can be
easily determined. As the production functions are neoclassical and mar-
kets are perfectly competitive, the variables can be expressed in per capita
terms. We introduce
K Y Kj Nj Yj X
k≡ , y ≡ , kj ≡ , nj ≡ , yj ≡ , x≡ i,
N N Nj N Nj N
wj
ω≡ , j = i , c.
rj
With these symbols, we can rewrite Eqs. (8.1.2) and (8.1.3) as

yi = f i (ki ) + x , yc (t ) = f c (k c ) − px , (8.1.10)
where f j (k j ) ≡ F j (k j , 1). For any given wage-rental, the optimal capital-

labor ratio k j = k j (ω ) is uniquely determined by (8.1.5) for k j > 0 , that
is
f j (k j ) (8.1.11)
ω= − kj .
f (k j )
j
'
We may also write the above equations as f j' = f j / (ω + k j ). Figure

8.1.1 plots how k j is determined.
Taking derivatives of Eqs. (8.1.11) with respect to ω yields
dk j
=−
(f ) j
' 2
> 0 , ∀ k j > 0.
(8.1.12)
dω f j f j"
By (8.1.5), we also determine the relative price as a function of ω

f c' (k c (ω )) (8.1.13)
p(ω ) = .
f i ' (ki (ω ))
Taking derivatives of the above equations with regard to ω yields
f (k j )
ω k j (ω ) kj
Fig. 8.1.1. Determination of the capital-labor ratios
1 dp(ω ) 1 1 (8.1.14)
= − ,
p(ω ) dω ki + ω kc + ω
where we use Eqs. (8.1.11) and (8.1.12). As ω is increased, the relative
price rises (falls) k c > (<) ki . For simplicity of discussion, we will confine
the study of the Oniki-Uzawa model to the case in which the consumption
good sector is always more capital-intensive than the investment good sec-
tor, i.e., k c (ω ) > ki (ω ), for all ω > 0 .
The equilibrium conditions (8.1.5), (8.1.7) and (8.1.8) can now be ex-
pressed as follows
ki (ω )ni + k c (ω )nc = k , ni + nc = 1, ni , nc ≥ 0 ,
y = yc + pyi , pyi = sy ,
ni = 0 , if p > p (ω ), nc = 0 , if p < p(ω ),
p = p(ω ), if n i > 0 , n c > 0 , (8.1.15)
where p is the relative price in the world market.

To solve the equilibrium conditions, we define ω j , j = i , c , by
k j (ω j ) = k . By (8.1.11), we can uniquely determine the wage ratios, ω j ,
for a given aggregate capital-labor ratio, k . We use notations ω j = ω j (k ).

The corresponding supply prices of the investment good are denoted by
p j (k ), that is
p j (k ) ≡ p (ω j (k )), j = i , c .
From (8.1.10) and (8.1.15), we solve

sf c (k c )nc (8.1.16)
x= − (1 − s ) f i (k i )ni .
p
From (8.1.11) and (8.1.1.12), the consumption good is more capital-
intensive than the investment good if and only if ωc (k ) < ωi (k ). From
(8.1.14), this also implies pc (k ) < pi (k ). Introduce
ω min ≡ min{ωc (k ), ωi (k )}, ω max ≡ max{ωc (k ), ωi (k )}.
We now examine patterns of specialization.
Case I: 0 < p ≤ pc (k )
According to (8.1.15), the economy is specialized to consumption good,
i.e.
ni = 0 , nc = 1, ω = ωc (k ). (8.1.17)
It can be seen that ni , nc , ki and kc are uniquely determined as func-

tions of p . By (8.1.16), we solve x as a function of p as follows
sf c (k ) (8.1.18)
x(t ) = , p ≤ pc (k ).
p
Case II: p ≥ pi (k )
According to (8.1.15), the economy is specialized to investment good,
i.e.
ni = 1, nc = 0 , ω = ωi (k ). (8.1.19)
By (8.1.16), we have
x( p ) = − (1 − s ) f i (k i )ni , p ≥ pi (k ). (8.1.20)
Case III: pc (k ) < p < pi (k )

The economy produces two goods. The wage-rental ratio, ω , is

uniquely determined by p = p(ω ). The labor distribution is determined by
(8.1.15) as follows
k c (ω ) − k k − k i (ω ) (8.1.21)
ni = , nc = .
k c (ω ) − k i (ω ) k c (ω ) − ki (ω )
By (8.1.11), (8.1.13), (8.1.21) and (8.1.16), we have
f i ' (ki )
x( p ) =
kc − ki
(8.1.22)
[s(k + ω ){s(k c + ω ) + (1 − s )(ki + ω )} − (k c + ω )(ki + ω )].
Using (8.1.14), we can show that for x determined by (8.1.22),
dx / dp < 0 .
In summary, we conclude that the reciprocal demand function, x( p ), is
jointly determined by (8.1.18), (8.1.20), and (8.1.22). The function is rep-
resented by the curve in Fig. 8.1.2a for the case of k c (k ) < ki (k ), and by
the curve in Fig. 8.1.2b for the case of k c (k ) = ki (k ). The shape of the func-
tion depends on k , s , f i (ki ) and f c (k c ). As we are mainly interested in ef-
fects of capital accumulation, we express x as a function of both p and
k , i.e., x = x( p , k ).
x pc (k ) = pi (k )
x( p )
x( p )
pc (k ) = pi (k )
pi (k )
pc (k ) p p
a) k c (k ) < ki (k ) b) kc (k ) = ki (k )
Fig. 8.1.2. The reciprocal demand curve

8.1.3 Global Division of Labor with Fixed Capital Stocks
We have derived the reciprocal demand curves for Home and Foreign with
given price. We are now concerned with determination of p and the
global economy as a whole. The relative sizes of labor force of Home and
Foreign, denoted by n* (t ) and n~ * (t ), are given by
N (t )
n * (t ) = ~ .
N (t ) + N (t )
From (8.1.18), (8.1.20), and (8.1.22), we know that the reciprocal de-
mand functions for Home and Foreign can be written as
()
s f c k / p , for p ≤ pc k () (8.1.23)

( ) ( )
x p , k =  x0 p , k , ()
for pc k < p < pi k ()

( )
− (1 − s ) f i k i ni , for p ≥ pi k ()
where p = p (ω ) for the non-specialized case and
x0 ≡
( ){ ( ) ( )} (
s k + ω s k c + ω + (1 − s ) k i + ω − k c + ω k i + ω
.
)( )
(
kc − ki / f i ' ki ) ( )
The equilibrium price of the investment good is determined by the fol-

lowing equation of reciprocal demand
n* x( p , k ) + n~ * ~
~
(
x p , k = 0. ) (8.1.24)
~
For given k and k , both x and ~
x are non-increasing functions of p
and
( ) (
x 0 , k = ∞ , x ∞ , k = 0. )
The properties of the reciprocal demand functions imply that there is a
~
( )
unique world price, denoted by p k , k . As we have required
k c (ω ) > ki (ω ), from (8.1.14) p rises in ω . If both countries are non-
specialized, then the wage-rental ratio is uniquely determined by the world
price; hence the wage rate and rentals are identical in both countries.
By Eq. (8.1.24) we uniquely determine p . Taking derivatives of this
equation with respect to k yields
∂p n *∂x / ∂k (8.1.25)
=− * ,
∂k n ∂x / ∂p + n~ *∂~
x / ∂p
where dx / dp ≤ 0 . It can seen that ∂p / ∂k has different signs according to

patterns of specialization. As shown by Oniki and Uzawa, signs of ∂p / ∂k
in the four possible patterns of specialization are determined as follows.
pattern I: Each country produces the two goods

In this case we have
∂p ∂p
> 0 , ~ > 0.
∂k ∂k
pattern II: Home produces the two goods and Foreign specializes in the
investment good
∂p ∂p
> 0 , ~ < 0.
∂k ∂k
pattern III: Home produces the two goods and Foreign specializes in the
consumption good
∂p ∂p
> 0 , ~ > 0.
∂k ∂k
pattern IV: Home produces the investment good and Foreign specializes
in the consumption good
∂p ∂p
< 0 , ~ > 0.
∂k ∂k
These results can be confirmed by (8.1.23) and (8.1.25). We see that
under kc > ki , if a country does not produce investment goods, the world
price of the investment good rises whenever the capital-labor ratio of that
country is increased. On the other hand, if a country produces investment
goods, an increase in the capital-labor ratio of that country will decrease
the world price of the investment good.
8.1.4 Capital Accumulation and Dynamic Properties
The previous section examines patterns of specialization with given levels

of capital-labor ratios. We now determine capital-labor ratios over time.
By (8.1.1), we have
s y (t ) (8.1.26)
k (t ) = − δk (t ),
&
p(t )
where δ ≡ n + δ k . We now find out explicit expressions of the two differ-

ential equations for the four patterns of specialization described in the pre-
vious section.
pattern I: Each country produces the two goods

&
k
k
( )
~
= Φ k , k ≡ s f i ' ki
k +ω
( ) k
−δ.
It is straightforward to confirm
∂Φ ∂Φ
< 0 , ~ < 0.
∂k ∂k
pattern II: Home produces the two goods and Foreign specializes in the
investment good
k&
k
( ) ~
= Φ k , k ≡ sf i ' (ki )
k +ω
k
−δ,
~&
k ~ ~ ~
( )
~ = Φ k, k ≡
s fi k
~
−δ.
()
k k
We have
~ ~
∂Φ ∂Φ ∂Φ ∂Φ
< 0, ~ < 0, = 0 , ~ < 0.
∂k ∂k ∂k ∂k
pattern III: Home produces the two goods and Foreign specializes in the
consumption good
k&
k
( )~
= Φ k , k ≡ sf i ' (ki )
k +ω
k
−δ,
( ) ( ( ))
~& ~ ~
k ~ ~ s fc k
~ = Φ k, k ≡ ~ ~ −δ.
k p k, k k
We have
~ ~
∂Φ ∂Φ ∂Φ ∂Φ
< 0, ~ < 0, < 0 , ~ < 0.
∂k ∂k ∂k ∂k
pattern IV: Home produces the investment good and Foreign specializes
in the consumption good
~ sf (k )
k&
k
( )
= Φ k, k ≡ i
k
−δ,
~&
~ (1 − s )n* f i (k )
k ~
( )
~ = Φ k, k ≡
k
~
n~ * k
−δ.
We have
~ ~
∂Φ ∂Φ ∂Φ ∂Φ
< 0, ~ = 0, > 0 , ~ < 0.
∂k ∂k ∂k ∂k
As the equations are explicitly given, it is straightforward to analyze the
model.
8.2 Economic Structure, Trade and Capital Accumulation
The importance of the Oniki-Uzawa model is that it is the first economic

model which deals with economic structure and equilibrium with capital
accumulation in trade theory. Nevertheless, the Oniki-Uzawa model is
based on a few strict assumptions which are not easy to relax for explicit
analytical conclusions.8 This section proposes a trade model with eco-
8 These assumptions include, for instance, fixed savings rates, identical produc-
tion functions for each sector in the two countries, classification of goods into con-
sumption and investment goods.
nomic structures and endogenous saving, synthesizing the Oniki-Uzawa

model and the one-sector growth trade model proposed in Sect. 7.1.
8.2.1 The Two-Sector Trade Model with Capital Accumulation
Most aspects of production sectors in our model are similar to the neo-
classical one-sector growth model. We classify economic product into
consumption good and investment good. Correspondingly, each economy
may have two sectors - consumption sector and investment sector. The two
economies are called Home and Foreign. Perfect competition prevails
within each country and between countries. There is no transaction cost.
Assume that there are two production factors, capital and labor; quantities
of factors are identical in the two economies. Each commodity is produced
by combining labor and capital. Labor is fixed.9 Like in the Oniki-Uzawa
model, consumption goods are instantaneously consumed and investment
goods are accumulated as capital stock.10 Capital is both internationally
and domestically completely mobile.11 Labor is internationally immobile
and domestically completely mobile.
For Foreign, we will use the same symbol that we use for Home, but
with a tilde ~. Home’s and Foreign’s total amount of employment of capi-
~ ~
tal and labor are denoted respectively by, K (t ) and N , K (t ) and N . The
populations, N , in Home and Foreign are fixed and the amount of total
capital stocks, K (t ), vary over time. Let subscript indexes, i and c , stand
for investment good and consumption good, respectively. We use symbols,
F j (t ), K j (t ), and N j (t ) to denote the amount of output, capital, and labor
with regard to sector j , j = i , c . Each economy may produce two goods
with the following Cobb-Douglas production functions
9 The fixed labor force is analytically the same as the assumption of an identical
fixed growth rate in all economies as assumed in the Oniki-Uzawa model as the
economic world is neoclassical.
10 Capital is not immobile as assumed in the Oniki-Uzawa model.
11 Another case of this type of models is the so-called dynamic Heckscher-
Ohlin model. To obtain the standard Heckscher-Ohlin model, we have two goods.
But the factors are immobile internationally and the technologies are the same in
the two countries. It may be easier to get explicit conclusions in the Heckscher-
Ohlin economy than in the current one.
F j (t ) = A j K j j (t )N j j (t ), j = 1, 2 ,
α β
α j , β j > 0 , α j + β j = 1, j = i , c , (8.2.1)
where α j , β j and A j are parameters. A variable with macron ¯ stands for

both Home and Foreign. We denote wage and interest rates by w (t ) and
r (t ) in Home and Foreign. In the free trade system, the interest rate is
equal throughout the world economy, i.e., r (t ) = r (t ). The prices of con-
sumption good and investment goods are equal throughout the world
economy. Let prices be measured in terms of the investment good. We
specify that the price of the investment good is unity. We use p(t ) to rep-
resent the price of consumption good in term of the investment good.
αi fi α c pf c (8.2.2)
r + δk = = , w = β i f i = β c pf c ,
ki kc
where δ k is fixed depreciation rate of capital12 and
Kj α
kj ≡ , f j ≡ Aj k j j .
Nj

dowments found in the economy. These resource constraints are given by
Ki + Kc = K , Ni + Nc = N .
We express the above conditions as
ni ki + nc kc = k , ni + nc = 1, (8.2.3)
where
Kj K Nj
kj ≡ , k ≡ , nj ≡ .
Nj N N
Let k w (t ) stand for the per capita wealth in Home and Foreign. The rep-
resentative household obtains the current income
12 For simplicity, we require that depreciation rate of capital is the same in dif-
ferent sectors in Home and in Foreign.

y (t ) = r (t )k w (t ) + w (t ), (8.2.4)
from the interest payment rk w and the wage payment w . The disposable
income is equal to
y d (t ) = y (t ) + k w (t ) (8.2.5)
The disposable income is used for saving and consumption.

among savings, s (t ), consumption of consumption good, c (t ). The budget
constraints are
p (t )c (t ) + s (t ) = y d (t ) = (1 + r (t ))k w (t ) + w (t ) . (8.2.6)
We assume that utility functions, U (t ), are specified as follows
U (t ) = c ξ 0 (t )s λ0 (t ), ξ 0 , λ0 > 0 . (8.2.7)
Maximizing U j subject to the budget constraints (4) yields
pc = ξ y d , s = λ y d , (8.2.8)
where
1
ξ ≡ ρ ξ 0 , λ ≡ ρ λ0 , ρ ≡ .
ξ 0 + λ0
According to the definition of s (t ), the wealth accumulation is given by
k w (t ) = s (t ) − k w (t ). (8.2.9)
&

~
( ~
) ~ ~
K (t ) + K (t ) = ∑ K j (t ) + K j (t ) = k w (t )N + k w (t )N .
(8.2.10)
j
The sum of net imports for consumption good over the world is zero
~
X (t ) + X (t ) = 0 . (8.2.11)
For each country, the demand for consumption good equals the supply
of the good at any point time
C (t ) = Fc (t ) + X (t ). (8.2.12)
The world production of the investment good is equal to the world net
saving. That is
   ~ ~~ ~ ~  ~ (8.2.13)
 S − Nk w + ∑ δ k K j  +  S − Nk w + ∑δ 
k K j  = Fi + Fi .
 j   j 
We have thus built the model.
8.2.2 The Reciprocal Demand Functions
We first derive the reciprocal demand functions. We are only concerned

with Home. From Eqs. (8.2.2), we solve
ki = ak c , (8.2.14)
where
αi βc
a≡ .
α c βi
In the reminder of this study, we require α i > α c , which implies
a > 1. 13 From a > 1 and ki = ak c , we have ki > k c . Hence, the require-
ment of α i > α c always guarantees that the investment good sector is al-
ways more capital-intensive than the consumption good sector.
From (8.2.14) and w = β c pf c = β i f i , we have
p(kc ) = Akcα i −α c , (8.2.15)
where
Ai β i a α i
A≡ .
Ac β c
From (8.2.2), we can also determine r and w as unique functions of
k s . Let p stand for the price of consumption good in the world market.
We now examine patterns of specialization.
Case I: 0 < p < p(k c )
13 It is straightforward to check α i β c − α c β i = α i − α c .
In this case, the economy is specialized to investment good. By Eqs.

(8.2.3) and (8.2.2), we have
ki = k , ni = 1, nc = 0 , r = α i Ai ki− β i − δ k , w = β i Ai kiα i . (8.2.16)
We see that the labor distribution, capital distribution and factor prices
are uniquely expressed as functions of k and p . From the definition of
yd , we have
yd (k , k w , p ) = (δ + α i Ai k − βi )k w + β i Ai kiα i , (8.2.17)
where δ ≡ 1 − δ k .
From C = Fc + X , we have X = cN − Nnc f c . Insert pc = ξyd in
(8.2.8) into this equation
ξNy d (8.2.18)
X = − Nnc f c .
p
From Eqs. (8.2.16)-(8.2.18), we have
[
X (k , k w , p ) = (δ + α i Ai k − β i )k w + β i Ai kiα i ]ξpN . (8.2.19)
Case II: p > p(kc )

The economy is specialized to consumption good. By Eqs. (8.2.3) and
(8.2.2), we have
k c = k , ni = 0 , nc = 1, r = α c Ac pk c− β c − δ k , w = β c Ac pk cα c . (8.2.20)
We see that the labor distribution, capital distribution and factor prices
are uniquely expressed as functions of k and p . From the definition of
yd , we have
y d (k , k w , p ) = (δ + α c Ac pk − β c )k w + β c Ac pk α c . (8.2.21)
From Eqs. (8.2.18), (8.2.20) and (8.2.21), we have
[
X (k , k w , p ) = (δ + α c Ac pk − β c )k w + β c Ac pk α c ]ξpN − NA k c
αc
.
(8.2.22)
Case III: p = p(kc )

The economy produces two goods. By Eqs. (8.2.3), (8.2.2) and (8.2.14),
we have
b
 p aki − k k − ki
ki = ak c , k c =   , ni = , nc = ,
 A (a − 1)ki (a − 1)ki (8.2.23)
r = α i Ai k i
− βi
− δ k , w = β i Ai ki , αi
where we use p(k c ) = Akc and b ≡ 1 / (α i − α c ). We see that the labor

α i −α c
distribution, capital distribution and factor prices are uniquely expressed as

functions of k and p . From the definition of yd , we have
y d (k , k w , p ) = (δ + α c Ac A β cb p1−bβ c )k w + β c Ac A−α c b p1+ bα c . (8.2.24)
From Eqs. (8.2.18), (8.2.23) and (8.2.24), we have
[
X (k , k w , p ) = (δ + α c Ac A β cb p1−bβ c )k w + β c Ac A −α cb p1+ bα c ]ξpN
p − bβ c k − (a / Ab ) p bα c
− . (8.2.25)
(a − 1)aA− β b / NAc
c
8.2.3 Global division of labor with fixed wealth
We have derived the reciprocal demand curves for Home and Foreign with
given price. We are now concerned determination of p and the global
economy as a whole. As examining the behavior of the Oniki-Uzawa
model, we may have four different patterns of specialization. As the prob-
lem is so complicated, we are only concerned with the pattern that Home
specializes in the investment good and Foreign specializes in the consump-
tion good. As shown in the previous section, this case occurs when
p (k c ) > p > ~
~
( )
p k c . In this case, the reciprocal demand functions are given
by
[
X (k , k w , p ) = (δ + α i Ai k − β i )k w + β i Ai kiα i ]ξpN ,
~~
~ ~ ~
( ) [(
~ ~ ~ ~ −βc ~ ~ ~ ~αc ξ N
X k , k w , p = δ + α c Ac k p k w + β c Ac k p
p
)~~ ~
− NAc k α c .
(8.2.26)
]
~
We now show that k and k can be expressed as functions of p , k w
~
and k w . From Eqs. (8.2.16), (6.2.20) and (8.2.10), we have
~ ~ ~~
α i Ai k − β i = α~c Ac pk − β c ,
~
kN + k N = K w ,
~ ~ ~
where K w ≡ k w N + k w N . We have the following equation to determine k
~~ ~~
NAI p −1/ β i k β c / β i + Nk = K w ,
~
(
where AI ≡ α~c Ac / α i Ai )
−1 / β i ~~
and k = AI p −1/ βi k β c / β i . For obtaining explicit
~
expressions, we further assume β i = β c . Under this requirements, we solve
K w AI ~ K w p1 / β i (8.2.27)
k= ~ , k = ~ .
NAI + Np1/ β i NAI + Np1/ βi
~
For given k w (t ) and k w (t ), by Eqs. (8.2.26) and (8.2.27), and
~
X + X = 0 , we see that the relative price is determined by
βi
 Kw 
g 0  ~ 1/ βi  + g1

 NAI + Np 
 ξNβ i Ai AIα i
+ ~
~~ ~
( 
− 1 − β cξ Ac p1 / β i  )Kw
~ 1/ βi = 0 , (8.2.28)
 N  NAI + Np
~
in which we also use k = AI p −1/ β i k and
(
~ δξNk
) ~~
g 0 k w , k w ≡ ~ w + δξ k w > 0 ,
N
(
~
g1 k w , k w ≡ )
ξα i Ai NAI− β c k w ~ ~ ~~
N
~ + α c Acξ k w > 0 .
~
Let Λ ≡ NAI + Np1 / β i . We express (8.2.28) as
−α i
g0 K Λ + 
 g1
αi
−
~~ ~
1 − β cξ Ac 
~ Λ +
(
ξNβ i Ai AIα i
~
) (8.2.29)
w
 Kw N  N
+
( ~~ ~
1 − β cξ Ac NAI
~
)
= 0,
N
where
g1
−
( ~~ ~
~ = 
)−
~~
~
(~
1 − β cξ Ac  1 − β cξ − ξα~c Ac k w N ~~ ~  1 )
− λ Ac k w  < 0.
Kw N  N  K w
Equation (8.2.29) has one positive solution. If we specify α i = 1 / 2 or

~
α i = 1 / 3 , then we can explicitly find the solution. We use p k w , k w to ( )
denote this solution. If this solution is meaningful,14 then taking derivatives
of (8.2.29) with respect to k w yields
D
dp
( )
~  ξk w N ~ 
= ξ − α iξ  ~ + k w δNK w Λ +
−α i −1 α i
~ ~~
ξ − ξ α~c Ac k w NΛ(,
)
dk w  N  K w2
where
 g
D ≡ − α i g 0 K w−α i Λ− β i + 1 − ~
(
~~ ~ ~

)
1 − β cξ Ac  Np α i / β i
> 0.
 K w N  β i
~
We conclude that if ξ > ξ , then dp / dk w > 0 . That is, if Home’s pro-
pensity to consume is higher than Foreign’s propensity to consume, then a
rise in Home’s per capita wealth tends to increase the price of the con-
~
sumption good. If ξ < α iξ , we have dp / dk w < 0 . Otherwise, the impact
~
is ambiguous. We can get dp / dk w .
8.2.4 A Discussion on Capital Accumulation
We studied equilibrium when Home specializes in the investment good

and Foreign specializes in the consumption good for given k w (t ) and
~
k w (t ) at any point of time. We now study the motion of the system over
time.
From (8.2.9) and s = λyd , we have
&
k w = λ yd − k w .
Insert Eqs. (8.2.17) and (8.2.21) in the above equations
k&w = (λδ − 1 + α i λAi k − β i )k w + β i Ai k iα i ,
14 It is not easy to confirm this as the expressions are tedious.

~&
(
~ ~~ ~ ~
) ~~
k w = λ δ − 1 + α i λ Ac k − β i p k w + β i Ac k α c p ,
(8.2.30)
~
where we use β i = β i . Substituting (8.2.27) into equations yields
 K A 
− βi
 K A 
αi
k&w = λδ − 1 + α i λAi  w I   k w + β i Ai  w I  ,

  ph    ph 
~ (8.2.31)
~~  K   ~
− βi αc
~& ~ K 
k w =  λ δ − 1 + α i λ Ac  w  k w + β i Ac p1 / β i  w  ,
  ph    ph 

~
where ph ≡ NAI + Np1 / β i .
( ~
)
Finally, substituting p k w , k w into Eqs. (8.2.31), we obtain two differ-
~
ential equations which describe the motion of k w (t ) and k w (t ) when Home
specializes in the investment good and Foreign specializes in the consump-
~
tion good. As k w (t ) and k w (t ) vary, the conditions that Home specializes
in the investment good and Foreign specializes in the consumption good
may be broken, then we have to deal with the motion of other possible pat-
terns of specialization. The entire dynamics are too complicated. We will
not further examine the model as the analysis is tedious. As we have pro-
vided the procedure to simulate the model, it is straightforward to illustrate
motion of the system with specified functional forms and parameter val-
ues.
8.3 Trade and Growth with Non-Traded Services
As shown in Chap. 2, it is difficult to determine terms of trade and patterns

of trade even when the world consists of only two countries, and each
country has two production sectors with two factors with differences in
preference and technology with the Cobb-Douglas production and utility
functions.15 One can see that the simple economic model in Chap. 2 will
become almost analytically intractable if we allow capital, knowledge,
or/and population to become endogenous variables. Nevertheless, if we
15 This also tells why in the literature of trade theory, there had been few equi-
librium trade models. Even an extremely simple equilibrium model with differ-
ences both in technologies and preferences tends to be analytically intractable.
consider some products which are not tradable, then the analysis may be-
come easier. For instance, when time and space are explicitly considered,
services have their typical characteristics. In most cases, they are produced
and consumed at the same time and at the same place. This means that ser-
vices can be consumed only in the country in which they are supplied. In
this section, it is assumed that services, such as hotels, restaurants, hospi-
tals, education, transportation and communication systems, supplied by
one country cannot be consumed by the other country.
8.3.1 The Two-Sector Trade Model with Country-Specified

Services
Most aspects of production sectors in our model are similar to the neo-
classical one-sector growth model. We classify economic product into
goods and services. Correspondingly, each economy may have two sectors
- good sector and service sector. The two economies are called Home and
Foreign. Perfect competition prevails within each country and between
countries. There is no transaction cost. Assume that there are two produc-
tion factors, capital and labor; quantities of goods are identical in the two
economies. Goods and services are produced by combining labor and capi-
tal. Labor is fixed.16 Capital is both internationally and domestically com-
pletely mobile. Services are country-specified and are consumed simulta-
neously as they are produced. Labor is internationally immobile and
domestically completely mobile.
For Foreign, we will use the same symbol that we use for Home, but
with a tilde ~. Home’s and Foreign’s total amount of employment of capi-
~ ~
tal and labor are denoted respectively by, K (t ) and N , K (t ) and N . The
populations, N , in Home and Foreign are fixed and the amount of total
capital stocks, K (t ), vary over time. Let subscript indexes, i and s , stand
for good and service good, respectively. We use symbols, F j (t ), K j (t ),
and N j (t ) to denote the amount of output, capital, and labor with regard to
sector j , j = i , s . Each economy may produce two goods with the fol-
lowing Cobb-Douglas production functions
16 The fixed labor force is analytically the same as the assumption of an identi-
cal fixed growth rate in all economies as assumed in the Oniki-Uzawa model as
the economic world is neoclassical.
F j (t ) = A j K j j (t )N j j (t ), j = 1, 2 ,
α β
α j , β j > 0 , α j + β j = 1, j = i , s , (8.3.1)
where α j , β j and Aj are parameters. A variable with macron ¯ stands for

both Home and Foreign. We denote wage and interest rates by w (t ) and
r (t ) in Home and Foreign. In the free trade system, the interest rate is
equal throughout the world economy, i.e., r (t ) = r (t ). The prices of con-
sumption good and investment goods are equal throughout the world
economy. Let prices be measured in terms of the good. We specify that the
price of the good is unity. We use p (t ) to represent the price of services in
term of the good in Home and Foreign.
α i fi α s pf s (8.3.2)
r + δk = = , w = β i f i = β s pf s ,
ki ks
where δ k is the fixed depreciation rates of capital17 and
Kj α
kj ≡ , f j ≡ Aj k j j .
Nj

Ki + K s = K , Ni + N s = N .
We express the above condition as
ni k i + ns k s = k , ni + ns = 1, (8.3.3)
where
Kj K Nj
kj ≡ , k ≡ , nj ≡ .
Nj N N
Let k w (t ) stand for the per capita wealth in Home and Foreign. The rep-
resentative household obtains the current income
17 Here, we assume that depreciation rate of capital is the same within any
country and between the countries.

y (t ) = r (t )k w (t ) + w (t ), (8.3.4)
from the interest payment rk w and the wage payment w . The disposable
income is equal to
y d (t ) = y (t ) + k w (t ). (8.3.5)

among savings, s (t ), consumption of good, ci (t ), and consumption of
services, cs (t ). The budget constraints are
ci (t ) + p (t )cs (t ) + s (t ) = y d (t ) = (1 + r (t ))k w (t ) + w (t ) . (8.3.6)
We assume that utility functions, U (t ), are specified as follows
U (t ) = ciξ 0 (t )csγ 0 (t )s λ0 (t ), ξ 0 , γ 0 , λ0 > 0 . (8.3.7)
Maximizing U subject to budget constraints (8.3.6) yields

ci = ξ y d , pcs = γ y d , s = λ y d , (8.3.8)
where
1
ξ ≡ ρ ξ 0 , γ ≡ ρ γ 0 , λ ≡ ρ λ0 , ρ ≡ .
ξ 0 + γ 0 + λ0
According to the definition of s (t ), the wealth accumulation is given by
k w (t ) = s (t ) − k w (t ). (8.3.9)
&

~
( ~
) ~ ~
K (t ) + K (t ) = ∑ K j (t ) + K j (t ) = k w (t )N + k w (t )N .
(8.3.10)
j
For each country, the demand for services equals the supply of services
at any point time
N cs (t ) = Fs (t ). (8.3.11)
~
Denote E (t ) ( E (t ) ) the capital stocks owned by Foreign (Home) but
employed by Home (Foreign). We have
E (t ) = K (t ) − N k w (t ). (8.3.12)
The sum of E (t ) is equal to zero. That is

~
E (t ) + E (t ) = 0 . (8.3.13)
Equation (8.3.13) can also be obtained from Eqs. (8.3.12) and (8.3.10).
The sum of net savings and consumption of goods of the world is equal to
its total product. That is18
  ~ ~ ~~ ~ ~ 
 Nci + S − Nk w + ∑δ k K j  +  Nc~i + S − Nk w + ∑ δ k K j 
 j   j  (8.3.14)
~
= Fi + Fi .
8.3.2 The Motion of the System
This section derives dynamic equations for global economic growth. From
Eqs. (8.3.2), we solve
k s = a ki , (8.3.15)
where
α s βi
a ≡ .
αi βs
From (8.3.15) and w = β i f i = β s pf s , we have
p = A k sα i −α s , (8.3.16)
where
Ai β i
A≡ .
a As β s
αi
18 It is straightforward to show that this equation is redundant in the sense that it
can be reduced from the rest equations in the system.

We require α i ≠ α s . We see that p can be determined as a unique

function of k s . From (8.3.2), we can also determine r and w as unique
~~ ~
functions of k . From r + δ = α A k − β i = α~ A k − β i , we have
s k i i i i i i
~ ~
(8.3.17)
ki = A0 kiβi / βi ,
where
~
~ 1/ βi
 α~i Ai 

A0 ≡   .

 α i Ai 
We see that from Eqs. (8.3.15)-(8.3.17) and (8.3.2), we determine r ,
~
w , k s and ki as unique functions of ki .
From the definitions of yd and Eqs. (8.3.2), we have
y d = y0 k w + β i f i , (8.3.18)
where δ ≡ 1 − δ k and
 α f 
y0 (k i ) ≡  δ + i i .

 ki 
We see that yd are functions of k w and ki . From Eq. (8.3.11), we have
N γyd (8.3.19)
( )
ns = Ψ k i , k w , k w ≡
pf s
, ni = 1 − Ψ ki , k w , k w , ( )
where we use pcs = γ y d and ni + ns = 1. From Eqs. (8.3.3), we have
(
k = k i + a0 k i Ψ k i , k w , k w , ) (8.3.20)
where a0 ≡ 1 − a . Hence, we determine ni , ns and k as functions of k w

and ki . From Eq. (8.3.10), we have
~~ ~ ~
Nk + k N = k w N + k w N .
Insert Eqs. (8.3.20) into the above equation
~~ ~~ ~ ~ ~
ki N + a0 Nk i Ψ + ki N + a~0 Nki Ψ = k w N + k w N . (8.3.21)
Substituting the definitions of Ψ in Eq. (8.3.21) yields

~
a1k i y d ~ a~ k ~ y ~
ki + + nki + 1~ i~ d = k w + nk w ,
βi fi βi fi
where we use β i f i = β s pf s and

~
N
n≡ , a1 ≡ a0γ β s N .
N
Insert the definitions of yd in the above equation
~
k w = Ψ0 (ki , k w ) ≡ (8.3.22)
~ −1
 a1ki y0 k w ~   a~1ki ~
y0 
k w − (k i + a1 )ki − − (n + a1 )ki   ~ ~ − n  .
~
 βi fi   βi fi 
We see that all the variables can be expressed as functions of k w (t ) and
ki (t ) at any point of time. We now derive the dynamics of the system.
We now substitute s = λ yd into Eqs. (8.3.9)
&
( )
k w = λ β i f i + λ y0 − 1 k w , (8.3.23)
where we use Eqs. (8.3.18). Taking derivatives of Eq. (8.3.22) with respect
to time yields
~& ∂Ψ0 & ∂Ψ0 &
kw = ki + kw .
∂k i ∂k w
We don’t give explicit expressions of the partial derivatives of Ψ0 with

respect to k w and ki . The calculation is straightforward. Insert Eqs.
(8.3.24) and (8.3.22) in Eqs. (8.3.23)
k&w = Λ w (k w , ki ) ≡ λβ i f i + (λy0 − 1)k w ,
k&i = Λ i (k w , ki ) ≡ (8.3.24)
−1
~~ ~
(
~~
)
λ β i f i + λ y0 − 1 Ψ0 − Λ w (k w , ki )
∂Ψ0 &  ∂Ψ0 
k w   .
∂k w  ∂ki 

Equations (8.3.24) contain two variables, k w and ki .
Lemma 8.3.1
For given initial values of k w (0) and ki (0 ), the motion of k w (t ) and ki (t )
is given by Eqs. (8.3.24). The values of the other variables are given as
functions of k w (t ) and ki (t ) at any point of time by the following proce-
~ ~ α
dure: k w by (8.3.22) → ki by (8.3.17) → k s by (8.3.15) → f j = A j k j j
→ p by (8.3.16) → r and w → yd by (8.3.18) → ci , cs and s (8.3.8)
→ ns and ni by (8.3.19) → k by (8.3.20) → E by (8.3.12) →
N j = n j N → K j = k j N j → Fj = N j f j .
We now can easily simulate the model with computer. It should be

noted that we don’t discuss the conditions for 0 ≤ ni < 1 as the expressions
are too tedious and it is difficult to get explicit interpretations.
8.3.3 Equilibrium of the Trade System
This section examines equilibrium of the system. By Eqs. (8.3.9) at equi-

librium we have
k w = λ yd , (8.3.25)
where we use s = λ y d . From Eqs. (8.3.25) and (8.3.18), we solve
λ βi fi (8.3.26)
kw = .
1 − λ y0
N γk w (8.3.27)
ns = Ψ = .
λ pf s
Inserting Eqs. (8.3.27) and (8.3.26) in Eq. (8.3.21), we have
~  ak  λ (8.3.28)
Φ(k i ) ≡ ki + nk i −  β i f i − 1 i  −
 λ  1 − λy 0
~
 ~ ~ a~1ki  nλ~
 βi fi − ~  ~ = 0,
 λ  1 − λ ~y0

~ ~
where we use ki = A0 kiβ i / β i . Equation (8.3.28) contains a single variable,
ki . Once we determine the variable, all the variables are determined
through the procedure given by the following lemma.
Lemma 8.3.2
Equation (8.3.28) determines ki . The equilibrium values of the other vari-
ables are determined as functions of ki by the following procedure:
~ ~ α
ki = A0 k iβ i / β i → k w by (8.3.26) → k s by (8.3.15) → f j = A j k j j → p by
(8.3.16) → r and w by (8.3.2) → yd by (8.3.18) → ci , cs and s by
(8.3.16) → ns and ni by (8.1.19) → k by (8.3.20) → E by (8.3.12) →
N j = n j N → K j = k j N j → Fj = N j f j .
8.3.4 Concluding Remarks
The dynamic multi-sector model developed in this section is similar to the

trade model, for instance, by Eaton (1987) in many aspects. A main differ-
ence of our model from the Eaton model (in which only one country is ex-
plicitly considered) is that our trade model is not partial in the sense that
our framework takes account of behavior of all consumers and producers
in the world economy. In fact, it may be claimed that not only the Eaton
model, most of dynamic trade models in the literature are partial in the
sense that not all trade participants are taken into account in modeling. For
instance, trade economists have been much concerned with economic be-
havior of small and open countries. By the assumption that an economy is
small and open, it is reasonable to assume some of its economic variables
like exchange rates and prices of some goods to be exogenous. From the
perspective of general economic theory, such a partial approach is only for
analytical convenience.
Appendix
A.8.1 Capital Accumulation and Services in a Multi-Country

Economy
The appendix generalizes the model in Sect. 8.3 to any number of coun-
tries. Let there be Q countries, indexed by q = 1, ... , Q . Country q' s ’s to-
tal amount of employment of capital and labor are denoted respectively by,
K q (t ) and N q . Let subscript indexes, i and s , stand for good and service
good, respectively. We use symbols, F jq (t ), K jq (t ), and N jq (t ) to denote the
amount of output, capital, and labor with regard to sector j , j = i , s . Each
economy may produce two goods with the following neoclassical production
functions
F jq (t ) = F jq (K jq (t ), N jq (t )), j = 1, 2 , j = i , s , q = 1, ..., Q . (A.8.1.1)
We denote wage and interest rates by wq (t ) and r (t ) . The prices of

consumption good and investment goods are equal throughout the world
economy. Let prices be measured in terms of the good. We specify that the
price of the good is unity. We use pq (t ) to represent the price of services
in country q . Marginal conditions for maximizing profits are given by
r + δ k = f iq' = pq f sq' , wq = f iq − kiq f iq' = pq ( f sq − k sq f sq' ), (A.8.1.2)
where δ k is the fixed depreciation rates of capital and

K jq F jq
k jq ≡ , f jq ≡ .
N jq N jq

dowments found in the economy, that is
niq kiq + nsq k sq = k q , niq + nsq = 1, (A.8.1.3)
where
K jq Kq N jq
k jq ≡ , kq ≡ , n jq ≡ .
N jq Nq Nq
Appendix 315
Let k wq (t ) stand for the per capita wealth in country q . The representative
household obtains the current income
y q (t ) = r (t )k wq (t ) + wq (t ). (A.8.1.4)
The disposable income is equal to

y dq (t ) = y q (t ) + k wq (t ). (A.8.1.5)
The budget constraints are

ciq (t ) + pq (t )csq (t ) + sq (t ) = ydq (t ) = (1 + r (t ))k wq (t ) + wq (t ) . (A.8.1.6)
We assume that utility functions, U q (t ), are specified as follows
U q (t ) = ciq0 q (t )csq0 q (t )sq 0 q (t ), ξ 0 q , γ 0 q , λ0 q > 0 . (A.8.1.7)

ξ γ λ
Maximizing U q subject to budget constraints (A.8.1.6) yields
ciq = ξ q y dq , pq csq = γ q y dq , sq = λq y dq , (A.8.1.8)
where
1
ξ q ≡ ρ q ξ 0 q , γ q ≡ ρ q γ 0 q , λ q ≡ ρ q λ0 q , ρ q ≡ .
ξ 0 q + γ 0 q + λ0 q
According to the definition of sq (t ), the wealth accumulation is given

by
k&wq (t ) = sq (t ) − k wq (t ). (A.8.1.9)

(A.8.1.10)
∑ K (t ) = ∑∑ K (t ) = ∑ k (t )N
q
q
q j
jq
q
wq q .
For each country, the demand for services equals the supply of services
at any point time
N q csq (t ) = Fsq (t ). (A.8.1.11)
Denote Eq (t ) the capital stocks employed by country q but owned by

other countries. We have
Eq (t ) = K q (t ) − N q k wq (t ). (A.8.1.12)
The motion of the system

We now derive dynamic equations for global economic growth. From
Eqs. (A.8.1.2), we shave
f iq' f sq'
= .
f iq − k iq f iq' f sq − k sq f sq'
Using the properties of neoclassical production functions, it is straight-

forward to check that if country q produces both products, then the above
equations determine a unique relation between k sq and kiq , denoted by
k sq = φq (k iq ). (A.8.1.13)
From (A.8.1.13) and f iq' = pq f sq' , we determine pq as a unique function

of kiq , denoted by
pq = φ pq (kiq ). (A.8.1.14)
We see that pq can be determined as a unique function of kiq . From

(A.8.1.2), we can also determine r and wq as unique functions of kiq .
From r + δ k = f i1' = f iq' , we can determine kiq as unique function of ki1 ,
denoted by
kiq = φ0 q (k i1 ), q = 1, ... , Q , (A.8.1.15)
where φ01 (k i1 ) = kiq . We have determined r , wq , k sq and kiq as unique

functions of a single variable, ki1 .
From the definitions of ydq and Eqs. (A.8.1.2), we have
y dq = y0 q (k i1 )k wq + wq (k i1 ), (A.8.1.16)
Appendix 317
where δ ≡ 1 − δ k and y0 q (ki1 ) ≡ δ + f iq' . We see that ydq are functions of

k wq and ki1 . From Eq. (A.8.1.11), we have
N qγ q y dq (A.8.1.17)
nsq = Ψq (ki1 , k wq ) ≡ , niq = 1 − Ψq (ki1 , k wq ),
pq f sq
where we use pq csq = γ q y dq and niq + nsq = 1. From Eqs. (A.8.1.3) and
(A.8.1.17), we have
k q = kiq + (k sq − k iq )Ψq (ki1 , k wq ). (A.8.1.18)
Hence, we determine niq , nsq and k q as functions of k wq and ki1 . From

Eq. (A.8.1.10), we have
∑N k
q
q q = ∑N kq
q wq .
Insert Eqs. (A.8.1.18) into the above equation
∑ [k
q
iq ]
+ (k sq − kiq )Ψq (ki1 , k wq ) N q = ∑ N q k wq .
q
(A.8.1.19)
Substituting the definitions of Ψq into Eq. (A.8.1.19) yields
∑ [k
q
iq ]
+ g q (ki1 ) y dq N q = ∑ N q k wq ,
q
where
g q (ki1 ) ≡
(k sq )
− kiq N qγ q
.
pq f sq
Insert the definitions of yq in the above equation
k w1 = Ω 0 (k i1 , {k wq }) ≡
 
∑ (k iq + g q wq )N q − ∑ (1 − g y0 q )N q k wq 
Q
1 (A.8.1.20)
,
 (1 − g1 y 01 )N1
q
q q =2
where {k wq } is the vector of elements, k w 2 , ... , k wQ . All the variables can

be expressed as functions of {k wq } and ki1 (t ) at any point of time. We now
derive the dynamics of the system.
We now substitute sq = λq ydq into Eqs. (A.8.1.9)
k&wq = (λq y0 q − 1)k wq + λq wq , (A.8.1.21)
where we use Eqs. (A.8.1.16). Taking derivatives of Eq. (A.8.1.20) with

respect to time yields
∂Ω 0 & Q
∂Ω 0 & (A.8.1.22)
k&w1 =
∂ki1
k i1 + ∑ ∂k
q=2
k wq .
wq
We don’t give explicit expressions of the partial derivatives of Ω 0 with

respect to k wq and ki1 . The calculation is straightforward. Insert Eqs.
(A.8.1.20) and (A.8.1.22) in Eqs. (A.8.1.21)
k&wq = Λ q (k i1 , {k wq }) ≡ (λq y0 q − 1)k wq + λq wq , q = 2 , ... , Q ,
k&i1 = Λ1 (k i1 , {k wq }) ≡ (A.8.1.23)
−1
 ∂Ω  ∂Ω 0 
Λ q (k i1 , {k wq }) 0 
Q
(λ1 y 01 − 1)k w1 + λ1 w1 − ∑  .
 q=2 ∂k wq  ∂k i1 
Equations (A.8.1.23) contain Q variables, k wq and ki1 . { }

Lemma A.8.1.1
For given initial values of {k wq (0 )} and ki1 (0), the motion of {k wq (t )} and
ki1 (t ) is given by Eqs. (A.8.1.23). The values of the other variables are
given as functions of {k wq (t )} and ki1 (t ) at any point of time by the follow-
ing procedure: k w1 by (A.8.1.20) → k sq by (A.8.1.13) → kiq by (A.8.1.15)
( )
→ f jq = f jq k jq → pq by (A.8.1.14) → r and wq by (A.8.1.2) → ydq
by (A.8.1.16) → ciq , csq and sq by (A.8.1.8) → nsq and niq by
(A.8.1.17) → k q by (A.8.1.18) → Eq by (A.8.1.12) → N jq = n jq N q →
K jq = k jq N jq → F jq = N jq f jq .
We can study equilibrium similarly as in Sect. 8.3.3.

Appendix 319
A.8.2 A Two-Country Model of Optimal Growth
Despite an extensive literature on optimal growth models of closed

economies on the basis of the Ramsey approach, analogous work on inter-
nationally trading economies is scarce. Recently, Brecher et al. (2005) pre-
sent a two-country optimal model, extending and generalizing the Oniki-
Uzawa trade model. We now illustrate how to model international trade
with multiple goods and multiple countries within the Ramsey approach.
We first outline a national economy that uses the services of capital and
labor to produce two tradable consumption goods, 1 and 2 , and capital as
non-traded good 3. Both factors of production are perfectly mobile among
all three industries of the economy, but completely immobile internation-
ally. Let K j (t ) and N j (t ) stand for respectively the capital stocks and la-
bor force employed by sector j . The neoclassical production functions,
F j (t ), are
F j (t ) = F j (K j (t ), H (t )N j (t )), j = 1, 2 , 3 ,
where H (t ) represents the number of efficiency units per natural unit of

labor at time t . We can also rewrite F j (t ) as
K j (t )
F j (t ) = H (t )N j (t ) f j (k j (t )), f j (k j (t )) ≡ F j ((t ), 1), k j (t ) ≡ .
H (t )N j (t )
Let W (t ) and R(t ) stand for respectively the nominal wage and rental
rates. The marginal conditions are
[
R = Pj f j' (k j ), W = Pj H f j (k j ) − k j f j' (k j ) , ] (A.8.2.1)
if F j > 0 , j = 1, 2 , 3 ,
where Pj (t ) is the price of good j . For convenience of discussion, in the

reminder of Sect. A.8.2, we require k1 > k 2 .
Assume that the total labor force, N (= 1) , be constant and the capital
does not depreciate. Introduce
P1 (t )
p1 (t ) ≡ , KT (t ) ≡ K (t ) − K 3 (t ), NT (t ) ≡ N − N 3 (t ),
P2 (t )
KT (t ) N (t )
kT (t ) ≡ , nT (t ) ≡ T .
H (t )N N
From Eqs. (A.8.2.1) and the definitions of the variables, it is straight-

forward to show that we can express the output levels of the two sectors as
follows
f j (t ) = Q j ( p1 , kT , nT ), j = 1, 2 . (A.8.2.2)
Let A(t ) stand for the nominal stock of household assets and
r (t ) ≡ R(t ) / P3 (t ) be the real rate of interest. Households choose the con-
sumption levels of two consumption goods, C1 (t ) and C2 (t ), to maximize
the present discounted value of lifetime utility, as follows
∞
u 1−θ (C1 (t ), C2 (t )) − 1 − ρ t
max ∫ e dt ,
0 1−θ
s.t. : A& (t ) = r (t )A(t ) + W (t ) − P1 (t )C1 (t ) − P2 (t )C2 (t ), (A.8.2.3)
where ρ (> 0) is the rate of time preference, 1 ≤ θ is the elasticity of the

marginal utility of income, and the utility function, u , is strictly quasi-
concave, first-degree homogenous and consistent with the Inada condi-
tions. It is further assumed that labor-augmenting technical process occurs
at a constant rate, g (> 0) , that is
H& (t ) = gH (t ).
As capital is not traded and capital depreciation is omitted, we have
K& (t ) = F3 (K 3 (t ), N 3 (t )). (A.8.2.4)
Because of market clearing for non-traded good 3 , a balanced budget

implies
P1C1 + P2 C 2 = P1Q1 + P2 Q2 . (A.8.2.5)
We have defined the basic model of a closed economy. We now briefly
illustrate how Brecher et al. use this basic model to examine trade patterns.
In addition to Home described above, we introduce Foreign into this basic
model. Further assume that Home and Foreign are identical in terms of
their underlying parameters, except for technological differences that result
in p1* ≠ ~ p1* , where asterisks are used to denote the values at steady state
before trading. For convenience of explanation, assume p * < ~ p * . This 1 1
condition implies that opening the countries to international trade leads

Appendix 321
Home to export good 1 in exchange for imports of good 2 from Foreign.

Introduce X ≡ C1 −F1 . Then clearing of world markets requires
~ (A.8.2.6)
X + X = 0.
We can now discuss the existence of a free-trade steady-state equilibrium.
The discussion is quite similar as in Sect. 8.1 for the Oniki-Uzawa model.
As it is very tedious and behavioral interpretations of the results compli-
cated, we will not further examine the model.
9 Growth and Trade with Capital and Knowledge
Adam Smith held that the large gains in the productivity of labor have their
origins in the large part of the skill, dexterity, and judgment, which are
consequences of the division of labor. The opportunities and incentives to
which workers respond in their investment in human capital are not seri-
ously considered by classical economists such as Smith, Ricardo, and
Marx. The omission was perhaps not so much misleading as it might ap-
pear, given the role of innovation and education in economic development
when the classical economists were constructing their theories. Neverthe-
less, to understand contemporary world economies, it is essential to exam-
ine possible effects of trade upon personal income distribution in a global-
izing world economy. It has been argued that productivity differences
explain much of the variation in incomes across countries, and technology
plays a key role in determining productivity.1 The pattern of worldwide
technical change is determined largely by international technology diffu-
sion because a few rich countries account for most of the world’s creation
of new technology. As globalization is deepening, it is important to pro-
vide analytical frameworks for analyzing global economic interactions. For
instance, it is important to examine how a developing economy like India
or China may affect different economies as its technology is improved or
population is increased; or how trade patterns may be affected as technolo-
gies are further improved or propensities to save are reduced in developed
economies like the US or Japan.
One of the first seminal attempts to render technical progress endoge-
nous in growth models was initiated by Arrow in 1962. He emphasized
one aspect of knowledge accumulation - learning by doing. In 1965 Uzawa
introduced a sector specifying in creating knowledge into growth theory.
The knowledge sector utilizes labor and the existing stock of knowledge to
produce new knowledge, which enhances productivity of the production
sector. Another approach is taken by, for instance, Kennedy in 1964,
Weizsäcker in 1966 and Samuelson in 1965, who took account of the as-
1 Different channels of inequalities are modeled by, for instance, Krugman and
Venables (1995), Manasse and Turrini (2001), Nakajima (2003), and Agénor
(2004).
324 9 Growth and Trade with Capital and Knowledge
sumption of “inducement through the factor prices”. In 1981 Schultz em-

phasized the incentive effects of policy on investment in human capital.2
There are many other studies on endogenous technical progresses.3 But on
the whole theoretical economists had been relatively silent on the topic
from the end of the 70s until the publication of Romer’s paper in 1986
(Romer, 1986). Since then there has been an even increasing number of
publications on the literature. In Romer’s approach, knowledge is taken as
an input in the production function and competitive equilibrium is ren-
dered consistent with increasing aggregate returns owing to externalities. It
is assumed that knowledge displays increasing marginal productivity but
new knowledge is produced by investment in research technology, which
exhibits diminishing returns. Various other issues related to innovation,
diffusion of technology and behavior of economic agents under various in-
stitutions have been discussed in the literature. There are also many other
models emphasizing different aspects, such as education, trade, R&D poli-
cies, entrepreneurship, division of labor, learning through trading, brain
drain, economic geography, of dynamic interactions among economic
structure, development and knowledge.4 These studies attempted to for-
malize trade patterns with endogenous technological change and monopo-
listic competition. They often link trade theory with increasing-returns
growth theory. Within such frameworks the dynamic interdependence be-
tween trade patterns, R&D efforts, and various economic policies are con-
nected. With the development of models with endogenous long-run
growth, economists now have formal techniques with which they explore
the relationship between trade policy and long-run growth either with
knowledge or with capital, but in most of them not with both capital and
knowledge within the same framework. One of problems with the new
growth theory is that its analytical framework is not effective in dealing
with capital accumulation and innovation in a single consistent framework.
It has been observed that world R&D activity and world production of
capital equipment are highly concentrated in a small number of countries.
As shown by Eaton and Kortum (2001), the countries that are most R&D
intensive are also the ones most specialized in making equipment. Al-
though each country may not spend much on R&D, the benefits may
2 See Arrow (1962), Uzawa (1965), Kennedy (1964), Weisäcker (1966),

Samuelson (1965), and Schultz (1981).
3 Works, for instance, by Sato and Tsutsui (1984) and Nelson and Winter (1982),
are examples along this line.

4 See, for example, Dollar (1986), Chari and Hopenhayn (1991), Krugman
(1991), Rauch (1991a), Stokey (1991), Nardini (2001), Martin and Ottaviano (2001),
Brecher et al. (2002), and Nocco (2005).
spread around the world through imitation and exports of capital goods
that embody new technology. It is argued that a country’s productivity de-
pends on its access to capital goods from around the world and its willing-
ness and ability to utilize them. Eaton and Kortum develop a model of
trade in capital goods to take account of this view. The theoretical frame-
work is a combination of the neoclassical growth model of technological
change embodied in new capital goods and a model of Ricardian trade. A
main purpose of the model is to link productivity to imports of capital
goods. The model also tries to discuss impact of trade barriers measured in
costs arising from factors such as marketing overseas, negotiating a foreign
purchase, transporting goods to foreign location, tariffs, non-tariff barriers,
distributing goods in foreign markets, installation in foreign production fa-
cilities, training foreign workers to use the equipment, and providing parts,
maintenance, and customer service from abroad.
This chapter examines interactions between growth, trade, knowledge
utilization, and creativity within a compact analytical framework. We con-
sider knowledge as an international public good in the sense that all coun-
tries access knowledge and the utilization of knowledge by one country
does not affect that by others. Section 9.1 introduces a growth model with
endogenous human capital accumulation for a national economy. Section 9.2
proposes a multi-country model with capital accumulation and knowledge
creation. This section assumes that knowledge creation is through learning by
doing and research. This section simulates the model to see how the system
moves over time and how the motion of the system is affected when some
parameters are changed. This section is organized as follows. Section 9.2.1
defines the multi-country model with capital accumulation and knowledge
creation. Section 9.2.2 examines the case when all the countries have the
same preference. We show that the motion of the global economy can be ex-
pressed by a two-dimensional differential equations system and we can ex-
plicitly determine the dynamic properties of the global economy. Section
9.2.3 shows that the dynamics of the world economy with J countries can be
described by ( J + 1) -dimensional differential equations. As mathematical
analysis of the system is too complicated, we demonstrate some of the dy-
namic properties by simulation when the world economy consists of three
countries. Sections 9.2.4 – 9.2.7 examine respectively effects of changes in
each country’s knowledge utilization efficiency and creativity, research pol-
icy, the propensity to save, and the population. The analytical results in Sect.
9.2.3 are proved in Appendix A.9.1.
9.1 A National Growth Model
This section introduces a growth model with endogenous human capital

accumulation for a national economy.5 As the international trade model
with capital and knowledge in the next section is complicated, we are first
concerned with a national economy to introduce the basic concepts for
economic dynamics with capital and knowledge. The model considers Ar-
row’s learning by doing and Uzawa’s education as two main sources of
human capital accumulation. Another important issue we will address in
this section is path-dependent economic development. An economy’s long-
term prosperity may depend on initial conditions is nowadays a familiar
idea in the growth literature. Many models capture different aspects of this
kind of phenomena in formal models.6 This section shows that when dif-
ferent sources of learning exhibit increasing and decreasing returns to
scale, then the system has multiple equilibrium points and its evolution is
characterized of being path-dependent.
9.1.1 The OSG Model with Endogenous Human Capital
The economy has one production sector and one education sector. The lat-
ter is called the university. We assume a homogenous and fixed national
labor force, N . The labor force is distributed between economic activities,
teaching and studying. We select commodity to serve as numeraire, with
all the other prices being measured relative to its price. We assume that
wage rates are identical among all professions. We introduce
F (t )  output level of the production sector at time t;

K (t )  level of capital stocks of the economy;
H (t )  level of human capital of the population;
N i (t ) and K i (t )  labor force and capital stocks employed by the produc-
tion sector;
5 The model is proposed by Zhang (2005a). See also Zhang (2006a: Sect. 3.2).
It should be noted that in Zhang (2007d) the time for education is an endogenous
variable.
6 There are a large number of the literature on economic growth with bifurcations
and chaos (for instance, Day, 1984; Hommes, 1991, 1998; Zhang, 1990, 1991; Azari-
adis, 1993; Boldrin, et al. 2001; Matsuyama, 1991, 2001; Shone, 2002). Zhang
(2005b, 2006b) introduces contemporary theories of differential and difference equa-
tions and their applications to economics.
N v (t ) and N e  number of teachers and number of students;

K e (t )  capital stocks employed by the university;
w(t ) and r (t )  wage rate and rate of interest.
We first model production and consumption. We assume that production

is to combine qualified labor force, H m (t )N i (t ), and physical capital,
K i (t ). Most aspects of our model are the same as the OSG model. The
production process is described by
F (t ) = AK iα (t )(H m (t )N i (t )) , A, α , β > 0 , α + β = 1.
β
The marginal conditions are given by

r (t ) = (1 − τ )αAki− β (t ), w(t ) = (1 − τ )βAH m (t )kiα (t ), (9.1.1)
where ki ≡ K i / H m N i and τ is the tax rate on the product level.

We denote per capita wealth by k (t ), where k (t ) ≡ K (t ) / N . Per capita
current income is given by
y (t ) = r (t )k (t ) + w(t ).
The per capita disposable income is given by
yˆ (t ) = y (t ) + k (t ).
The budget constraint is given by:
c(t ) + s (t ) = yˆ (t ) .
The utility function is given
U (t ) = c ξ (t )s λ (t ), ξ , λ > 0 , ξ + λ = 1.
The optimal solution is given by
c(t ) = ξyˆ (t ), s (t ) = λyˆ (t ). (9.1.2)
The change in the household’s wealth is equal to the savings minus the
wealth sold at time t , i.e.
k&(t ) = s ( yˆ (t ) ) − k (t ) = λyˆ (t ) − k (t ). (9.1.3)
We now study the behavior of the university. We assume that there are
two sources of improving human capital, through education and learning
by producing. Arrow first introduced learning by doing into growth theory;
Uzawa took account of trade offs between investment in education and

capital accumulation.7 We propose that human capital dynamics is given
by
υ K α e (H m N v ) v (H m N e ) e (9.1.4)
β β
υF
H& = e e + i π − δhH ,
N NH
where δ h (> 0) is the depreciation rate of human capital, υ e , υi , α e , β v ,
and β e are non-negative parameters. The above equation is a synthesis
and generalization of Arrow’s and Uzawa’s ideas about human capital ac-
cumulation. The term, υ e K eα e (H m N v ) v (H m N e ) e , describes the contribu-
β β
tion to human capital improvement through education. Human capital

tends to increase with an increase in the number of students. The term di-
vided by N measures the contribution per capita. We take account of
learning by doing effects in human capital accumulation by the term
υi F / H π . This term implies that contribution of the production sector to
human capital improvement is positively related to its production scale,
F , and is dependent on the level of human capital. The term, H π i , takes
account of returns to scale effects in human capital accumulation. The case
of π > (<) 0 implies that as human capital is increased it is more difficult
(easier) to further improve the level of human capital.
We assume that the students and teachers are paid by government’s tax
income at the same wage rate as the wage rate of workers. We assume that
the economy has a fixed ratio of the population who is getting education in
the university. The number of students is given by N e = ne N . Assume that
the total tax income is used for paying the students, teachers and the capi-
tal stocks employed by the university. The government spends w(t )N e
amount of money on students. Obviously, this assumption is strict. A way
to relax this assumption without increasing analytical complex of the
model is to assume that each individual spends a given amount of time on
education. The time distribution is given by Ti + Te = T , where T is the
7 Arrow (1962) and Uzawa (1965). Learning by doing has been introduced into
growth theory in different ways. For instance, Chari and Hopenhayn (1991), Par-
ente (1994), and Stokey (1988) study learning by doing as a force for sustained
growth; Brezis et al. (1993), Krusell and Rios-Rull (1996), and Jovanovic and
Nyarko (1996) show that learning by doing can give rise to the overtaking; Karp
and Lee (2001) examined learning by doing and the choice of technology; and
Liso et al. (2001) examine the implications of learning by doing for division of la-
bor.
fixed available time, Ti is the work time and Te is the time as a student.
The student gets free education but does not receive any wage. It can be
seen that the conclusions will not be different in the two cases and the
model is still analytically tractable. The budget for paying teachers and the
capital stocks of the university is given by
w(t )N v (t ) + r (t )K e (t ) = τF (t ) − w(t )N e . (9.1.5)
The university distributes its total resource, τF (t ) − w(t )N e , to the teach-

ers, N v (t ), and the capital stocks, K e (t ), in such a way that the output of
the university, υ e K eα e (H m N v ) v (H m N e ) e , will be maximized. The univer-
β β
sity’s problem is formed as follows
Max υ e K eα e (H m N v ) v (H m N e ) e ,
β β
subject to Eq. (9.1.5). The solution is given by

α e (τF − wN e ) β v (τF − wN e ) (9.1.6)
Ke = , Nv = .
(α e + β v )r (α e + β v )w
Labor force and capital stocks are fully employed
Ni + Ne + Nv = N , Ki + Ke = K. (9.1.7)
We have thus built the model. We now examine properties of the dy-
namic system.
9.1.2 The Dynamics and Multiple Equilibrium Points
From Eq. (9.1.7), we get N i + N v = N − N e . From Eqs. (9.1.1) and

(9.1.6), we obtain
α e ki N i H m (τ − (1 − τ )βN e / N i )
Ke = ,
ατ 0
β v (τN i − (1 − τ )βN e ) (9.1.8)

Nv = ,
βτ 0
where we use
F = N i H m f , τ 0 ≡ (α e + β v )(1 − τ ).
From Eqs. (9.1.8) and N i + N v = N − N e , we solve

N − N e + β v N e / (α e + β v )
Ni = τ 0β ,
τ 0 β + τβ v
β v (τN i − (1 − τ )βN e ) (9.1.9)

Nv = .
τ 0β
Hence, given the government policy on education (measured by τ and
N e ), and the university’s production character (measured by α e and β v )
we uniquely determine the labor distribution, which is invariant in time. If
τ , N e , α e , and/or β v are shifted, then the labor distribution will be
changed. The invariance of the labor distribution for the given policy and
university production character is due to the assumed Cobb-Douglas func-
tional forms. As shown in the appendix, the invariance is not generally
held.
According to the definition of ki (t ), from Eqs. (9.1.8), we have
α e (τ − (1 − τ )βN e / N i )
K e = aK i , a ≡ .
ατ 0
From the above equations and K i + K e = Nk , we solve
Nk (t ) aNk (t ) (9.1.10)
K i (t ) = , K e (t ) = .
1+ a 1+ a
As ki = K i / H m N i , we obtain
k (t ) (9.1.11)
ki (t ) = ni ,
H m (t )
where ni ≡ N / N i (1 + a ). We see that ki (t ) is a function of k (t ) and H (t ).

Summarizing the above discussions, we have the following lemma.
Lemma 9.1.1
For any given levels of wealth and human capital, k (t ) and H (t ), all the
other variables in the system are uniquely determined at any point of time.
The values of the variables are given as functions of k (t ) and H (t ) by the
following procedure: N i and N v by Eqs. (9.1.9) → K i (t ) and K e (t ) by
Eqs. (9.1.10) → ki (t ) by Eq. (9.1.11) → f = Akiα and F = N i H m f →
r (t ) and w(t ) → y = rk + w and yˆ = y + k → c and s by Eqs. (9.1.2)

→ U = cξ s λ .
We now show how to determine by k (t ) and H (t ) at any point of time.

From Eqs. (9.1.3) and (9.1.4), and Lemma 9.1.1, it is not difficult to see
that the dynamics of k (t ) and H (t ) are explicitly given by the following
two differential equations
k&(t ) = λ* k α H βm − ξk ,
H& = υ e*k α e H β v m + β e m + υi* H m −π −αm k α − δ h H , (9.1.12)
where
λ* ≡ λA(1 − τ )(αni− β + βniα ),
αe
 aN  υ e N vβ v N eβ e υ Anα N
υ ≡ 
*
e
 , υi* ≡ i i i .
1 + a  N N
Lemma 9.1.1 guarantees that if we know values of k (t ) and H (t ), then

we can solve all the other variables as functions of k (t ) and H (t ). Hence,
to examine the dynamic properties of the system, it is sufficient to examine
dynamic properties of Eqs. (9.1.12).
A steady state of the system is given by
λ* k α H βm = ξk ,
υ e*k α e H β v m+ β e m + υi* H m−π −αm k α = δ h H . (9.1.13)
From the first equation in Eqs. (9.1.13), we solve k = (λ* / ξ ) H m .

1/ β
Substituting this equation into the second equation in Eqs. (9.1.13) yields
Φ( H ) ≡ Φ e ( H ) + Φ i ( H ) − δ h = 0 , (9.1.14)
where
αe / β α /β
 λ*   λ* 
Φ e (H ) ≡   υ H , Φ i (H ) ≡  
* xe
υ i* H xi ,
ξ  ξ 
e
xe ≡ (α e + β v + β e )m − 1, xi ≡ m − π − 1.
We see that the number of economic equilibrium points is equal to the

number of solutions of the equation, Φ(H ) = 0 for 0 < H < ∞ . As shown
in Fig. 9.1.1, the equation may have none, one equilibrium point, or two
equilibrium points. As shown in Fig. 9.1.1a, if xe < 0 and xi < 0 , the
equation monotonically decreases in H and it passes the horizontal axis
only once. Figure 9.1.1b depicts the case of xe > 0 and xi > 0 , the func-
tion monotonically increases in H and it passes the horizontal axis only
once. Figure 9.1.1c depicts the case of xe > 0 and xi < 0 ( xe < 0 and
xi > 0 ).
a) both exhibit decreasing returns b) both exhibit increasing returns
Fig. 9.1.1. The two sectors exhibit different returns to scale effects
We can prove the conditions in Fig. 9.1.1. The following proposition

shows that the properties of the dynamic system are determined by the two
returns to scale parameters, xe and xi .
Proposition 9.1.18
(1) If xe < 0 and xi < 0, the system has a unique stable equilibrium; (2) If
xe > 0 and xi > 0 , the system has a unique unstable equilibrium; and (3)
If xe > 0 and xi < 0 ( xe < 0 and xi > 0 ), the system has either no equi-
librium, one equilibrium or two equilibrium points. When the system has
two equilibrium points, the equilibrium with low (high) level of H is sta-
ble (unstable).
We only interpret the stability condition, xe < 0 and xi < 0. From the
definitions of xe and xi , we may interpret xe and xi respectively as
measurements of returns to scale of the university and the industrial sector
in the dynamic system. When xe (< (>) 0, we say that the university dis-
plays decreasing (increasing) returns to scale in the dynamic economy. We
conclude that if both the university and the production sector display de-
creasing returns, then the dynamic system has a unique stable equilibrium.
If the two sectors exhibit decreasing returns to scale, the system will ap-
proach to its equilibrium in the long term. In a traditional society like the
one constructed by Adam Smith where increases in human capital mainly
come from division of labor and traditional education, the economic sys-
tem tends to be dominated by stability. In a newly industrializing econ-
omy, education may exhibit increasing returns to scale and learning by do-
ing may not be effective in improving human capital. The economy may
have multiple equilibrium points. If the society fails to explore increasing
returns effects from education, it may not achieve rapid industrialization.
We now demonstrate dynamics of the nonlinear system with multiple equi-
librium points.
9.1.3 The Path-Dependent Motion of the System by Simulation
We stimulate the model with two equilibrium points. We specify the pa-
rameters as follows
α = 0.35, N = 1, A = 2, N e = 0.06, τ = 0.08, λ = 0.7,
α e = 0.7, β e = 0.7, β v = 0.7, ν e = 1.8, ν i = 0.02,
(9.1.15)
δ h = 0.08, π = 0.3, m = 0.8.
8 The proof of the proposition is referred to Zhang (2005a).

Under the above specifications, we have xe = 0.4 and xi = − 0.5. The

university exhibits increasing returns to scale and the production sector is
characterized of decreasing returns. The system has two equilibrium points
(k1 , H1 ) = (17.858, 2.226), (k 2 , H 2 ) = (10.401, 19.509).
The one with lower levels of human capital and per capita wealth is sta-
ble; the other is unstable, also as analytically proved. Figure 9.1.2 depicts
the vector field and the steady states of the dynamic system. As shown in
Fig. 9.1.2, an economy with low level of human capital, even if it was ini-
tially rich, tends to converge to the stable equilibrium with low standard of
living and low level human capital. An economy with high level of human
capital, even if it was initially poor, tends to experience sustained growth.
This nonlinear dynamic system has path-dependent features. Here, we can
see the significance of cultural value for education. Japanese, Korean, and
Chinese-dominated economies like Singapore and Taiwan could have sus-
tained economic growth irrespective of their initial poor conditions in the
1960s, mainly because of their cultural values on education, rather than
due to high saving rates.9 In the 1950s, no one could have foreseen rapid
economic development of East Asia, because few economists recognized
the significance of education in economic development and fewer knew
the validity of rationalism in classical Confucianism for modern econo-
mies.10 In the literature of economic growth and development published in
the 1960s and 1970s, capital accumulation is the main engine of economic
development. Economists failed to properly interpret economic evolution
of these regions because they did not properly examine the cultural values
of education in this region.
We simulate three paths of the economy with the initial values
(k0 , H 0 ) = (1.5, 10), (k0 , H 0 ) = (115, 12), (k0 , H 0 ) = (70, 23).
The paths with (k 0 , H 0 ) = (1.5, 10) and (k 0 , H 0 ) = (115, 12 ) converge to
the low levels of human capital and per capita wealth. It is interesting to
note that the path with (k 0 , H 0 ) = (115, 12 ) starts with high level of wealth.
But its level of human capital is not improved over time. As decreasing re-
turns dominate this path, its prosperity does not last long. The path with
(k0 , H 0 ) = (70, 23) will grow infinitely because the increasing return to
9 The modern economic developments of Confucian regions, Japan, Korea,
Singapore, Hong Kong, and Mainland China are systematically examined by
Zhang (1998a, 2002a, 2003b, 2006c, 2007b).
10 Among well-known East Asian thinkers, perhaps only Fukuzawa Yukichi
(1835-1901) is exceptional.
scale dominates the economic evolution. Indeed, this kind of infinite

growth will not happen in reality as our model neglects many other signifi-
cant factors such as endogenous population change, negative externalities
such as pollution, and limitations of natural resources, which are neglected
in this model.
H
25
20
15
10
20 40 60 80 100 120
Fig. 9.1.2. Path dependent economic evolution
As far as qualitative features of economic development are concerned,

Fig. 9.1.2 provides some insights into difference in the economic devel-
opment in Mainland China and Taiwan during the period of 1950 to 1980.
The two areas started the economic development with similar economic
conditions but different average educational levels. Before the economic
reform in 1978 started in Mainland China, the living standards and educa-
tional achievements in the two Chinese societies had been enlarging. It is
only in recent years that Mainland China has begun to explore the oppor-
tunities of economic development. Structurally speaking, Mainland
China’s political economic system had devaluated modern (Western) edu-
cation so that no sector in the society could have explored potential bene-
fits of increasing returns offered by the Western civilization. Both cultural
values and political systems matter in our “neoclassical” model – I call this
model as neoclassical in the sense that except the utility function, all the
assumptions accepted in this study were developed and accepted in the lit-
erature of neoclassical economic growth theory developed in the 1950s

and 1960s.
9.1.4 Comparative Dynamic Analysis11
We first examine effects of tax on the dynamic system. In our system, the
tax income is totally spent on education. We may thus interpret increases
in the tax rate as the promotion policy taken by the government. We may
simulate the model again. Here, we are interested in the path-dependent
case. We still specify the parameter values as in (9.1.15) except the tax
rate, τ . We reduce the resource for education. Let us consider the case that
the expenditure on education is reduced from 8 percent of the GDP to 7
percent, that is
τ : 0.08 ⇒ 0.07.
Figure 9.1.3 shows the simulation results – the points with larger sizes is
the new steady states and the other two points with smaller sizes are the
old steady states. The two steady states shift as follows:
(k1 , H1 ) : (17.858, 2.226) ⇒ (14.758, 1.718),
(k 2 , H 2 ) : (101.401, 19.509) ⇒ (230.783, 53.417 ).
We see that the new stable steady state has lower levels of human capi-
tal and per capita wealth; but the new unstable steady states have much
higher levels of k and H . It seems promising with the new education pol-
icy because the new unstable steady state of higher k and H is much bet-
ter than the old unstable one. Nevertheless, the economy with the discour-
aging policy has more chances to the traditional trap than to the economic
miracle. For instance, if we start from the following three points as in the
previous example in Fig. 9.1.2:
(k0 , H 0 ) = (1.5, 10), (k0 , H 0 ) = (115, 12), (k0 , H 0 ) = (70, 23).
As demonstrated in Fig. 9.1.3, all the paths with these initial condi-
tions end up in the poverty trap. But in Fig. 9.1.2, the path with
(k 0 , H 0 ) = (70, 23) exhibits the economic miracle. This example shows
that the discouraging policy deprives the society from development oppor-
tunity. The “chance” for development is loss due to the new policy. As
shown in Fig. 9.1.3, for the economy to experience sustained growth, the
11 Here, we are only concerned with simulation results. We refer to Zhang
(2005a) for the analytical results on comparative statics analysis.

economy must have a much higher initial level of human capital than in
the case of τ = 0.08 . Hence, if the society reduces its investment in educa-
tion, it will have much less opportunities to experience sustained economic
growth, even though heavy investment in education will not guarantee sus-
tainable development of the nonlinear system in certainty.
H
70
60
50
40
30
20
10
50 100 150 200 250 k
Fig. 9.1.3. The path dependent-development as the education is discouraged
We now examine effects of the propensity to save. We still specify the

parameters values as in (9.1.15), except the propensity to save λ. We in-
crease the propensity to save. Let us consider the case that the propensity
to save is increased from 0.7 to 0.73 , that is, λ : 0.7 ⇒ 0.73 . Figure
9.1.4 shows the simulation results – the points with larger sizes is the new
steady states and the other two points with smaller sizes are the old steady
states. The two steady states shift as follows:
(k1 , H1 ) : (17.858, 2.226) ⇒ (14.758, 1.718),
(k 2 , H 2 ) : (101.401, 19.509) ⇒ (230.783, 53.417 ).
We see that the new stable steady state has higher levels of human
capital and per capita wealth; but the new unstable steady state has lower
levels of k and H . Figure 9.1.4 depicts the impact of change in λ on the
dynamics of the system.
H
25
20
15
10
k
20 40 60 80 100 120
Fig. 9.1.4. An increase in the propensity to save
9.2 Trade and Growth with Learning-by-Doing and

Research
It is well known that dynamic-optimization models with capital accumula-

tion are associated with analytical difficulties. To avoid these difficulties,
this study applies an alternative approach to consumer behavior. It will be
demonstrated that the multi-country trade model with capital accumulation
and knowledge creation becomes analytically tractable with the new ap-
proach to consumer behavior. The model in this section is a further devel-
opment of the two models by Zhang. Zhang (1992) proposed a multi-
country model with capital accumulation and knowledge creation. The
study used the traditional approach to household behavior as in the Solow
one-sector growth model, assuming a constant fraction using for saving.
The knowledge creation is only through Arrow’s learning by doing. This
study models the behavior of households in an alternative way and as-
sumes that knowledge creation is through learning by doing and research.
Although Zhang (1993c) introduced research into growth model, the
model was limited to a two-country economy and the study was only con-
cerned with equilibrium. This section synthesizes the main ideas in the
previous two models, though it extends the previous studies in some as-
pects. This study models behavior of consumers different from the previ-
ous studies. Moreover, the previous studies were only concerned with ex-
amining equilibrium and comparative statics analysis. As no simulation
was provided in the previous studies, it is almost impossible to see how the
multi-country system moves over time. This section simulates the model to
see how the system moves over time and how the motion of the system is
affected when some parameters are changed. This section is organized as
follows. Section 9.2.1 defines the multi-country model with capital accu-
mulation and knowledge creation. Section 9.2.2 examines the case when
all the countries have the same preference. We show that the motion of the
global economy can be expressed by a two-dimensional differential equa-
tions system and we can explicitly determine the dynamic properties of the
global economy. Section 9.2.3 shows that the dynamics of the world econ-
omy with J countries can be described by ( J + 1) -dimensional differential
equations. As mathematical analysis of the system is too complicated, we
demonstrate some of the dynamic properties by simulation when the world
economy consists of three countries. Sections 9.2.4 – 9.2.7 examine re-
spectively effects of changes in each country’s knowledge utilization effi-
ciency and creativity, research policy, the propensity to save, and the
population. The analytical results in Sect. 9.2.3 are proved in Appendix
A.9.1.
9.2.1 The Multi-Country Trade Model with Capital and

Knowledge
Each country has one production sector and one university. The university
is financially supported by the government through taxing the production
sector. Knowledge growth is through learning by doing by the production
sector and R&D activities by the university. In describing the production
sector, we follow the neoclassical trade framework. It is assumed that the
countries produce a homogenous commodity.12 Most aspects of production
sectors in our model are similar to the neo-classical one-sector growth
model.13 There is only one (durable) good in the global economy under
consideration. Households own assets of the economy and distribute their
incomes to consume and save. Production sectors or firms use capital and
labor. Exchanges take place in perfectly competitive markets. Production
sectors sell their product to households or to other sectors and households
sell their labor and assets to production sectors. Factor markets work well;
12 This follows the Oniki-Uzawa trade model and its various extensions with one
capital goods.
13 Burmeister and Dobell (1970).
factors are inelastically supplied and the available factors are fully utilized
at every moment. Saving is undertaken only by households, which implies
that all earnings of firms are distributed in the form of payments to factors
of production. We omit the possibility of hoarding of output in the form of
non-productive inventories held by households. All savings volunteered by
households are absorbed by firms. We require savings and investment to
be equal at any point of time. The system consists of multiple countries,
indexed by j = 1, ..., J . Each country has a fixed labor force, N j ,
( j = 1, ..., J ). Let prices be measured in terms of the commodity and the
price of the commodity be unity. We denote wage and interest rates by
w j (t ) and r j (t ) , respectively, in the j th country. In the free trade system,
the interest rate is identical throughout the world economy, i.e.,
r (t ) = rj (t ).
For convenience, we term the people working in the production sector
as workers and the people working in the university as scientists. The
population is classified into workers and scientists. We introduce
K (t )  the capital stocks of the world economy;

F j (t )  the output level of the production sector by country j ;
K j (t ) and K j (t )  the capital stocks employed and the wealth owned by
country j ;
i , r  subscript indexes denoting the production sector and the univer-
sity, respectively;
N qj (t ) and K qj (t )  the labor force and capital stocks employed by sec-
tor q , q = i , r , in country j ;
kˆ j (t ) , c j (t ) and s j (t )  the wealth owned by, the consumption levels of
and the total savings made by per person in country j ; and
w j (t ) — the wage rate in country j .
First, we describe behavior of the production sections. We assume that
there are three factors, physical capital, labor, and knowledge at each point
of time t . The production functions are given by
F j (t ) = A j Z (t )K ijα (t )N ijβ (t ),
mj j j
A j > 0 , α j + β j = 1, α j , β j > 0 , j = 1 , L , J ,
in which Z (t ) (> 0) is the world knowledge stock at time t . Here, we call

m j country j ' s knowledge utilization efficiency parameter. If we interpret
mj /β
Z N j as country j ' s human capital or qualified labor force, we see that
the production function is a neoclassical one and homogeneous of degree
one with the inputs. As cultures, political systems and educational and
training systems vary between countries, m j are different.
ucts, and firms earn zero profits. The rate of interest, r (t ), and wage rates,
w j (t ), are determined by markets. Hence, for any individual firm r (t ) and
w j (t ) are given at each point of time. The production sector chooses the
two variables, K j (t ) and N ij (t ), to maximize its profit. The marginal con-
r + δ kj = τˆ j A jα j Z j k j
m −β j α
, w j = τˆ j A j β j Z j k j j ,
m
(9.2.1)
where δ kj are the depreciation rate of physical capital in country j and
K ij (t )
k j (t ) ≡ , τˆ j ≡ 1 − τ j ,
N ij (t )
in which τ j is country j' s tax rate on its production sector.
Each worker may get income from wealth ownership and wages. Con-
sumers make decisions on consumption levels of goods as well as on how
much to save. Let kˆ (t ) stand for the per capita wealth in country j . Each
j
consumer of country j obtains income
y j (t ) = r (t )kˆ j (t ) + w j (t ), j = 1, L, J , (9.2.2)
from the interest payment rkˆ j and the wage payment w j . The disposable
income is equal to
yˆ j (t ) = y j (t ) + kˆ j (t ). (9.2.3)


between savings, s j (t ), and consumption of goods, c j (t ). The budget con-
straint is given by
c j (t ) + s j (t ) = yˆ j (t ) = rkˆ j (t ) + w j (t ) + kˆ j (t ). (9.2.4)
At each point of time, consumers have two variables to decide. A con-

sumer decides how much to consume and to save. Equation (9.2.4) means
that consumption and savings exhaust the consumers’ disposable personal
income.
We assume that utility levels that the consumers obtain are dependent
on the consumption level of commodity, c j (t ), and the savings, s j (t ). The
utility level of the consumer in country j , U j (t ), is specified as follows
U j (t ) = c j 0 j (t )s j 0 j (t ), ξ 0 j , λ0 j > 0 , (9.2.5)
ξ λ
where ξ 0 j and λ j are respectively household j ’s propensities to consume

and to hold wealth. Here, for simplicity, we specify the utility function
with the Cobb-Douglas from. It would provide more insights if we take
some other forms of utility functions.
Maximizing U j subject to the budget constraints (9.2.4) yields
c j (t ) = ξ j yˆ j (t ), s j (t ) = λ j yˆ j (t ), (9.2.6)
in which
ξ0 j λ0 j
ξj ≡ , λj ≡ .
ξ 0 j + λ0 j ξ 0 j + λ0 j

representative household in country j is given by
& (9.2.7)
kˆ j (t ) = s j (t ) − kˆ j (t ).
Knowledge creation and behavior of the university

Like capital, a refined classification of knowledge and technologies tend
to lead new conceptions and modeling strategies. Some major new knowl-
edge and inventions that had far reaching and prolonged implications, such
as Newton’s mechanics, Einstein’s theory of relativity, steam engine, elec-
tricity, and computer. Small improvements and non-lasting improvements
take place everywhere, serendipitously and intentionally. Innovations may
also happen in a drastic, discontinuous fashion or in a slow, continuous

manner. The introduction of the first steam engine rapidly triggered a se-
quence of innovations. The same is true about electricity and computer.
Bresnahan and Trajtenberg (1995) argued that technologies have a treelike
structure, with a few prime movers located at the top and all other tech-
nologies radiating out from them. They characterize general purpose tech-
nologies by pervasiveness (which means that such a technology can be
used in many downstream sectors), technological dynamism (which means
that it can support continuous innovational efforts and learning), and inno-
vational complementarities (which exist because productivity of R&D in
downstream sectors increases as a consequence of innovation in the gen-
eral purpose technology, and vice versa). This study uses knowledge in a
highly aggregated sense. We assume a conventional production function of
knowledge in which labor, capital, and technology are combined to create
new knowledge in a deterministic way. This is an approximate description
of the idea that devoting more resources to research yields more rapidly
new knowledge. There does not appear to have certain evidence for sup-
porting any form of how increases in the stock of knowledge affect the
creation of new knowledge. We do not require that the creation function
for knowledge have constant returns to scale in capital and labor. It is pos-
sible that doubling the number of computers and scientists increases three
times of the knowledge creation than before – the university’s knowledge
creation exhibits increasing returns to scale in scientist and capital. It is
also possible for the university to have decreasing returns to scale. We thus
should allow three possibilities - increasing, constant, decreasing returns to
scale in scientists and capital – in the university’s knowledge creation.
We consider that research is carried out only by the universities.14 We
propose the following equation for knowledge growth
J  τ F (t )  (9.2.8)
Z& (t ) = ∑  ε ij + τ rj Z rj (t )K rj rj (t )N rj rj (t ) − δ z Z (t ),
ij j ε α β
j =1  Z (t ) 
in which δ z (≥ 0) is the depreciation rate of knowledge, and ε qj , τ qj , α rj
and β rj are parameters. We require τ qj , α rj , and β rj to be non-negative.
14 In some studies it is assumed that the research sector consists of two sub-
sectors: a private research sector and a government research sector, for instance,
Park (1998). In Park’s model, the government may create knowledge useful for
defense, space, and environment and the private sector for industrial, agricultural,
and consumption goods. Some overlapping knowledge, like mathematical and sci-
entific knowledge, may be tailored for research as particular activities.
To interpret Eq. (9.2.8), first let us consider a special case that knowl-
edge accumulation is through learning by doing. The parameters τ ij and
ε ij
δ z are non-negative. We interpret τ ij F / Z as the contribution to knowl-
edge accumulation through learning by doing by country j ' s production
sector. To see how learning by doing occurs, assume that knowledge is a
function of country j ' s total industrial output during some period
 t 
Z (t ) = a1  F j (θ ) dθ  a2 + a3 ,
∫
 0 
in which a1 ,a2 and a3 are positive parameters. The above equation implies
that the knowledge accumulation through learning by doing exhibits de-
creasing (increasing) returns to scale in the case of a2 < (>) 1 . We inter-
pret a1 and a3 as the measurements of the efficiency of learning by doing
by the production sector. Taking the derivatives of the equation yields
τ ij F j
Z& = ε ij
Z
ε α β
in which τ ij ≡ a1a2 and ε ij ≡ 1 − a2 . The term, τ rj Z rj K rj rj N rj rj , is the con-
tribution to knowledge growth by country j ' s university. It means that
knowledge production of the university is positively related to the capital
stocks, K rj , employed by the university and the number of scientists, N rj .
To interpret the parameter, ε rj , we notice that on the one hand, as the
knowledge stock is increased, the university may more effectively utilize
traditional knowledge to discover new theorems, but on the other hand, a
large stock of knowledge may make discovery of new knowledge difficult.
This implies that ε rj may be either positive or negative. It is reasonable to
assume that the more equipments, books, and buildings, and scientists the
university employs, the more productive it becomes. That is, α rj and β rj ,
are positive.
The universities are financially supported by the governments. In this
model, the governments collect taxes to support the universities. As tax in-
come are used only for supporting the utilities, we have
(r (t ) + δ )K (t ) + w (t )N (t ) = τ F (t ),
kj rj j rj j j j = 1, ... , J . (9.2.9)
The university pays the interest, (r + δ kj )K rj , for the equipments it uses

and the scientists’ wage, w j N rj , it employs; it obtains the research fund,
τ j F j , from the government. We now design the distribution policy to de-
termine the number of scientists and the amount of equipments.
We determine K rj (t ) and N rj (t ) by assuming that country j ' s univer-
sity utilizes its financial resource, τ j F j (t ), in such a way that its output –
contribution to knowledge growth – is maximized. The behavior of the
university is thus formulated by
Max τ rj Z
ε rj
(t )K rjα (t )N rjβ (t ),
rj rj
s.t.: (r (t ) + δ kj )K rj (t ) + w j (t )N rj (t ) = τ j F j (t ).
Country j ' s university allocates the financial resource as follows
α jτ j F j (t ) β jτ j F j (t ) (9.2.10)
K rj (t ) = , N rj (t ) = ,
r (t ) + δ kj w j (t )
where
α rj β rj
αj ≡ , βj ≡ .
α rj + β jr α rj + β rj
If the other conditions remain the same, an increase in the tax rate or
output enables the university to utilize more equipments and to employ
more people. An increase in factor price will reduce the employment level
of the factor.
Full employment and the demand and supply balance

The assumption that the labor force and capital are always fully em-
ployed in each country is represented by
N ij (t ) + N rj (t ) = N j , K ij (t ) + K rj (t ) = K j (t ). (9.2.11)
The total capital stocks employed by the world is equal to the wealth
owned by the world. That is
J J
(9.2.12)
K (t ) = ∑ K (t ) j = ∑ kˆ (t )N
j j .
j =1 j =1
savings. That is
J
C (t ) + S (t ) − K (t ) + ∑δ kj K j (t ) = F (t ),
j =1
where
J J J
C (t ) ≡ ∑ c j (t )N j , S (t ) ≡ ∑ s j (t )N j , F (t ) ≡ ∑ F j (t ).
j =1 j =1 j =1
We have thus built the model with trade, economic growth, capital ac-
cumulation, knowledge creation and utilization in the world economy in
which the domestic markets of each country are perfectly competitive, in-
ternational product and capital markets are freely mobile and labor is in-
ternationally immobile.
9.2.2 The Dynamics when the World Has the Same Preference
This section examines a special case when the households in the world
have the identical preference and the depreciation rates are the same
among the economies. We are interested in this case because we can ex-
plicitly determine dynamic properties of the system as shown below. We
require
ξ = ξ j , λ = λ j , δ k = δ kj , α = α j , j = 1, ...., J .
We now show that all the variables in the dynamic system can be ex-
pressed as functions of k1 (t ) and Z (t ) at any point. First, from Eqs. (9.2.1)
we obtain
m
k j = M j Z j k1 , j = 1, ... , J , (9.2.13)
in which
1/ β
 A jτ j  m j − m1
M j ≡   , mj ≡ .
 A1τ 1  β
Country j' s capital intensity of the production function can be ex-
pressed as a unique function of the knowledge and country 1' s capital in-
tensity of the production function. The ratio between any two countries’
capital intensities is related to the two countries’ tax rates and the level of
the knowledge. We determine the rate of interest and the wage rates as
functions of k1 (t ) and Z (t ) as follows
r = τˆ1 A1αZ m1 k1− β − δ k , w j = τˆ j A j β α jα Z j j k1α , j = 1, L, J . (9.2.14)

αm + m

K rj α jτ j N rj β jτ j (9.2.15)
= , = .
K ij τ jα j N ij τ j β j
From Eqs. (9.2.11) and (9.2.15), we solve the capital and labor distribu-
tion between the production sector and the university in country j as fol-
lows
K qj (t ) = aqj K j (t ), N qj = bqj N j , q = i , r , j = 1, ... , J , (9.2.16)
where
α jτ j τˆ jα j
arj ≡ , aij ≡ ,
α jτ j + τˆ jα α jτ j + τˆ jα
β jτ j τˆ j β
brj ≡ , bij ≡ .
β jτ j + τˆ j β β jτ j + τˆ j β
The labor distribution is constant as it is determined by the tax rate and
capital distribution is proportional to the total capital stocks employed by
the country. By k j = K ij / N ij and Eqs. (9.2.16) and (9.2.13), we have
m
K j = M j Z j k1 , j = 1, ..., J , (9.2.17)
where M j = N ij M j / aij . Adding all the equations in (9.2.17) yields
K = k1Λ 0 (Z ), (9.2.18)
∑
J
where we use K = j =1
K j and
J
Λ 0 (Z ) ≡ ∑ M j Z
mj
.
j =1
m
From F j = A j Z j K ijα N ijβ and Eqs. (9.2.16) and (9.2.17), we have
F j = aijα A j N ijβ M αj Z
m j +αm j
k1α . (9.2.19)
Substituting Eqs. (9.2.16), (9.2.17) and (9.2.19) into Eq. (9.2.8), we

have
Z& = Λ (k1 , Z ) ≡
∑ {τ }
J
m j + αm j − ε ij α α β α rj m j + ε rj α
ij aijα Aj N ijβ M αj Z k1α + τ rj arj rj M j rj N rj rj Z k1 rj − δ z Z . (9.2.20)
j =1
We see that the motion of Z can be described as a unique function of

k1 and Z .
From Eqs. (9.2.2) and (9.2.3), we have yˆ j = (1 + r )kˆ j + w j . Substituting
s j = λyˆ j and the above equations into Eqs. (9.2.7), we have
& (9.2.21)
kˆ j = λw j − (1 − λ − λr )kˆ j .
Multiplying the equation for k̂ j by N j and then adding the J resulted

equations, we have
( ) (9.2.22)
J
K& = λβ k1α ∑τˆ j A jα jα Z j j − λ − τ 1 A1αλ Z m1 k1− β K ,
αm + m
j =1
∑ kˆ j N j and λ ≡ 1 − λ + λδ k .
J
where we use Eqs. (9.2.14) and K = j =1
Kk&1  J m −1 
(9.2.23)
K& = +  k1 ∑ m1 M j Z j  Z& .
k1  j =1 
Substituting Eqs. (9.2.22), (9.2.18) and (9.2.22) into Eq. (9.2.23) yields
λβ k1α
( )
J
∑τˆ A α
αm j + m j
k&1 = j j
α
j Z − λ − τˆ1 A1αλZ m1 k1− β k1
Λ0 j =1
 J m −1  Λ
(9.2.24)
−  k1 ∑ m1 M j Z j  .
 j =1  Λ0
Summarizing the above results, we obtain the following lemma.
Lemma 9.2.1
Assume that all the households in the world have the same preference. The
motion of the two variables, k1 (t ) and Z (t ), are given by two differential
Eqs., (9.2.20) and (9.2.24). For any given k1 (t ) and Z (t ), r (t ) and
w j (t ), j = 1, L, J , by (9.2.14). The variables, kˆ j (t ), are solved by Eqs.

(9.2.21) as follows
kˆ j (t ) = e ∫
− (1 − λ − λr ) d τ
(
h j + λ ∫ w j (τ ) e ∫
(1 − λ − λr )d τ
dτ , )
j = 1, L , J , (9.2.25)
where h j are constants to be determined by initial conditions. For any
given positive values of Z (t ), k1 (t ) and kˆ j (t ) at any point of time, the
other variables are uniquely determined by the following procedure:
k j (t ), j = 2, L, J by (9.2.13) → N qj , q = i , r , j = 1, L, J by (9.2.16)
→ K j (t ) by (9.2.17) → K qj (t ) by (9.2.16) → yˆ j = (1 + r )kˆ j + w j by
(9.2.20) → c j (t ) and s j (t ) by (9.2.6) → F j = Z j K ijα N ijβ .
m
The dynamic properties of the world economy are determined by two

differential equations. Equilibrium is determined by
∑ {τ }
J
m j +αm j −ε ij α α β α rj m j + ε rj α
ij aijα A j N ijβ M αj Z k1α + τ rj arj rj M j rj N rj rj Z k1 rj
j =1
= δzZ ,
( ) (9.2.26)
J
λβ k1α ∑τˆ j A jα jα Z
αm j + m j
− λ − τˆ1 A1αλZ m1 k1− β k1Λ 0 = 0 .
j =1
By the second equation in Eqs. (9.2.26), we solve
λ
1/ β (9.2.27)
k1 = Ω10/ β   ,
λ 
where
β J
Ω 0 (Z ) ≡ ∑τˆ A α
αm j + m j
j j
α
j Z + τˆ1 A1αZ m1 .
Λ0 j =1
Substitute Eq. (9.2.27) into the first equation in Eqs. (9.2.26)

Ω(Z ) ≡
∑ {τ }− δ
J
m j +αm j −ε ij −1 α rj m j + ε rj −1 α /β
ij Z Ωα0 / β + τ rj Z Ω 0 rj z = 0, (9.2.28)
j =1
where
α /β
λ
τ ij ≡ τ ij aij A j N ij M j  
α β α
> 0,
λ 
α rj / β
α α β λ
τ rj ≡ τ rj arj rj M j rj N rj rj   > 0.
λ 
From Lemma 9.2.1 and the above discussions, we have the following
corollary.
Corollary 9.2.1
The number of equilibrium points is the same as the number of solutions of
Ω(Z ) = 0 , for Z > 0 . For any solution Z > 0 , all the other variables are
uniquely determined by the following procedure: k1 by (9.2.27) → r and
w , j = 1, L, J , by (9.2.14) → kˆ = λw / (1 − λ − λr ) → k , j =
j j j j
2, L, J by (9.2.13) → N qj , q = i , r , j = 1, L, J by (9.2.16) → K j by
(9.2.17) → K qj by (9.2.16) → yˆ j = (1 + r )kˆ j + w j by (9.2.20) → c j and
m
s j by (9.2.6) → F j = A j Z j K ijα N ijβ .
The number of equilibrium points is the same as the number of solutions

of Ω(Z ) = 0 , for Z > 0 . As the expression is tedious, it is difficult to ex-
plicitly judge under what conditions the equation has a unique or multiple
equilibrium points. To see that equation (9.2.28) may have either a unique
or multiple equilibrium points, we are concerned with a case that all the
countries have identical population, identical production function, equal
tax rate, and identical learning by doing and university’s knowledge crea-
tion functions. In this case, the world economy is the same as a single
economy. It is straightforward to show that in this case Eq. (9.2.28) be-
comes
Ω(Z ) = τ 0i Z xi + τ 0 r Z xr − δ z = 0 ,
in which we omit index j as all the countries are identical and

m αrm
xi ≡ − ε i − 1, xr ≡ + ε r − 1,
β β
τ 0i ≡ Jτˆi A(βα ατ + ατ ) > 0 , τ 0 r ≡ Jτˆr (βα ατˆ + ατˆ ) r

α /β α /β
> 0.
It can be shown that the dynamics in this case is the same as that of the
model in Sect.9.1. In this case, the dynamic properties of the model have
been examined. The properties are summarized in the following corollary.
Corollary 9.2.2
If xi < 0 and xr < 0 (or xi > 0 and xr < 0 ), the system has a unique sta-
ble (unstable) equilibrium point; and if xi < 0 and xr < 0 ( xi > 0 and
xr < 0 ), the system may have none, one, or two equilibrium points. When
the system has two equilibrium points, the one with higher value of Z is
stable and the other one is unstable.
By the definitions of xi and xr , we interpret xi and xr respectively as

measurements of returns to scale of the production sector and university in
the dynamic system. When x j < (>) 0 , we say that sector j displays de-
creasing (increasing) returns to scale in the dynamic economy. The above
proposition tells us that if the both sectors display decreasing (increasing)
returns, the dynamic system has a unique equilibrium; if one sector dis-
plays decreasing (increasing) returns and the other sector exhibits increas-
ing (decreasing), the system may have none, one, or two equilibrium
points.
The previous section examined the dynamic properties when the world
population has an identical preference. It is straightforward to carry out
dynamic analysis as the world economy is actually controlled only by two-
dimensional differential equations. We will not further examine the behav-
ior of the system because we will simulate the model when the households
have different preferences. This section shows that in general case the dy-
namics of the world economy can be expressed by a ( J + 1) − dimensional
differential equations system.
Lemma 9.2.2
The dynamics of the world economy is governed by the following
(J + 1) − dimensional differential equations system with Z (t ), k1 (t ) and
kˆ (t ), j = 2, L , J , as the variables
j
( )
J
Z& = Λ (k1 , Z ) ≡ ∑ τ ij Z j ij φ j j + τ rj Z rj φ j rj − δ z Z ,
m −ε α ε α
j =1
( {} )
k&1 = Λ1 k1 , kˆ j , Z ≡
J J
 1
∑ n j Λ j + λ1 w1 − n0 Rψ − R ∑ n j k j − n0ψ Z Λ 
ˆ ,
 j =2 j =2  n0ψ k1
( )
kˆ j = Λ j k1 , k j , Z ≡ λ j w j − (1 − λ j − λ j r )kˆ j , j = 2 , ... , J ,
&
in which φ j , R , Λ j , ψ , ψ Z , ψ k1 , r and w j are unique functions of

Z (t ), k1 (t ) and kˆ j (t ) at any point of time, defined in Appendix, and
n0 , n j , and τ qj are parameters defined in the appendix. For any given
positive values of Z (t ), k1 (t ) and kˆ j (t ) at any point of time, the other vari-
ables are uniquely determined by the following procedure: kˆ1 (t ) by
(A.9.1.7) → k j (t ), j = 2, L, J by (A.9.1.1) → r (t ) → w j (t ), j =
1, L, J by (A.9.1.2) → N qj , q = i , r , j = 1, L, J by (A.9.1.4) → K j (t )
by (A.9.1.5) → K qj (t ) by (A.9.1.4) → yˆ j (t ) by (A.9.1.8) → c j (t ) and
s j (t ) by (9.2.6) → F j = A j Z j K ij j N ij j .
m α β
We have the dynamic equations for the world economy with any num-
ber of countries. The system is nonlinear and is of high dimension. It is
difficult to generally analyze behavior of the system. We now solve equi-
librium problem. For simplicity, we require δ k = δ kj , j = 1, ..., J . Equa-
tions (A.9.1.1) and (A.9.1.2) now become
k j = φ j (k1 , Z ) = τ kj Z j k1 1
m β /β j
,
w j = φ j (k1 , Z ) = τ wj Z (9.2.29)
m0 j α
k1 wj , j = 1, L, J ,
where
1/ β j
 τˆ A α  m j − m1 α
τ kj ≡  j j j  , mj ≡ , τ wj ≡ τˆ j A j β jτ kj j
 τˆ1 A1α1  βj
β1α j
m0 j ≡ m j + α j m j , α wj ≡ .
βj
By Eqs. (9.2.7), we have s j = kˆ j . By the definition of R and Eqs.

(9.2.1), we have
R(k1 , Z ) = λ1 (λu1 − τˆ1 A1α1 Z m1 k1− β1 ), (9.2.30)
in which λu1 ≡ 1 / λ1 − 1 + δ k . From the equations for k j in (9.2.29) and

Eqs. (A.9.1.5), we have
J
β /βj
τ kj N ij k1 1 Z
mj (9.2.31)
K =ψ = ∑ .
j =1 aij
From s j = kˆ j and Eqs. (9.2.6), we have yˆ j = kˆ j / λ j . Substitute

yˆ j = kˆ j / λ j into (A.9.1.8)
τ wj Z 0 j k1 wj
m α (9.2.32)
kˆ j = , j = 2 , ..., J ,
λuj − τˆ1α1 A1 Z m1 k1− β1
where we use Eqs. (9.2.29) and (9.2.1) and λuj ≡ 1 / λ j − 1 + δ k . By Eqs.

(A.9.1.12), at equilibrium we have
Ω k (k1 , Z ) ≡
α β /β
τ wj n j Z 0 j k1 wj J τ N k 1 jZ
m mj
J
(9.2.33)
∑ λ
j =1 uj − τˆ α A Z m1 − β1
k
− n0∑
j =1
kj ij 1
aij
= 0,
1 1 1 1
in which n1 = 1, we use Λ = Λ j = 0 , and Eqs. (9.2.29)-(9.2.32). Substi-

β /β j
tuting φ j = τ kj Z j k1 1
m
into Eq. (A.9.1.13) and setting the resulted equa-
tion at equilibrium, we have
Ω Z (k1 , Z ) ≡
∑ (τ τ )− δ
J
α ij β α j /βj α β α rj / β j (9.2.34)
+ τ rjτ kj rj Z rj k1 1
x x
ij kj Z ij k1 1 z = 0,
j =1
in which
xij ≡ m j − ε ij + α ij m j − 1, xrj ≡ ε rj + α rj m j − 1.
We see that two equations, Ω k (k1 , Z ) = 0 and Ω Z (k1 , Z ) = 0 , contain

two variables, k1 and Z . The two equations determine equilibrium values
of k1 and Z . By Eqs. (9.2.32), we determine k̂ j for j = 2 , ... , J . Follow-
ing the procedure in Lemma 9.2.2, we determine all the other variables at
equilibrium. We see that the main problem is to solve Ω k (k1 , Z ) = 0 and
Ω Z (k1 , Z ) = 0 , for k1 > 0 and Z > 0 .
As we cannot explicitly solve the equilibrium values of k1 and Z , we
simulate the model to illustrate properties of the dynamic system. We
specify the parameters as follows:
 N1   3   A1   1   m1   0.4   τ 1   0.05 
               
 N2  =  4,  A2  =  0.8  ,  m2  =  0.2  , τ 2  =  0.04  ,
 N  8  A   0.7   m   0.1  τ   0.02 
 3    3    3    3  
 α1   0.3   α1r   0.4   β1r   0.4   τ i1   0.02 

               
 α 2  =  0.32  ,  α 2 r  =  0.4  ,  β 2 r  =  0.3  , τ i 2  =  0.01  ,
 α   0.31   α   0.4   β   0.2  τ   0.01 
 3    3r     3r     i3   
 τ r1   0.08   ε i1   0.1   ε r1   0.4   ξ 01   0.2 

               
τ r 2  =  0.06  ,  ε i 2  =  0.2  ,  ε r 2  =  0.3  ,  ξ 02  =  0.2  ,
τ   0.03   ε   0.3   ε   0.2   ξ   0.3 
 r3     i3     r3     0.3   
 λ01   0.75  (9.2.35)

   
 λ02  =  0.7  , δ k = 0.05 , δ Z = 0.04 .
 λ   0.65 
 03   
Country 1, 2 and 3' s populations are respectively 3 , 4 and 8. Country
3 has the largest population. Country 1, 2 and 3' s total productivities,
A j , are respectively 1, 0.8 and 0.7 . Country 1, 2 and 3' s utilization ef-
ficiency parameters, m j , are respectively 0.4 , 0.2 and 0.1. Country 1

utilizes knowledge mostly effectively; country 2 next and country 3 util-
izes knowledge lest effectively. We call the three countries respectively as
developed, industrializing, and underdeveloped economies (DE, IE, UE). The
DE has the highest tax rate for supporting research and the UE has the
lowest tax rate. We specify the values of the parameters, α j , in the Cobb-
Douglas productions approximately equal to 0.3. 15 The DE’s learning by do-
ing and university creativity parameters, τ i1 and τ r1 , are the highest among
the countries. The returns to scale parameters in learning by doing, ε ij , are
all positive, which implies that knowledge exhibits decreasing returns to scale
in learning by doing. The depreciation rates of physical capital and knowl-
edge are specified respectively at 0.05 and 0.04 . The DE’s propensity to
save is 0.75 and the UE’s propensity to save is 0.65. The value of the IE’s
propensity is between the two other countries. Similar to the previous sector,
we introduce country j ' s returns to scale parameters for the production
sector and the university respectively as follows:
mj α rj m j
xij* ≡ − ε i1 − 1, xrj* ≡ + ε rj − 1, j = 1, 2 , 3.
βj βj
It is straightforward to calculate that with the specified values of the pa-
rameters, we have xij* < 0 and xrj* < 0 for all j . As no sector in the global
economy exhibits increasing returns to scale, it is expected that the dy-
namic system has a unique equilibrium point and it is stable. We now
show that the dynamic system has a unique equilibrium point. Figure 9.2.1
plots the two equations, Ω k (k1 , Z ) = 0 and Ω Z (k1 , Z ) = 0 , for k1 > 0 and
Z > 0 . The solid lines represent Ω k (k1 , Z ) = 0 and the dashed line stands
for Ω Z (k1 , Z ) = 0 .
From Fig. 9.2.1, we see that the two equations have multiple solutions.
Nevertheless, it can be shown that only the following solution
k1 = 20.567 , Z = 20.610 .
is meaningful and all the other variables are not economically meaningful.
For instance, we also have a solution as k1 = 2.195 and Z = 7.726 . Nev-
15 The value is often used in empirical studies. For instance, Abel and Bernanke
(1998).
ertheless, this point is economically meaningless because at this point, we

have
Z
25
20
ΩZ = 0
15
10
Ωk = 0
k1
5 10 15 20 25 30
Fig. 9.2.1. Solutions of Eqs. (9.2.33) and (9.2.34)
kˆ1 = − 34.230 , kˆ2 = 22.546 , kˆ3 = 3.557 .
As yˆ1 = λ1kˆ1 < 0 , we see that the disposable income is negative, which
means negative consumption in country 1.
We evaluate the other variables at the unique equilibrium point,
k1 = 20.567 and Z = 20.610 , as in Table 9.2.1. The global output is 46.2
and the interest rate is about 6.5 percent. The shares of the global outputs
by the DE, ID and UD are respectively 52 , 23.5 and 24.5 percent. The
population shares of the three economies are respectively 20 , 26.7 and
53.3 percent. The per-worker output levels of the DE, ID and UD are re-
spectively 8.31, 2.78 and 1.43. The differences in labor productivity are
mainly due to the differences in knowledge utilization efficiency. The table
also gives the labor and capital distributions between the sectors in each
country and the capital distribution among the three countries. More than
half of the global capital stocks is employed by the DE. The DE uses more
capital stocks in research than the IE, even though its number of scientists
is less than the number in the IE. The wage rates in the DE, ID and UD are
respectively 5.53 , 1.82 and 0.97 .
Table 9.2.1. The equilibrium values of the global economy
Z K F r C
20.610 126.665 46.199 0.065 39.831
Country 1 Country 2 Country 3 National shares
F1 24.026 F2 10.848 F3 11.326 F1 / F 0.520
F1 / N i1 8.310 F2 / N i 2 2.783 F3 / N i 3 1.430 F2 / F 0.235
K1 64.681 K2 30.791 K3 31.193 F3 / F 0.245
K i1 59.465 Ki2 28.939 Ki3 29.881 K1 / K 0.511
K r1 5.216 Kr2 2.132 K r3 1.311 K2 / K 0.243
N i1 2.891 Ni2 3.898 N i3 7.922 K3 / K 0.246
N r1 0.109 Nr2 0.149 N r3 0.078 Kˆ / Kˆ
1
0.649
K̂1 82.265 K̂ 2 24.888 K̂ 3 19.511 Kˆ 2 / Kˆ 0.196
C1 21.937 C2 8.889 C3 9.001 Kˆ / Kˆ
3
0.154
w1 5.530 w2 1.817 w3 0.967 C1 / C 0.551
k̂1 27.422 k̂ 2 6.222 k̂3 2.439 C2 / C 0.223
ŷ1 34.734 ŷ 2 8.444 ŷ3 3.565 C3 / C 0.226
c1 7.313 c2 2.222 c3 1.126
The trade balances of the three countries are given by

( )
E j (t ) = Kˆ j (t ) − K j (t ) r (t ), j = 1, 2 , 3.
When E j (t ) is positive (negative), we say that country j is in trade

surplus (deficit). When E j (t ) is zero, country j ' s trade is in balance. We
calculate the trade balances at equilibrium as follows
E1 = 1.146 , E2 = − 0.385 , E3 = − 0.761.
The DE is in trade surplus and the other two economies in trade deficit.
So far we have been concerned with equilibrium. Although we did not
prove the stability of the equilibrium point, we expect that the equilibrium
is stable. We start with different initial states not far away from the equi-
librium point and find that the system approaches to the equilibrium point.
This implies that the system is locally stable. In Fig. 9.2.2, we plot the mo-
tion of the system with the following initial conditions
k1 (0 ) = 17 , kˆ2 (0) = 8 , kˆ3 (0 ) = 3 , Z (0) = 17 .

The system approaches to its equilibrium in the long term.
120 22
100 K 20 F1 0.071
80 18
0.069 10 20 30 40 50t
16
60 F 14 0.068
40
Z 12 F3 0.067 r
10 20 30 40 50
t t 0.066
10 20 30 40 F 50
(a) Z (t ), K (t ) and F (t ) (b) F j (t ) (c) r (t )
2
20
C1 80
18 70 1
0.75 E1
16 60 K̂1 0.5
50 0.25
14
12 40 K̂ 2 -0.25 10 E2 30
20 40 50t
30 -0.5
10
C t t -0.75 E3
10 20C 30 340 50 10 20
2 K̂303 40 50
(d) C j (t ) (e) K̂ j (f) E j (t )
7
5 w1 25
4
6 c1
20
k̂1 5
3 15 4
2 w2 10 3 c2
k̂2 2
c3
w3 t 10 20 30 40 50
t t
10 20 30 40 50 10 20 30 40 50
k̂3
(g) w j (t ) (h) k̂ j (i) c j (t )
Fig. 9.2.2. The motion of some variables
9.2.4 Knowledge Utilization Efficiency
We simulated the motion of the dynamic system. It is important to ask

questions such as how a developing economy like India or China may af-
fect the global economy as its technology is improved or population is
enlarged; or how the global trade patterns may be affected as technologies
are further improved or propensities to save are increased in developed
economies like the US or Japan. The rest of this section examines effects
of changes in some parameters on dynamic processes of the global eco-
nomic system.
First, we examine the case that all the parameters, except country 1' s
knowledge utilization efficiency, m1 , are the same as in (9.2.35). We in-
crease the knowledge efficiency parameter, m1 , from 0.4 to 0.45. The
simulation results are demonstrated in Fig. 9.2.3. In the plots, a variable
∆x j (t ) stands for the change rate of the variable, x j (t ), in percentage due
to changes in the parameter value from m10 ( = 0.4 in this case) to m1
( = 0.45 ). That is
x j (t ; m1 ) − x j (t ; m10 ) (9.2.36)
∆x j (t ) ≡ ×100 ,
x j (t ; m10 )
where x j (t ; m1 ) stands for the value of the variable x j with the parameter
value m1 at time t and x j (t ; m10 ) stands for the value of the variable x j
with the parameter value m10 at time t . We will use the symbol ∆ with
As the DE improves its knowledge utilization efficiency, the knowledge
and capital of the global economy are increased; the output level of the
global economy falls initially and then rises. The DE’s output level rises;
the other two countries’ output levels fall initially and then rise. As the rate
of interest rises initially and knowledge rises but not much initially, we see
that the costs of production are high for the IE and UE and their productiv-
ities are not much improved, the two economies’ output levels fall initially.
As time passes, the world accumulates more knowledge and the rate of in-
terest falls, the IE’s and UE’s output levels are increased. We see that in
the long term the DE’s trade balance is improved and the other two
economies’ trade balances slightly deteriorate. In the long term the wage
rates and the levels of per capita consumptions and wealth in the three
economies are all improved. Hence, we conclude that as UE improves its
knowledge utilization efficiency, all the consumers in the globe benefit in
the long term.
We now examine effects of the underdeveloped economy’s knowledge
efficiency upon the global economy. We allow
m3 : 0.1 ⇒ 0.2 .
The effects of the UE’s improvement in knowledge utilization are pro-
vided in Fig. 9.2.3. As in the case when the DE improves its knowledge
utilization efficiency, the knowledge and capital of the global economy are
increased; different from the case when the DE improves its knowledge
utilization efficiency, output level of the global economy rises all the time.
The UE’s output level rises; the other two countries’ output levels are af-
fected slightly. The rate of interest rises over the time. The DE and IE’s
trade balances are improved and the UE’s trade balance deteriorates. In the
long term the wage rate, the per-capita wealth and consumption level are
increased; the the wage rate, the per-capita wealth and consumption level
of the DE and IE are effected slightly.
It should be noted that as the UE improves its knowledge utilization ef-
ficiency, the economic variables of the UE are improved, but some vari-
ables of the other economies might not be improved. For instance, Figure
9.2.5 illustrates the case that the wage rate and the output level in the IE
are actually reduced. This implies that, for instance, if India and China
more effectively apply knowledge, economies like Taiwan and Korea
might be hurt, even though the US and Japan may benefit
25
20
30 ∆F1 20
15
∆K 15
10
∆Z 20
5
t 10 ∆F2
10
5
∆r
10 20 30 40 50
-5 t t
-10 ∆F 10 20 30 40 ∆F503 10 20 30 40 50
(a) ∆Z (t ), ∆K (t ) and ∆F (t ) (b) ∆F j (t ) (c) ∆r (t )
30 ∆C1 30 0.4 ∆E2

20 ∆K̂1 0.2
20
10 ∆K̂ 2 ∆E3 10 20 30 40 50
10 ∆C 2 -0.2
50 t -0.6
-0.4
∆C3 10 20 ∆K̂ 340
30 ∆E1
10 20 30 40 50t -10
-0.8
-10 -20
(d) ∆C j (t ) (e) ∆K̂ j (f) ∆E j (t )
30
30 ∆w1 20 ∆k̂1
30
∆c1
20
20 10
∆k̂ 10 ∆c2
10 ∆w2 10 20 30 ∆k̂
2
40 350 t
t
-10 10 20 30 ∆c403 50 t
10 20 30
∆w350
40 -20 -10
(g) ∆w j (t ) (h) ∆k̂ j (i) ∆c j (t )
Fig. 9.2.3. The developed economy improves its knowledge utilization efficiency
50 5
12
10
∆F 40 ∆F3 4 ∆r
8 ∆K 30 3
6
20 2
4 ∆Z 10
2 ∆F1 1
10 20 30 40 50 t 10 20 30 ∆F 50 t
40 10 20 30 40 50t
2
50 50
∆C 3 ∆K̂ 3
1
40 40
0.5 ∆E1
30 30 ∆E2
20 20 10 20 30 40 50 t
10 ∆C1 10 ∆K̂1 -0.5 ∆E3
t -1
10 20
∆C 2
30 40 50 10 20
∆K̂ 240
30 50
(d) ∆C j (t ) (e) ∆K̂ j (f) ∆E j (t )
50
∆w3 50
∆k̂3 50 ∆c3
40 40 40
30 30 30
20 20 ∆k̂1 20
10 10 10 ∆c1
∆w1 t
10 20 30 40∆w50t 10 20 ∆k̂ 40
30 50 t 10 20 30∆c240 50
2 2
(g) ∆w j (t ) (h) ∆k̂ j (i) ∆c j (t )
Fig. 9.2.4. The underdeveloped economy raises knowledge utilization efficiency
0.1
10 20 30 40 50
-0.1
-0.2
-0.3
-0.4
-0.5 ∆F2 = ∆w2
-0.6
Fig. 9.2.5. The negative effects on F2 and w2
We now examine effects of changes in creativity parameters in learning

by doing and research, τ ij and τ rj . We increase the DE’s learning by do-
ing efficiency as follows: τ i1 : 0.2 ⇒ 0.25. The effects are plotted in Fig.
9.2.6. The knowledge, global wealth and output levels are increased. The
rate of interest rises initially and falls later on. The total output and con-
sumption levels, total wealth, per capita consumption levels, and per capita
wealth levels of the three economies are all increased. The trade balance of
the DE improves and the other two economies deteriorate. It can be seen
that the effects of change in other τ ij or any τ rj are similar.
20
10 ∆F1
15 ∆Z 8
0.5
∆F2 0.25
t
10 ∆K 6
-0.25 50 100 150 200
5 ∆F
4
∆F3 -0.5
2 -0.75
-1 ∆r
50 100 150 200
t 50 100 150 t
200
10 10
8 ∆C1 8 ∆K̂1 0.06
6 ∆C2 6 ∆K̂ 2 0.04 ∆E1

0.02
4 4
∆K̂ 3 50 100 150 200
t
2
∆C3 2 -0.02 ∆E2
50 100 150 200 t 50 100 150 200t ∆E3
(d) ∆C j (t ) (e) ∆K̂ j (f) ∆E j (t )
10 10
10
8
∆w1 8 8 ∆c1
∆k̂1 ∆k̂ 2 ∆c2
6
∆w2 6 6
4 4 4
∆c3
2 ∆w3 2
∆k̂3 2
50 100 150 200

t 50 100 150
t
200 50 100 150 200
t
(g) ∆w j (t ) (h) ∆k̂ j (i) ∆c j (t )
Fig. 9.2.6. The developed economy improves its creativity in research
9.2.5 The National Research Policies and the Global Economy
We now study how changes in the research policies affect the global econ-
omy. The DE increases its tax rate as follows: τ 1 : 0.05 ⇒ 0.07 . The DE’s
tax rate is increased from 5 percent to 7 percent. As the DE strengthens
its research policy, the knowledge, global wealth and output level are in-
creased. The rate of interest is reduced. The three economies’ output levels
are increased. The wage rate, total consumption and wealth levels, per-
capita wealth and consumption levels in each economy are increased. The
IE’s trade balance improves and the other two countries’ trade balances de-
teriorate. It should be remarked that the desirable results for the DE to in-
crease its tax for supporting research don’t hold if the tax rate is too high.
For instance, if we increase the tax rate as follows: τ 1 : 0.05 ⇒ 0.5 , then
country 1' s consumption, output level and wealth will fall. Evidently, if
few workers are engaged in economic production, all the knowledge cre-
ated by the DE will only increase the output levels of the other two coun-
tries and the DE itself does not economically benefit.
14 5 ∆F1 1 ∆r
12
10 ∆Z 4
t
8 3
2
∆F2 -1
50 100 150 200
6
4
2
∆K 1
∆F3 t
-2
50 100 150 200 -3
∆F 100
50 150 200
t -1
5 ∆C1 5 ∆K̂1
4 4 ∆K̂ 2 0.08
3 ∆C 2 3
0.06
0.04 ∆E2
2 2 0.02 ∆E3
1 ∆C3 1 ∆K̂ 3 50 100 150 200t
-0.02
∆E1
200 t 200 t
-0.04
50 100 150 50 100 150
-1 -1
(d) ∆C j (t ) (e) ∆K̂ j (f) ∆E j (t )
5 ∆w1 5 ∆k̂1 5 ∆c1

4 4 4
3 ∆w2 3 ∆k̂ 2 3 ∆c 2
2
2 2
1
∆w3 t 1 ∆k̂3 1 ∆c3
-1 50 100 150 200
50 100 150 200 t 50 100 150 200 t
-2 -1 -1
(g) ∆w j (t ) (h) ∆k̂ j (i) ∆c j (t )
Fig. 9.2.7. The developed economy increases its tax rate
We now allow the UE to increase its tax rate as follows:

τ 3 : 0.02 ⇒ 0.04 . As the UE strengthens its research policy, the knowl-
edge, global wealth and output level are increased. The rate of interest is
increased. The DE and IE’s output levels are increased; but the UE’s out-
put level is reduced. The wage rate, total consumption and wealth levels,
per-capita wealth and consumption levels in the DE and the IE are in-
creased; the wage rate, total consumption and wealth levels, per-capita
wealth and consumption levels in the UE are reduced. The DE and IE’s
trade balances improve and the UE’s trade balance deteriorates. This im-
plies that the UD will harm itself if it strengthens the research policy.
2 0.7
3 ∆Z ∆F1 0.6
1 0.5
2
∆K ∆F2 t
0.4
0.3
∆r
1 50 100 150 200
0.2
∆F -1 ∆F3 0.1
50 100 150 200 t -2 50 100 150
t
200
∆C1
2 2
∆K̂1 0.04
1 1
0.02 ∆E1
∆C 2 ∆ K̂
50 100 150 200 t 50 100 150 2 200 t 50 100∆E
150 200t
-1 -1 2
-0.02
-2
∆C3 -2
∆K̂ 3 -0.04 ∆E3
(d) ∆C j (t ) (e) ∆K̂ j (f) ∆E j (t )
2 2
∆k̂1 2 ∆c1
1 ∆w1 1 1
∆w
150 2 200 t ∆ k̂ t ∆c2 t
50 100 50 100 150 2 200 50 100 150 200
-1 -1 -1
-2
∆w3 -2
∆k̂3 -2 ∆c3
-3
(g) ∆w j (t ) (h) ∆k̂ j (i) ∆c j (t )
Fig. 9.2.8. The underdeveloped economy increases its tax rate
9.2.6 Preference Change
We now allow the DE to increase its propensity to save as follows:

λ01 : 0.75 ⇒ 0.78 .
The results are plotted in Fig. 9.2.9. As the DE increases its propensity to
save, the knowledge, global wealth and output level are increased. The rate
of interest is reduced. The DE and IE’s output levels are increased; but the
UE’s output level is reduced. The wage rate, total consumption and wealth
levels, per-capita wealth and consumption levels in the DE and the IE are
increased; the wage rate, total consumption and wealth levels, per-capita
wealth and consumption levels in the UE are reduced. The DE trade bal-
ance improves and the IE and UE’s trade balance deteriorate. As the DE
increases the propensity to save, the UD loses.
4 t
5
∆K 3 ∆F1 ∆F2 -0.5 50 100 150 200
4
3
∆Z 2 -1
-1.5
1 -2
2
∆F t -2.5
1
-1
50 100 150 200 -3
-3.5 ∆r
50 100 150 200 t
∆F3 -2
4 8
3 ∆C1 ∆C2 6 ∆K̂1 0.1 ∆E1
2
4 0.05
1
t ∆K̂ 2
50 100 150 200
2
50 100 150
t
200
-1
-2 50 100 150 200
t -0.05 ∆E2
-3 ∆C3 -2 ∆E3
∆K̂ 3
(d) ∆C j (t ) (e) ∆K̂ j (f) ∆E j (t )
4 4
3 ∆w1 8
∆k̂1 3 ∆c1
2 ∆w2 6
2
1 4
∆k̂ 2 1 ∆c2
50 100 150 200
t 2
50 100 150 200
t
-1 -1
-2 200 t -2
-3 ∆w3 -2
50 100 150
∆ kˆ3 -3 ∆c3
(g) ∆w j (t ) (h) ∆k̂ j (i) ∆c j (t )
Fig. 9.2.9. The developed economy increases its propensity to save
We now allow the UE to increase its propensity to save as follows:

λ03 : 0.65 ⇒ 0.7 . The results are plotted in Fig. 9.2.10. The knowledge,
global wealth and output level are increased. The rate of interest is re-
duced. The DE and IE’s output levels are increased; but the UE’s output
level is reduced. The wage rate, total consumption and wealth levels, per-
capita wealth and consumption levels in the DE and the IE are increased;
the wage rate, total consumption level, per-capita consumption level in the
UE are reduced. The UE trade balance improves and the IE and DE’s trade
balance deteriorate.
The relationship between population change and economics is a chal-
lenging area. Although this study assumes the population fixed, it is impor-
tant to examine effects of changes in the population sizes. As different
countries have different levels of knowledge utilization efficiency and
creativity, increases in the population sizes may have different effects upon
the global economy. For instance, it is important to examine implications
of possibly negative population growth in developed economies and rapid

population growth in underdeveloped economies.16
4 ∆F1 200t
∆Z 2 -0.2 50 100 150
3
∆K 1 ∆F2 -0.4
2 -0.6
50 100 150
t
200 -0.8
1
∆F -1 -1
∆r
t ∆F3 -1.2
50 100 150 200 -2
2 ∆C1 6
5 ∆K̂ 3 0.06
50 100
∆C2 t
150 200 4
0.04 ∆E3
0.02
-2 3
∆C3 2 ∆K̂ 2 50 100 150 200t
-4 1 ∆K̂1 -0.02 ∆E2
50 100 150
t
200
-0.04 ∆E1
(d) ∆C j (t ) (e) ∆K̂ j (f) ∆E j (t )
2 ∆w1 6
∆k̂3 2 ∆c1
1 ∆w2 5
4
∆c2 t
50 100 150 200
200 t 3
∆c3
-1
50 100 150
2 ∆k̂1 -2
1 ∆k̂ 2 -4
-2
-3
∆w3 t
50 100 150 200
(g) ∆w j (t ) (h) ∆k̂ j (i) ∆c j (t )
Fig. 9.2.10. The underdeveloped economy increases its propensity to save
9.2.7 Population Change and the Global Economy
First, we are concerned with the effects of an increase in the DE’s popu-
lation as follows: N1 : 3 ⇒ 3.5 . The effects are plotted in Fig. 9.2.12. The
knowledge, global wealth and output levels are increased. The rate of in-
terest falls. The total output and consumption levels, total wealth, per cap-
ita consumption levels, and per capita wealth levels of the three economies
16 It has been observed that the effect of population growth varies with the level
of economic development and can be positive for some developed economies.
Theoretical models with human capital predict situation-dependent interactions
between population and economic growth (see, Ehrlich and Lui, 1997; Galor and
Weil, 1999; and Boucekkine et al. 2002).
are all increased in the long term. The trade balance of the DE improves
and the other two economies deteriorate.
25
t
20
∆K
30
25 ∆F1 -0.5 50 100 150 200
15 ∆F 20 -1
15 -1.5
10
10 ∆F2 -2
-2.5 ∆r
5
∆Z 5 ∆F3 t -3
50 100 150 200
t 50 100 150 200
30
25
30
25 ∆K̂1 0.15 ∆E1
20 ∆C1 20
0.1
15 15 0.05
10 ∆C2 10 ∆K̂ 2 t
5 5 -0.05
50 100
∆150
E2 200
50∆C3100 150 200

t 50∆ K̂ 3100 150 200
t -0.1 ∆E3
(d) ∆C j (t ) (e) ∆K̂ j (f) ∆E j (t )
15
12.5 ∆w1 12.5
∆k̂1 12.5 ∆c1
10 10
10 ∆k̂ 2
7.5 7.5 7.5
∆c2
5 ∆w2 5
2.5 ∆k̂3
5
2.5
2.5
∆w3 t t ∆c3 t
-2.5 50 100 150 200 -2.5 50 100 150 200 -2.5 50 100 150 200
(g) ∆w j (t ) (h) ∆k̂ j (i) ∆c j (t )
Fig. 9.2.11. The developed economy increases its population
We now examine the case when the DE’s population changes as fol-
lows: N 3 : 8 ⇒ 9 . The effects are plotted in Fig. 9.2.12. The knowledge,
global wealth and output levels are increased. The rate of interest rises.
The total output, total consumption levels, and total wealth of each econ-
omy are all increased in the long term. The trade balance of the DE and IE
improve and the trade balance of the UE deteriorates.
In the DE and IE, the wage rates, per capita consumption levels and per
capita wealth are all increased; in the UE, the wage rate, per capita con-
sumption level and per capita wealth are all reduced.
5 10 2
4 ∆Z ∆F 8 ∆F3
3
1.5 ∆r
∆K 6
1
2 4
∆F1 0.5
1 2
t 50 100∆F2150 200
t 50 100 150
t
200
50 100 150 200
12 12
10 10 ∆K̂ 3 0.1 ∆E1
8 ∆C3 8 0.05 ∆E2
200t
6 6
4 ∆C1 4 ∆K̂1 -0.05
50 100 150
2 2 -0.1 ∆E3
∆C ∆K̂ 2200 t
50 100 2
150 200 t 50 100 150
(d) ∆C j (t ) (e) ∆K̂ j (f) ∆E j (t )
2 ∆w1
3
2 ∆k̂1
3
2
∆c1
1
∆w2 1
∆k̂ 2
1 ∆c2
200 t t 200t
50 100 150
-1 50 100 150 200 50 100 150
-1 -1
-2
-3 ∆w3 -2
∆k̂3 -2 ∆c3
-3 -3
(g) ∆w j (t ) (h) ∆k̂ j (i) ∆c j (t )
Fig. 9.2.12. The underdeveloped economy increases its population
9.3 Conclusions
This chapter proposed a multi-country growth model with capital accumu-

lation and knowledge creation. Different from the growth models with the
Ramsey approach, the alternative utility function determines saving and
consumption without leading to a higher dimensional dynamic system like
by the traditional approach. The dynamics of J -country world economy is
controlled by a ( J + 1) -dimensional differential equations system. We also
simulated the motion of the model and demonstrated effects of changes in
the parameters. It is well known that one-sector growth model has been
generalized and extended in many directions. It is not difficult to general-
ize our model along these lines. It is straightforward to develop the model
in discrete time. We may analyze behavior of the model with other forms
of production or utility functions. There are multiple production sectors
and households are not homogenous. In the contemporary literature, pri-
vate research and endogenous population have been emphasized.
Appendix 369
Appendix
A.9.1 Proving Lemma 9.2.2
First, from Eqs. (9.2.1) we obtain

1/ β j
 τˆ j A jα j Z j
m

k j = φ j (k1 , Z ) ≡   , j = 1, ..., J ,
 τˆ1 A1α1 Z m1 k1− β1 + δ j  (A.9.1.1)
 
where δ j ≡ δ k1 − δ kj . It should be noted that φ1 = k1 . From Eqs. (9.2.1)
and (A.9.1.1), we determine the wage rates as functions of k1 (t ) and Z (t )
as follows
w j = φ j (k1 , Z ) ≡ τˆ j A j β j Z j φ j j (k1 , Z ), j = 1, L, J . (A.9.1.2)
m α

K rj α jτ j N rj β jτ j (A.9.1.3)
= , = .
K ij τˆ jα j N ij τˆ j β j
From Eqs. (9.2.11) and (A.9.1.3), we solve the capital and labor distri-
bution between the production sector and the university in country j as
follows
K qj (t ) = aqj K j (t ), N qj = bqj N j , q = i , r , j = 1, ... , J , (A.9.1.4)
where
α jτ j τˆ jα j β jτ j
arj ≡ , aij ≡ , brj ≡
α jτ j + τˆ jα j α jτ j + τˆ jα j β jτ j + τˆ j β j
τˆ j β j
bij ≡ .
β jτ j + τˆ j β j
We conclude that the labor distribution is constant as it is determined by
the tax rate and capital distribution is proportional to the total capital
stocks employed by the country.
By k j = K ij / N ij and Eqs. (A.9.1.4), we have
N ij k j (A.9.1.5)
Kj = , j = 1, ..., J .
aij
As k j are functions of k1 (t ) and Z (t ), we see that K j (t ) are also func-

tions of k1 (t ) and Z (t ). From Eqs. (A.9.1.4), we also solve K rj (t ) as func-
tions of k1 (t ) and Z (t ). We see that the capital distribution among the
countries and between sectors in each country are uniquely determined as
functions of k1 (t ) and Z (t ). By K = ∑ j =1 K j , we see that K is also
J
uniquely determined as a function of k1 and Z . We denote this function as

follows: K = ψ (k1 , Z ).
m α β
Substituting F j = Z j K ij j N ij j into Eq. (9.2.8), we have
Z& = Λ (k1 , Z ) ≡
∑ (τ )
J
β m j − ε ij α β ε α (A.9.1.6)
ij A j N ij j Z K ij j + τ rj N rj rj Z rj K rj rj − δ z Z .
j =1
We see that the motion of Z can be described as a unique function of

k1 and Z .
From Eqs. (9.2.12), we solve
J
(A.9.1.7)
kˆ1 = n0ψ (k1 , Z ) − ∑ n j kˆ j ,
j =2
in which
1 Nj
n0 ≡ , nj ≡ , j = 2 , ..., J .
N1 N1
{ } ( )
Introduce kˆ(t ) ≡ kˆ2 (t ), L, kˆJ (t ) . We see that country 1' s per capita
wealth, kˆ1 (t ), can be expressed as a unique function of the knowledge,
country 1 ’s capital intensity of production function and the other coun-
{ }
tries’ per capita wealth, kˆ(t ) , at any point of time.
yˆ j = (1 + r )kˆ j + w j . (A.9.1.8)
Appendix 371
Substituting s j = λ j yˆ j and the above equations into Eqs. (9.2.7), we

have
&
( )
kˆ1 = Λ1 k1 , kˆ1 , Z ≡ λ1 w1 − R (k1 , Z )kˆ1 ,
(A.9.1.9)
( )
kˆ j = Λ j k1 , kˆ j , Z ≡ λ j w j − (1 − λ j − λ j r )kˆ j , j = 2 , ..., J ,
& (A.9.1.10)
in which R(k1 , Z ) ≡ 1 − λ1 − λ1r . Equations (A.9.1.10) are the differential

equations for k j (t ) in Lemma 9.2.2, j = 2 , ... , J . Taking derivatives of Eq.
(A.9.1.7) with respect to t yields
& J
& (A.9.1.11)
k1 = n0ψ k1 k&1 + n0ψ Z Z& − ∑ n j k j ,
j =2
where ψ k1 and ψ Z are the partial derivatives of ψ (k1 , Z ) with respect to

k1 and Z . Equaling the right-hand sizes of Eqs. (A.9.1.9) and (A.9.1.11),
we get
J
&
n0ψ k1 k&1 + n0ψ Z Z& − ∑ n j kˆ j = λ1 w1 − Rkˆ1 .
j =2
Substitute Eq. (A.9.1.7) into the above equation

( {} )
k&1 = Λ1 k1 , kˆ j , Z ≡
J J
 1 (A.9.1.12)
∑ n j Λ j + λ1 w1 − n0 Rψ + R ∑ n j k j − n0ψ Z Λ 
ˆ ,
 j =2 j =2  n0ψ k1
where we use Eqs. (A.9.1.10) and (A.9.1.6). This is the differential equa-
tion for k1 (t ) in Lemma 9.2.2. Substitute Eqs. (A.9.1.4), (A.9.1.5),
(A.9.1.1) and (A.9.1.12) into Eq. (A.9.1.6), we have
( ) (A.9.1.13)
J
Z& = Λ(k1 , Z ) = ∑ τ ij Z j ij φ j j + τ rj Z rj φ j rj − δ z Z ,
m −ε α ε α
j =1
where
α −α β α
τ ij ≡ τ ij A j N ij , τ rj ≡ τ rj arj rj aij rj N rj rj N ij rj .
This is the differential equation for Z (t ) in Lemma 9.2.2. In summary,

we have proved Lemma 9.2.2.
10 Trade Dynamics with Innovation and
Monopolistic Competition
Marshall recognized that if an economic system did not satisfy some con-
stant or decreasing returns postulate, competition itself is not dynamically
stable. He argued that industries in which particular processes exhibit in-
creasing returns to scale must rapidly become monopolized. The contem-
porary economic reality in developed economies is rarely purely competi-
tive or purely monopolistic. Growth theory based on perfect competition
may be proper for revealing complexity of economic growth on highly ag-
gregated - sectorial, interregional, national, international – levels; it tends
to lose validity if one wants to explain driving forces of economic growth
on levels of firms. Because large companies have increasingly – globally
as well as locally - dominated the scene of economic life, it is reasonable
for the contemporary mainstream of growth theory, dubbed as the new
growth theories, to swap the paradigm of monopolistic competition for that
of perfect competition of the neoclassical growth theory. The new trade
theory considers it necessary to integrate nominal rigidities, market imper-
fections and institutional barriers into trade theory. Imperfection competi-
tion in product and factor markets is a key ingredient in the new trade
theories. In contrast to perfect competition, monopoly power permits the
explicit analysis of pricing decisions.
Chapter 9 dealt with issues related to economic growth with endogenous
human capital and knowledge. Although knowledge was treated as an ex-
ogenous variable, the model had a limitation if one wants to know in the
microeconomic level about what are the motives for private companies to
make innovation and for individuals to get educated. For instance, in the
previous chapter, knowledge stock, Z (t ), receives no compensation, and
every individual is assumed to be free to exploit the entire stock of Z (t ).
Although these models are congruous with that technological change
drives economic growth and the knowledge is a nontrivial good, they don’t
explain why profit-maximizing private firms would make efforts to gener-
ate technological changes. The ‘new’ endogenous growth pioneered by
Romer (1986) and Lucas (1988) has attempted to explain technical change
as the outcome of market activity in response to economic incentives. In
374 10 Trade Dynamics with Innovation and Monopolistic Competition
the new growth theory, technological change does not take place in a pre-
determined fashion without any social and economic costs. The new
growth theory has modeled endogenous knowledge accumulation through
many channels, including formal education, on-the-job training, basic sci-
entific research, learning by doing, process innovations, industrial innova-
tions, and product innovations. The crucial assumption that leads to sus-
tainable endogenous growth is the existence of increasing returns to scale
in economic production under monopolistic competition. This chapter pre-
sents some of the key ideas in the approach in international trade theory.
Section 10.1 introduces a dynamic, two-country growth model with trade
in which endogenous technical change results from the profit-maximizing
behavior of entrepreneurs. Section 10.2 is concerned with the role of intel-
lectual property rights (IPRs) in encouraging firms in developed countries
to innovate and in helping developing countries gain access to knowledge
on the global frontier. The section introduces a dynamic general-
equilibrium product-cycle model to analyze the effects of Southern IPRs
on incentives of Northern firms to innovate and to license state-of-the-art
technologies to the South. The quality-ladders model with endogenous in-
novation and licensing integrates licensing into the theory of endogenous
product cycles. Section 10.3 introduces trade costs into North-South en-
dogenous growth model. The model tries to analyze interactions among
factor endowments, trade costs, production location, and growth. Section
10.4 introduces a model of growth and innovation of a small economy.
The small country faces perfectly elastic demand in world markets and
trades at exogenously given prices. If the small economy trades on world
capital markets, it does so at an exogenously given rate of interest. The
R&D activities of the small country does not influence the rate of accumu-
lation of knowledge capital in the world at large. Section 10.5 introduces
another important mechanism of economic growth. We introduce a model
of economic growth with externalities by Nishimura and Shimomura. The
model introduces sector-specific externalities in the Heckscher-Ohlin two-
country general equilibrium model. Section 10.6 concludes the chapter.
Section A.10.1 introduces growth model with a variety of consumer products
for a national economy. The idea is to introduce a variety of consumer goods
into the utility function that parallels the treatment of a variety of intermediate
products in the production function as in the previous section. Section A.10.2
introduces the Aghion-Howitt model of economic growth which explains
Schumpeter’s process of creative destruction. Section A.10.3 studies tech-
nological changes through improving quality of the current products.
10.1 Comparative Advantage with Endogenous Technological Change 375
10.1 Comparative Advantage with Endogenous

Technological Change
This section introduces a dynamic, two-country growth model with trade

in which endogenous technical change results from the profit-maximizing
behavior of entrepreneurs.1 The model assumes presence of cross-country
differences in the effectiveness with which primary resources can perform
different activities, that is, comparative advantage.
10.1.1 The Model
The system under consideration consists of two countries, called Home

and Foreign. Each country carries out three activities: producing a final
good, producing a continuum of varieties of differentiated middle products
(i.e., intermediate inputs), and R&D. A single primary factor, labor, is used
in production and is assumed to be fixed in each country. Output of final
goods in Home and Foreign are given by
β /α
n α 
 ∫ x (ω ) dω  , 0 < α , β < 1,
1− β
F = BA N Y
0 
where N Y represents employment in the final-goods sector, x (ω ) denotes
the input of middle product, ω , A is a country-specific productivity pa-
rameter, n is the number of varieties of middle products available. Here,
we omit time in expressions. For given n , the production function exhibits
constant returns to scale, but an increase in n raises total factor productiv-
ity. Competition in the final-goods sectors ensures marginal-cost pricing.
Producer prices satisfy
β / (1−ε )
1− β
 n 1−ε  (10.1.1)
w 1
pY =    ∫ p X (ω ) dω  , ε ≡ > 1.
A 0  1−α
where w is the wage and p X (ω ) is the price of variety ω .

At time t the existing producers of middle products engage in oligopo-
listic price competition. The producer of a variety ω chooses p X (ω ) to
maximize profits
1 The model is proposed by Grossman and Helpman (1990). Their model is in-
fluenced by Romer (1990) and Ethier (1982b).

βp X−ε (ω )
π (ω ) = [ p X (ω ) − w a N ] (p F + ~p F~ ),
p1X−ε (ω ) dω
n Y Y
∫0
where a N is the unit labor requirement for producing intermediates in

Home and Foreign. The expression for profits comprises the product of
profits per unit (in square bracket) and derived demand for variety ω . 2 The
first-order condition for the maximization is given by
αp X (ω ) = w a N . (10.1.2)
This equation also implies that varieties originating from the same coun-
try bear the same price. Hence, we can omit ω in p X (ω ). Let n stand for
the number of intermediate inputs produced in Home and Foreign. From
Eqs. (10.1.1) and (10.1.2), we have
1− β (10.1.3)
w
pY =   (np 1−ε
X + n p1X−ε )
β / (1−ε )
,
A
αp X = w a N . (10.1.4)
Now the profits can be expressed as

X
π = (1 − α ) p X ,
n
where X is aggregate output of intermediates given by
X =
np
βp X−ε
1−ε
+ np 1−ε
(p F + ~p F~ ).
Y Y
(10.1.5)
X X
Research is conducted by private, profit-maximizing entrepreneurs.3 As-

sume that innovators receive indefinite patent protection and blueprints are
not tradable so that all profits must be derived from production in the
country in which a middle product has been developed. Let R&D costs be
denoted with cr (t ). Free entry by entrepreneurs guarantees that the present
value of future operating profits from producing there must equal the cur-
rent cost. The zero-profit condition is expressed as
2 Here, it is assumed that neither the prices of competing products nor the value
of final production varies with p X (ω ).
3 Judd (1985) and Grossman and Helpman (1989).
∫e
−[ R (τ ) − R (t )]
π (τ ) dτ = cr (t ),
0
where R(t ) is the cumulative interest factor from 0 to t ( R(0) = 1 ). We

express the above condition in the following form
π + c&r (10.1.6)
= R& .
cr
As in Romer (1990), assume that R&D generates a second output,
which takes the form of a contribution to the stock of disembodied knowl-
edge. Knowledge contributes to the productivity of further research efforts
by reducing the amount of labor needed for an inventor to develop a new
product. It is also assumed that general knowledge disseminates immedi-
ately and costlessly throughout the world. Let N r denote units of labor en-
gaged in research. These researchers produce a flow of new products n&
NZ (10.1.7)
n& = r ,
ar
where Z is the current stock of knowledge and ar is a country-specific

productivity parameter. We choose units of measuring Z in such a way
that Z = n + n~ and
~ (10.1.8)
& Nr Z Nr Z
Z= + ~ .
ar ar
As knowledge is a free input, the cost of product development can be
written as
w ar (10.1.9)
cr = .
n + n~
Assume that consumers worldwide share identical, homothetic prefer-
ences, represented by
∞
U (t ) = ∫ e − ρ (τ − t ) log u[c(τ ), c~ (τ )]dτ ,

t
where ρ is the subjective discount rate and c is consumption of final

goods from Home and Foreign. Assume that the instantaneous sub-utility
function, u , is nondecreasing, strictly quasi-concave, and positively line-

arly homogeneous.
The problem is typically solved in two steps. First, the consumer maxi-
mizes static utility for a given level of expenditure, E (τ ), at time τ . This
generates an indirect utility function, v[ pY (τ ), ~
pY (τ )] E (τ ). The second-
stage problem chooses the time pattern of expenditure to maximize
∞
V (t ) = ∫ e − ρ (τ − t ) {log v[ pY (τ ), ~
pY (τ )] + log E (τ )}dτ ,
t
∞ ∞
s.t.: ∫ e −[ R (τ ) − R (t )] E (τ ) dτ ≤ ∫ e −[ R (τ ) − R (t )] w(τ ) dτ + W (t ),
t t
where W (t ) is the value of asset holdings at t . It should be noted that this

expression is for Home. We have similar expression for Foreign. The wage
rate varies by country. The first-order conditions to this problem yields
E& (10.1.10)
= R& − ρ .
E
For two final goods market, we should have
pY F = s E ,
where s ( pY , pY ) is the share of world spending allocated to F . It can be

shown that relative commodity prices are constant in the vicinity of a
steady state with active R&D activities in both countries. As the share
functions are homogeneous degree of zero, we can treat s ( pY , pY ) as be-
ing constant. Labor market clears, that is
ar n& p F (10.1.11)
~ + a X X + (1 − β ) Y = N ,
n+n w
where N is the total labor available in Home and Foreign. We have thus
completed introducing the basic structure of the model. We now examine
its behavior.
10.1.2 Behavior of the Model
As this model does not involve money, it is “free” to choose a time pattern
for one nominal variable. Let us specify the numeraire as follows:
1/ ε
a 
PY = (n + n~ ) X  .
 ar  (10.1.12)
It is shown by Grossman and Helpman that a necessary condition for
convergence to a steady state with positive R&D in both countries is
1/ ε
~  a~  (10.1.13)
PY = (n + n~ ) ~X  .
 ar 
It is straightforward to check that the relative prices of middle products,
the relative wages, and relative prices of final goods, and expenditure
shares are all constant along the convergent path. Introduce the rate of
growth of the numbers of products and the stock of knowledge
n& (t )
g (t ) ≡ .
n(t )
We see that p X and w grow at the rate of g . From Eq. (10.1.9), cr are
constant. From Eqs. (10.1.5) and (10.1.6), it is also straightforward to
show that X and R& are
n b 1 / α βE 1 βE (10.1.14)
X = ~ ~ , R& =
(
(n + n ) bn + b n
~ ) ~ ,
ε − 1 bn + b n~
where b ≡ (ar / a N ) . We say that Home enjoys comparative advantage in

α
~
conducting R&D iff b < b .
Introduce
E n ~
e≡ ~ , ns ≡ ~ , nas ≡ bns + b n~s .
n+n n+n
From g = n& / (n + n~ ) + n~& / (n + n~ ) and Eqs. (10.1.11), it can be shown

that the growth rate is given as
~ βe (1 − β ) s0 e (10.1.15)
g = N0 + N0 − − ,
nas α
where
N s ~s
N0 ≡ , s0 ≡ + ~ .
ar b b
Using e& / e = E& / E − g and n& s + n& s = 0 , we can show that the motion
of the entire dynamic system is given by two differential equations as fol-
lows
e&
=
βe
+
(1 − β ) s0 e − N − N~ − ρ ,
e α nas α
0 0
~~ (1 − β )e − a  ~ (1 − β ) s0 e  (10.1.16)
σ& = bN 0 + b N 0 −  N 0 + N 0 −  .
α α
as
 
This is an autonomous system of differential equations in e and σ . It is
readily verified that once these two variables are determined at any point
of time, then all the other variables are determined. We now list up some
interesting insights from examining properties of the dynamic system.
Proposition 10.1.1
Stronger relative demand for the final good of the country with compara-
tive advantage in R&D lowers the longer-run share of that country in the
number of middle products and slows long-run growth of the world econ-
omy. In the absence of comparative advantage in R&D, the long-run
growth rate is independent of the relative demand for final goods.
The proposition is proved by examining how the equilibrium values are

changed when the parameters, s , are shifted.
Proposition 10.1.2
An equiproportionate, once-and-for-all increase in the effective labor
forces of both countries accelerate long-run growth.
Greater resources generate faster growth in the model. This result is

typically of this type of models with linear knowledge growth and increas-
ing returns to scale.
Proposition 10.1.3
The long-run growth rate is higher the larger is the effective labor force of
the country with comparative advantage in R&D. A larger effective labor
force in the country with comparative disadvantage in R&D may be asso-
ciated with faster or slower growth, depending upon the extent of produc-
tivity differences. In the absence of comparative advantage, long-run
growth is faster the larger is the effective labor force of either country.
It is quite interesting to compare the results obtained from the

Grossman-Helpman’s model to Zhang’s model with endogenous physical
capital and knowledge in Chap. 9.4
10.2 Intellectual Property Rights (IPRs) and Trade
This section is concerned with the role of intellectual property rights

(IPRs) in encouraging firms in developed countries to innovate and in
helping developing countries gain access to knowledge on the global fron-
tier. We introduce a dynamic general-equilibrium product-cycle model to
analyze the effects of Southern IPRs on incentives of Northern firms to in-
novate and to license state-of-the-art technologies to the South.5 The qual-
ity-ladders model with endogenous innovation and licensing integrates li-
censing into the theory of endogenous product cycles.
Issues related to the dynamic effects of IPRs with an innovative North
and an imitative South are also modeled by different researchers.6 It is ar-
gued by Helpman that stronger IPRs would diminish both the Northern
rate of innovation and Southern welfare when imitation is the only channel
of technology transfer. Hence, in the absence of licensing, strengthening
IPRs would raise imitation costs, restrict technology diffusion, and reduce
long-run incentive to innovate. In the model proposed by Yang and Mas-
kus, the Northern innovative firm first chooses the intensity of effort it de-
votes to innovation. Once the innovation is successful, it decides whether
to license. It is argued that stronger IPRs in the South both would reduce
the imitation risk faced by innovative Northern firms and would create an
improved legal framework for the enforcement of licensing contracts.
We now introduce the model. The economy consists of two regions:
North and South. They are different in their abilities to conduct state of art
research and development. All innovation takes place in the North in a
steady-state equilibrium. The South would not have the technology to pro-
duce the top quality level by itself, except it may license technology from
the North. This section neglects FDI, even though in reality some countries
may prefer licensing to equity investment as the mode of technology trade.
We also omit imitation from direct examination of imported goods. This
4 Zhang’s approach is also referred to Zhang (2005a, 2006b, 2008a). A more

comprehensive economic theory can be constructed by synthesizing Zhang’s ap-
proach and the new growth theory.
5 The model is proposed by Yang and Maskus (2001).
6 For instance, Helpman (1993), Lai (1998), and Grossman and Lai (2004).
means that licensing is the only means by which the South can acquire
Northern top-level technologies.
Consumption7
The economy has a continuum of goods indexed by ω ∈ [0, 1]. Each
good potentially may be improved a continuously infinite number of times,
indexed by qualities j = 0, 1, 2, .... The increments to quality are common
to all products and exogenously given by a parameter λ > 0 . The in-
tertemporal utility function for the representative consumer is given by
∞
U = ∫ e − ρt u (t ) dt ,
0
where ρ is the subjective discount rate, and u (t ) represents instantaneous

utility at time t and
1
∞ 
u (t ) = ∫ ln ∑ λ j d jt (ω ) dω ,
0  j =0 
where d jt (ω ) stands for consumption of quality j of good ω at time t .
Every consumer maximizes discounted utility subject to an intertemporal
budget constraint
∞
∫e
− R (t )
E (t ) dt = A(0),
0
where R(t ) = ∫ r (s ) ds is the cumulative interest factor up to time t ; A(0)

t
is the value of initial asset holdings plus the present value of factor income
and
t ∞
E (t ) = ∫ ∑ p (ω )d (ω ) dω ,
jt jt
0 j =0
where p jt (ω ) is the price of a product ω of quality j at time t. The con-

sumer’s utility-maximization problem is broken into two stages. In the first
stage, the consumer evenly spreads lifetime spending across time. In the
second stage, the consumer allocates an equal expenditure share to every
product ω . At any point of time, only the highest quality level available is
sold as it offers the lowest quality-adjusted price.
7 The consumption side is identical to Grossman and Helpman (1991).

Market and innovation

In North firms that have innovated the current highest quality level of
any good are defined as “leaders” and other firms are followers. It is only
followers that conduct R&D for product improvement; leaders would not
conduct R&D. The licensor uses the rent share to deter imitation by the li-
censer. The licensee commits to payments for all future time even if it imi-
tates the licensor’s product and the licensor’s commits to refund part of the
payments should it choose to switch licensees. Rent sharing is commonly
observed in licensing contracts. As mentioned before, the model is to con-
sider the effect of IPRs on the rent split. It is assumed that the licensor’s
rent share is a positive function of the effectiveness of Southern IPRs as
δ = δ (κ ), 0 < δ (κ ) < 1, δ ' > 0 ,
where δ is the licensor’s share and κ is the degree of strength in the
Southern IPRs regime. Following Helpman (1993) and Segerstrom (1991),
we assume Bertrand competition between licensees and potential imitators
in consideration of imitation by Southern followers. Both firm types oper-
ate in the South and have the same marginal costs. If a follower firm were
to imitate the licensee’s product successfully, the licensee would price at
the imitator’s marginal cost and neither firm would earn positive profits.
This implies no imitation from Southern followers.
For each good, there are two possible market types, called the licensed
South technology market, i.e., S market (where the highest-quality goods
are produced in the South through licensing) and the original North tech-
nological market, i.e., N market (where the highest-technology goods are
produced in the North). Innovation may be conducted for both markets.
Individual research success is a continuous Poisson process. A firm that
engages in innovation at intensity I for an interval of time length dt suc-
ceeds with probability Idt . This effort requires a I ⋅ I units of labor per
unit of time. Here, successful licensing is modeled as a random process.
Assume the duration τ between the time of innovation and the time of li-
censing has an exponential distribution with cumulative density
Pr (τ ≤ t ) = 1 − e −ιt . Here, the variable ι is the Poisson arrival rate at which
the high-quality technology will be licensed to the South in the next instant
and ι∆t gives the probability that licensing takes place in the time interval
(t , t + ∆t ), given that the product is produced in the North after innovation
up to time t . Assume that licensing is costly, requiring aLι / κ units of la-
bor per unit of time.
Normalize the wage rate in the South to be 1 and let w stand for the
wage rate and VI for a market value that successful innovators attaint.
Each firm may achieve an expected gain of VI Idt , by undertaking R&D at

intensity I for an interval dt . Free entry and exit in innovation leads to
the following zero-profit condition
VI = wa I , I > 0 .
Now consider licensing. Successful licensors attack a stock value of
δ (κ )VL . Each such firm which undertakes licensing-related R&D at inten-
sity ι for an interval dt may achieve an expected gain of δ (κ )VLιdt . As
the wage rate is 1 in the South, the condition that the costs of adaptation
equal expected rewards for the licensing intensity to be finite and positive
is given by
wa L (10.2.1)
δ (κ )VL = VI + .
κ
In steady state, VL and VI are constant. The value of a firm must equal
its present value of lifetime profits. Firms in the North technology market
face the risk of innovation and the risk of the highest-quality technology
being licensed to the South. For the leading form in the N market, VI is
given by
π N + ιδ (κ )VL (10.2.2)
VI = ,
ρ + I +ι
where π N is the instantaneous profit that the leading firm gets when the
follower’s innovation fails and its own licensing does not occur. If rival
innovation succeeded, the leading firm in the N market would not be out
of the market. If licensing occurred, the firm would become the leading
firm in the S market and earn δ (κ )VL . For a firm to license a technology,
a licensee earns the following reward in steady state
πL
VL = ,
ρ+I
where π L is the instantaneous profit that the licensee achieves when the
Northern follower’s innovation does not take place. If innovation hap-
pened, the leading firm in the S market would be driven out the market.
The licensor would share the rents with the licensee and would earn
δ (κ )VL .
For the leading firm in the N market, its closest competitor is the
Southern firm that can produce the second-level quality product. The firm
sets a quality-adjusted price equal to the marginal cost of production of the

competitor. With constant-return-to scale technology, one unit of output
requires one unit of labor, i.e., PN = λ , The firm captures the entire mar-
ket and makes sales of E / λ with E being aggregate spending. Its instan-
taneous profit
 w
π N = E 1 − .
 λ
Licensees price against those Southern firms that can produce the sec-
ond-level products and therefore set PL = λ . Each licensee’s instantaneous
profit is given by
 1
π L = E 1 − .
 λ
The model has only one input, labor. It is assumed that the labor supply
in the North, N N , and in the South, N S , are exogenously given and are
fully employed. Let nN and nS stand for, respectively, the measure of the
North technology market and the measure of the South licensing market.
The labor-market clearance condition in the North is
E a  (10.2.3)
nN + Ia I nI + Ia I nS + ι  L nN = N N .
λ κ 
The first term is labor employed in production, the second term and the
third term in innovation, and the fourth term in licensing. The labor-market
clearance condition in the South is
E
nS = N S .
λ
The flow out of the N market is InN dt + ιnN dt for an interval dt and
the flow into the N market is InN dt + ιnS dt . From In N dt + ιnN dt =
InN dt + ιnS dt , we have InS = ιnN . Furthermore n N + nS = 1. We have
thus completed the description of the steady-state equilibrium.
Steady-state equilibrium
By nN + nS = 1 and InS = ιnN , we have
InS (10.2.4)
n N = 1 − nS , ι = .
1 − nS
We now solve other four endogenous variables (I , nS , E , w). From

EnS / λ = N S and Eqs. (10.2.3) and (10.2.4), we get
(1 − ns ) N +
aL
InS + Ia I = N N .
(10.2.5)
κ
S
nS
From Eq. (10.2.5), in the case of N S / nS > a L InS / κ , dnS / dI > 0 and
d 2 nS / dI 2 > 0 hold.
From
VI = wa I , VL = π L / (ρ + I ), π N = E (1 − w / λ ),
π L = E (1 − 1 / λ ),
and Eqs. (10.2.1) and (10.2.2), we express the zero-profit condition in in-
novation and the zero-profit condition in licensing respectively as follows:
 w  a  InS  (10.2.6)
E 1 −  = wa I (ρ + I ) − L   ,
 λ  κ  1 − nS 
 1  a  (10.2.7)
δ (κ )E 1 −  = w a I + L (ρ + I ).
 λ  κ 
From EnS / λ = N S and Eqs. (10.2.4), (10.2.6), and (10.2.7), we find the
relation between I and nS as follows
 a 
 a I + L (ρ + I ) =
 κ 
 1  a I nS N 
δ (κ )1 −   a I (ρ + I ) − L + S .
 λ  κ 1 − nS nS  (10.2.8)
It is straightforward to show dnS / dI < 0 , which implies that the rate of

innovation and the extent of licensing are negatively related. An increase
in innovation effort would cause the current leading firm to face a higher
risk of losing its market through licensing. The leading firm would earn its
instantaneous profits for a shorter period. It would become less attractive
for the leading firm to transfer technology to the South if it knew the life
cycle of its product were shortened, providing it with less time and smaller
returns to cover its transfer costs. Equations (10.2.5) and (10.2.8) contain
only two variables. As illustrated in Fig. 10.2.1 in which LC and VC
curves respectively correspond Eqs. (10.2.5) and (10.2.8), the two equa-
tions determine a unique equilibrium.
The extent of licensing
LC
*
nS
VC
I* The extent of innovation

Fig. 10.2.1. The relation between licensing and innovation
We now examine how the equilibrium is affected by changes in parame-

ters. If κ is increased, that is, IPRs is tightened, we see that the LC curve
would shift to the right and shift up the VC curve. By Eqs. (10.2.5) and
(10.2.8), we can show that if IPRs are strengthened in the South, both the
rate of innovation in the North and the extent of licensing to the South are
increased. As IPRs becomes stronger, the legal framework for enforcing
licensing contracts and reducing the costs associated establishing and po-
licing an arm’s-length relationship is improved and the rent share that the
licensor receives is increased. Thus firms would be encouraged to license
technology to take advantage of lower labor costs and earn higher instan-
taneous economic returns. As shown by Yang and Maskus, the effect of
stronger IPRs on the relative wage is ambiguous. As the equilibrium is
given, it is straightforward to examine effects of changes in other parame-

ters.
10.3 Trade Costs and Trade Patterns
This section introduces trade costs into North-South endogenous growth

model.8 Rapid globalization in recent years has been associated with fal-
ling trade costs.9 The model tries to analyze interactions among factor en-
dowments, trade costs, production location, and growth. The world con-
sists of two economies Home (North) and Foreign (South).10 Each country
is endowed with two types of labor, skilled and unskilled, respectively in-
dexed with subscripts, S and U . Denote labor force with N S and NU .
Labor is fully employed, mobile intersectorally, and immobile internation-
ally. Home is relatively more skilled-labor abundant, that is, we require the
~ ~
inequality, N S / NU > N S / NU . There are two industries in the world, a
perfectly competitive, homogenous agricultural product, and a monopolis-
tically competitive, differentiated manufacturing product. Depending on
the pattern of international specification, a country may have one or two
industries.
Agricultural production uses unskilled labor and is characterized by
constant returns to scale. The unit labor requirement is one.11 The agricul-
tural good is chosen to be the numeraire and, if it is produced in that coun-
try, the unskilled labor wage rate is unity. Let wU stand for the wage of
unskilled labor. The agricultural good can be traded costlessly between
countries. Manufacturing industry produces a large number of varieties
with increasing returns to scale. International trade in manufactures is
costly, and trade costs are modeled as an iceberg cost τ ( τ > 1 ).12Manu-
8 This section is based on Gao (2007).

9 These costs are, for instance, tariffs, transport costs and telecommunication
costs.
10 We use the same symbols as in Chap. 2 to distinguish the two countries.
“Home” here corresponds to the developed North in the literature and “Foreign” to
the developing South.
11 It should be noted that in this type of North-South models, neither land nor
capital is considered in agricultural product. For how to introduce capital and land
into a growth model with economic structure and endogenous knowledge, see
Zhang (2005a).
12 This implies that if τ units are shipped from one country to the other, only
one unit arrives in destination

10.3 Trade Costs and Trade Patterns 389
facturing employs both skilled and unskilled labor. Firms in the industry
compete monopolistically in the Dixit-Stiglitz fashion. Manufacturing car-
ries out R&D to create new varieties and produce output of existing ones.
The cost of developing a blueprint is incurred once and unrelated to the
output level of the subsequent production of the variety.13 With a blueprint
ready, the firm proceeds to produce the output of its variety infinitely into
the future. For each variety, blueprint development and output production
are kept within a single, atomistic manufacturing firm.
As in the model by Grossman and Helpman,14 assume that a firm hires
skilled labor only to develop a blueprint and the amount of skilled labor
necessary to create a blueprint is a / N R , where N R is the total number of
blueprints previously developed in the country and a is a constant (equal
in Home and Foreign).15 Firms enter freely into R&D and finance the cost
by issuing equity in the stock market. Equity holders of a firm will receive
the future profits of the firm. Let v denote the value of a firm that locates
its R&D in Home and Foreign. Due to free entry v is equal to the cost of
creating a blueprint, that is
aw (10.3.1)
v = ,
N
where w is the wage rate for skilled labor. Individuals can borrow or lend
freely at an instantaneous interest rate of R . A firm is called a national
firm if it develops a blueprint and produces output in the same country. It
sells its output from a country and makes profits π . The owners of a na-
tional firm obtain an instantaneous return of v& + π . On the other hand, a
loan valued at v yields a return of Rv . Arbitrage in the capital market
implies
v& + π = Rv . (10.3.2)
A firm which undertakes R&D in one country and produces output in

the other is called a foreign-invested firm in the other country.16 This
firm’s arbitrage condition is given by
13 This may be interpreted as the assumption of fixed cost in creativity.

14 Grossman and Helpman (1991: Chap. 3). See also Zhang (2005a: Chap. 10).
15 This formation means that there exist knowledge spillovers in R&D activity –
the cost falls in the number of blueprints created. This formation also implies that
spillovers occur within the country.
16 It is assumed that all stocks of a firm are held by investors from the country
where the firm’s blueprint is created.

v& + π~ = Rv , or v~& + π = Rv~ . (10.3.3)
Final output is produced with combination of skilled labor, unskilled la-

bor, and intermediate input. As in Krugman and Venables (1995), assume
that the intermediate input is manufacturing varieties aggregated into a
composite good through a constant elasticity of substitution (CES) func-
tion with the elasticity of substitution, σ > 1. The same composite good,
whose price is P , is also consumed by consumers. The marginal cost of
output production in a country is a function the wage rates and the price of
intermediate good, being specified as
β (wUγ w 1−γ )1− λ

P λ , 0 < γ , λ < 1,
where unity is the wage rate of unskilled labor, β , γ , and λ are constant.
The number of varieties is sufficiently large so that the price elasticity of
demand for each variety is also σ . Hence, a monopolistically competitive
firm producing its output in a country prices its output as
p = (wUγ w 1−γ ) (10.3.4)

1− λ
Pλ ,
where we require (1 − 1 / σ )β = 1. The profit of a firm producing output in

a country is
π = px − β (wUγ w 1−γ ) P λ x = (1 − β ) px , (10.3.5)

1− λ
where x is the level of output. The price of the composite intermediate in

country — is
(
P = np1−σ + n~ (τ~
p)
1−σ
)( 1 / 1−σ ) ~
(
p1−σ + n(τp )
, P = n~~
1−σ
)(
1 / 1−σ )
, (10.3.6)
where n is the number of varieties with output production in the country.

All the people have the same identical preference, represented by
∞
(10.3.7)
[ ]
U = ∫ e − ρ t log A1−θ (t ) Dθ (t ) dt , 0 < θ < 1,
0
where A is the consumption of the agricultural good and D is the con-

sumption of manufacturing composite, ρ is the subjective discount factor,
and θ is a parameter. It can be shown that at each point in time consumers
spend a fixed fraction, θ , of their income on the manufacturing compos-
ite. We have thus built the model with trade costs. We will refer further
analysis of the model to Gao (2007).17 An interesting insight from this

model is that in steady state a reduction in trade costs leads to a relocation
of production to the South in a differentiated-product sector. As a result,
more resources are shifted to R&D in the North.
10.4 Growth and Innovation of a Small Open Country
This section introduces a model of growth and innovation of a small econ-

omy.18 The small country faces perfectly elastic demand in world markets
and trades at exogenously given prices. If the small economy trades on
world capital markets, it does so at an exogenously given rate of interest.
The R&D activities of the small country does not influence the rate of ac-
cumulation of knowledge in the world at large. Assume that the small
country trades two final goods at an exogenously given relative price and
confines innovation to a sector that produces nontradable goods.
Local producers manufacture the two final goods, called goods 1 and
2 , with primary and intermediate inputs. The primary factors, labor and
human capital (which are respectively called 1 and 2 ), are available in
fixed and inelastic supply. For illustration, assume that each sector makes
direct use of only one primary input. Let H and N stand for the aggre-
gate supplies of unskilled labor and human capital. The sector that pro-
duces good 1 employs human capital in amount, H 1 , and the sector that
produces goods 2 employs unskilled labor in amount, N 2 . There is no in-
ternational trade in financial markets. Households use their savings to ac-
cumulate claims on domestic profit-making enterprises or to acquire risk-
less domestic bonds. We specify production functions of the two sectors as
follows
F1 = A1 D1β H 11− β , F2 = A2 D2β N 21− β , (10.4.1)
17 As most authors of this type of the trade models, Gao fails to give a proper
dynamic analysis of the behavior of the model. We introduce it as the model

shows a way of how three mechanisms of trade are integrated within the same
framework. A more comprehensive survey of this type of models (with trade costs
and monopolistic competition) is referred to Fujita and Thisse (2002).
18 The model is proposed by Grossman and Helpman (1991: Chap. 6). This sec-
tion is based on the reference just mentioned. As in Chap. 6, the assumption of a

small country implies that the economy does not affect the larger economic envi-
ronment in which it operates.
where D j represents an index of the intermediate inputs used in sector

j , j = 1, 2 , and A j is a parameter.19 With proper choices of the constants
A j , the conditions that the unit cost of each final good equals its world
price are given by
p j = w1j− β pDβ , (10.4.2)
where p j is the world price of good j , w j is the reward to factor j , and

p D is an index of the prices of intermediates. Production of a good ceases
if its unit cost rises above the world price.
Assume that intermediates are not traded. We take the product space to
be continuous. First, we consider that variety of intermediates is endoge-
nous. Let n(t ) denote the measure of intermediates invented before time
t , The variable n is called the number of available varieties. Following
Dixit and Stiglitz (1977), the index, D j , is now is specified in such a way
that it exhibits a constant and equal elasticity of substitution between every
pair of goods
1/ α
n  (10.4.3)
D j =  ∫ xαj (ω ) dω  , 0 < α < 1,
0 
where x j (ω ) denotes the input of intermediate ω in the production of fi-
nal good j . This specification has found many applications in the contem-
porary literature of economic growth with high product differentiation.
Another type of technological changes is to improve quality of the cur-
rent products. Let there be fixed types of intermediate goods. It is assumed
that when a product or technology is improved, the new good or method
tends to displace the old one. As we assume that different qualities of a
particular type of intermediate input are perfect substitutes, the discovery
of a higher grade turns out to drive out completely the lower grades. The
process is characterized by Schumpeter’s creative destruction in the sense
that successful researchers tend to eliminate the monopoly rentals of their
predecessors. In the formation with endogenous product quality, the index,
D j , is specified as follows
19 It is assumed that the two sectors are equally intensive in their use of inter-
mediate inputs in order to ensure the existence of a balanced growth path. Without
this assumption, the importance of one of the two sectors would decline over time.
1
 
D j = ∫ log ∑ qm (ω )xmj (ω ) dω ,
0 m 
where xmj (ω ) is the input of quality m of intermediate product ω in the
production of final good j and qm (ω ) is the quality of input. In this sec-
tion, we are only concerned with the innovation specified by (10.4.3).
Assume that the various components are produced with similar constant
returns to scale technologies. Let c x (w1 , w2 ) denote the marginal and aver-
age cost of producing any known intermediate. At equilibrium we have
c x (w1 , w2 ) (10.4.4)
px = ,
α
where p x is the price of the intermediate.
As all intermediates bear the same price, all are demanded to the same
amount by final good producers. It can be shown that the indexes of inter-
mediate inputs in (10.4.3) can be expressed as
D j = AD X j , (10.4.5)
where X j is the aggregate quantity of intermediate inputs used in the pro-

duction of final good j (the number of intermediates timing the quantity
employed of each one) and AD is the productivity of intermediates given
by AD (t ) = n (1−α )/ α (t ). 20 From Eq. (10.4.5) and p D D j = p x X j , we have
px (10.4.6)
pD = .
AD
It can be seen that from the equations described so far, we can solve the
prices of the primary and produced inputs as functions of the state of tech-
nology, AD , and the prices of the final goods. As world prices remain con-
stant, the price of typical intermediate good and the rewards to the two
primary inputs all grow at a common rate. This rate equals the product of
β (the cost share of intermediates) and the rate of productivity growth
A& / A .
D D
We now assume that R&D requires the input of human capital, but not
unskilled labor. Let a denote the input coefficient in R&D activity. We
20 As each intermediate good is demanded to the same extent, from Eqs.
(10.1.3) and (10.1.5), we get the expression.

have that a / n units of human capital are needed to invent one new prod-
uct per unit of time.21 The free-entry condition v = w1a / n equates the
value of a firm in the nontradables sector to the cost of market entry. Using
V ≡ 1 / nv to represent the inverse of the aggregate value of the stock mar-
ket, we have
1 (10.4.7)
V = .
aw1
Households maximize
∞
U (t ) = ∫ e − ρ (t −τ ) log u[C1 (τ ), C2 (τ )] dτ ,
0
where C j (t ) is the consumption of final good j at time t , and u is non-

decreasing, strictly quasi-concave, and homogeneous of degree one in its
arguments. The optimal path for spending satisfies
E& (10.4.8)
= r − ρ,
E
where r is the interest rate in the local capital market and E is the level of
expenditure. Trade balance requires that the value of spending equals na-
tional income
E = p1 F1 + p2 F2 . (10.4.9)
The condition that the return on equity claims equates the sum of the
firm’s dividend rate and the expected rate of capital gain the risk-free in-
terest rate is given by
V& (10.4.10)
+ γ = (1 − α )β ( p1 F1 + p2 F2 )V − r ,
V
where γ is the rate of new product introduction n& / n . In (10.4.10), V& / V
represents the profit rate for a typical producer of intermediates. The equa-
tion thus equates the excess of the dividend rate over the interest rate to the
expected rate of capital loss on shares in the representative firm. Market
clearing implies
a γ + (a11 + a1x a X 1 ) F1 + a1x a X 2 F2 = H ,
21 Here, n reflects the local stock of knowledge capital.

a2 x a X 1 F1 + (a22 + a2 x a X 2 )F2 = N , (10.4.11)
where a11 and a X 1 are respectively the per unit inputs of human capital
and aggregate intermediates in the production of good 1, a22 and a X 2 are
respectively the per unit inputs of human capital and aggregate intermedi-
ates in the production of good 2 , and a jx is the input of factor j in the
production of a un it of the aggregate intermediate good X . We have thus
described the dynamics of the model.
10.5 Growth and Trade with Externalities
This section introduces another important mechanism of economic growth.

We introduce a model of economic growth with externalities by Nishimura
and Shimomura (2002b). The model introduces sector-specific external-
ities in the Heckscher-Ohlin two-country general equilibrium model.22
The world consists of two countries, Home and Foreign, and each coun-
try may have two sectors and two goods. Each good is produced with two
factors; factors are mobile intersectorally and immobile between interna-
tionally. Two goods, a consumption good and an investment good (which
are respectively indexed as good 1 and good 2 ), are produced using two
factors of production, capital and labor. The two countries are endowed
with the same fixed amount of labor, N , and different capital stocks K .
Consumption good is selected as the numeraire and the price of investment
good is denoted by p .
Behavior of firms
The level of sector j ' s output is represented by F j (t ). Let K j (t ) and
N j (t ) stand for the capital stocks and labor employed by section j . Fol-
lowing Benhabib et al. (2000), the production function of good j ,
j = 1, 2 , is
F j (t ) = φ j (K j , N j ) K j j N j j , α j , β j > 0 , (10.5.1)
α β
22 Chen (1992) proposed a dynamic version of the Heckscher-Ohlin model.

Basing on Sect. 3.5 and Chap. 8, one can introduce externalities into the analytical
framework with Zhang’s approach. The reader is encouraged to do the exercise, in
particular, with multiple countries and simulation.
where φ j (K j , N j ) represent factor-generated externalities. For conven-

ience, we specify
φ j (K j , N j ) = K j j N j j , a j , b j ≥ 0 .
a b
The specifications mean that the two countries have the identical tech-
nologies. We further require
α j + β j + a j + b j = 1.
This implies that technologies are constant returns to scale from the so-
cial perspective but decreasing returns to scale from the private perspec-
tive. If a j = b j = 0 , j = 1, 2 , then the model becomes the standard dy-
namic Heckscher-Ohlin model. Introduce θ j ≡ a j + α j . If θ1 > (<) θ 2 ,
we say that the consumption good is capital (labor) intensive from the so-
cial perspective. On the other hand, if ∆ ≡ α1 β 2 − α 2 β1 > (<) 0 , we say
that the consumption good is capital (labor) intensive from the private per-
spective.
Under (10.5.1) profit maximization of each firm implies
α1 F1 α 2 pF2 β1 F1 β 2 pF2 (10.5.2)
r = = , w= = ,
K1 K2 N1 N2
where r and w are respectively the rate of interest and the wage rate.
Like in Sect. 3.5, it is straightforward to show that if θ1 ≠ θ 2 , then we can
express r and w as unique functions of p , 23 denoted as r ( p ) and w( p ).
It is straightforward to check the following relations
pr ' ( p ) θ1 pw' ( p ) 1 − θ1
= , =− .
r( p) θ1 − θ 2 w( p ) θ1 − θ 2
Households behavior
Assume that the two countries have the same preference. Introduce prof-
its or the remuneration for factor-specific factor of production, Π (t ), as24
23 As in Sect. 3.5, as the two countries have the same technologies and the price
of investment good is equal, the rate of interest and wage rate are equal between
the two countries.
24 According to Benhabib and Nishimura (1998), profits are possible because of
fixed costs of entry. According to Nishimura and Shimomura (2002a), there are
sector-specific factors of production in both sectors and externalities may be nega-
tive. When production technologies are subject to constant to scale from the social
Π ≡ F1 + pF2 − (w N + r K ).
Consumers’ behavior is described by
∞
C 1−η − ρ t
Max ∫ e dt , 0 < η < 1, ρ > 0 ,
01−η
K& = F1 + pF2 − pC − δ k K =
s.t:
w N + r K + Π − pC − δ k K , (10.5.3)
where δ k is the fixed depreciation rate of capital. The necessary conditions
for optimality are
C −η = λ p , (10.5.4)
where λ (t ) is the co-state variable which follows
λ& = λ [ρ + δ k − r ( p )]. (10.5.5)
The transversality condition is

lim K (t ) λ (t ) e − ρ t = 0 .
t →∞
The world market-clearing condition for the consumption good is25

~ (10.5.6)
C + C = F2 + F2 .
Introduce
∆ (θ 2 − θ1 )[ρ + δ k (1 − β1 )]
η0 ≡ .
θ1α1 β 2 (ρ + δ k ) + β1 (1 − θ1 )[ρ α 2 + δ kα1 β 2 + α 2δ k (1 − β1 )]
Before stating the properties of the model, we make the following as-
sumption.
Assumption 10.5.1
θ1 < θ 2 , ∆ > 0 and 1 / η > max [1, 1 / η 0 ].
perspective, the variable is interpreted as the remuneration of sector-specific fac-

tors of production, compatible with free entry and exit.
25 The market-clearing condition for the investment good is obtained from the
equations already defined.

The conditions, θ1 < θ 2 and ∆ > 0 , respectively means that the con-
sumption good is labor intensive from the social perspective but capital in-
tensive from the private perspective. The condition, 1 / η > max [1, 1 / η 0 ], is
guaranteed if η is sufficiently small. The following two theorems are
proved by Nishimura and Shimomura (2002b).
Theorem 10.5.1
Under Assumption 10.5.1, in the long term the price, p , and the world
~
capital, Kˆ (= K + K ) , are uniquely determined. Moreover, there exists a
~
continuum of countries’ capital, K and K , at which both economies are
incompletely specified.
Theorem 10.5.2
Under Assumption 10.5.1 and (ρ + δ k )(α1 − α 2 ) − δ k ∆ < 0 , there exists a
neighborhood of a long-run equilibrium such that from any initial distribu-
~
tion of capital, K and K , in that neighborhood there exists a continuum
of equilibrium paths. Moreover, different equilibrium paths converge to
different long-run equilibria.
10.6 On Innovation and Monopolistic Competition
As Solow (2000) commented, the endogenousness of the growth rate in the

new growth theory is merely assumed. In fact, models of the new growth
theory are less attractive than they claim. Evidently, physical capital is im-
portant for understanding economic growth. Nevertheless, the analytical
frameworks used in the theory are not effective in introducing capital ac-
cumulation into the growth theory. Moreover, Solow (2000) observes,
“Their [Aghion and Howitt] ambition is to make a model that gets close to
our intuition about the endogenous generation of new technology. Even so,
it is still pretty far from anything that feels like a description of real re-
search, academic or industrial. In one way this paper – and the whole lit-
erature [of the New Growth Theory] may be too ambitious.” Evenson and
Westphal (1995: 220) also point out: “To date, endogenous growth theory
has achieved few robust policy generalizations. Moreover, development
economists who grew up arguing about the merits of Rosenstein-Rodan’s
(1943) ‘big push’ and debating balanced versus unbalanced growth are
prone to find much that is not really new in endogenous growth theory.
The vocabulary is new, but many of the insights that are today considered
Appendix 399
novel were the staple of development economics in the 1950s and 1960s.
Indeed, as is relatively well known, the basic insights on which much en-
dogenous growth theory is built are present in Adam Smith’s discussion of
pin making technology.” These comments are acceptable if we are only
limited to the level of ‘rough insights’ or conceptual discussion; but it may
not be right to conclude that Smith’s discussion of pin making technology
already includes the basic insights simply because many insights into
complexity of economic evolution could not be obtained in the 1950s and
1960s, not to mention in Smith’s time. It is also important to cite from Paul
Krugman’s comments about the new growth theory:
[to explain plainly the new economic geography] “requires some funny as-
sumptions both about consumer behavior and about the technology of produc-
tion; but it has the virtue of producing in the end a picture of an economy in
which there are increasing returns, in which one need not get into the fascinat-
ing but messy issues posed by realistic oligopoly.26”
Appendix
A.10.1 Variety of Consumer Goods and National Growth
This section introduces growth model with a variety of consumer products.

The model is referred to Barro and Sala-i-Martin (1995: Sect. 6.2).27 The
idea is to introduce a variety of consumer goods into the utility function
that parallels the treatment of a variety of intermediate products in the pro-
duction function as in the previous section. Let us assume that there con-
sumers care about variety consumer goods, which is measured by an index
for consumer i
M 
1/ ε
(A.10.1.1)
ci =  ∑ cijε  , 0 < ε ≤ 1,
 j=i 
where cij is household i ’s consumption of goods of type j , M is the
number of types available at the current time. The household i ’s utility is
given by
26 Fujita and Krugman (2004: 143).

27 The model is influenced by Spence (1976) and Grossman and Helpman (1991).
∞
 ci1 − θ − 1  − ρt
Ui = ∫ 0

 1−θ 
 e dt .
To see why the formation of utility function captures the idea that con-
sumers like variety, suppose that cij are measured in a common physical
unit and the quantities consumed of each type are the same, cij = ci / M .
We have
ci1 − θ − 1 M (1 − ε )(1 − θ )/ ε ci1 − θ − 1
= .
1−θ 1−θ
Hence, the flow of utility rises as M increases for a fixed ci . This

shows a positive relation between consumers’ utility and variety.
The invention of a new product – an increase in M is assumed to cost
η units of goods. The inventor retains a perpetual monopoly in the pro-
duction of the associated nondurable consumer good, C j . The marginal
cost of production of each consumer good is 1, and the producer deter-
mines the consumer price, Pj , maximizing the flow of monopoly profit.
To determine Pj , we need to know the demand function. Let a(t ) stand
for assets per person. Then
M
a& (t ) = w(t ) + r (t )a (t ) − ∑ P (t )c (t ),
j ij
j =1
where w and r are respectively the wage rate and rate of interest. The
Hamiltonian associated with consumers’ utility maximization is defined by

 (∑ M
cε )
(1 − θ ) / ε
− 1 − ρt  M

J =
j = 1 ij
1−θ
e + v w + ra − ∑Pc j ij
 .
   j =1 
The first-order condition with respect to cij yields

− 1 / (1 − ε )
cij P 
=  j  , j , k = 1, ..., M .
cik  Pk 
This condition enables us to derive the consumer’s demand function for
the j th good
Appendix 401
 ∑M Pk cik  (A.10.1.2)
 
cij =  M −α / (1 − α )  Pj− 1/ (1 − ε ) .
k =1
 ∑k = 1 Pk 
We assume that M is sufficiently large so that the producer of good j

can neglect the effect of Pj on the households’ total spending per variety
of good, that is, on the ratio of sums given in Eq. (A.10.1.2). Consumer
demand then has the constant elasticity − 1 / (1 − ε ) with respect to Pj .
Hence, the monopoly producer of good j determines the consumer price
with a markup on the unit marginal cost of production, Pj = 1 / ε . As all
prices are equal, we denote the prices by P . Since the prices of all con-
sumer goods are equal and the goods enter symmetrically into the utility
function, the quantities consumed are the same: cij = ci / M . If we can de-
termine ci and M , then cij are determined.
To determine the evolution of ci , we use the remaining optimization
conditions associated with the Hamiltonian. Setting the derivative of J
with respect to cij equal to zero and then substituting cij = ci / M for all
good, we find
vP = M (1 − ε )(1 − θ )/ ε (ci ) e − ρt . (A.10.1.3)
−θ
The second condition is associated with the state variable a

v& = − rv . (A.10.1.4)
The two conditions, (A.10.1.3) and (A.10.1.4) determine
c&i 1   (1 − ε )(1 − θ )  M& 
= r − ρ +   M .
ci θ   ε  
Using this equation, we obtain
d (ci / M ) M& c& 1 θ + ε − 1  M&  (A.10.1.5)
= − i = r − ρ +   M .
dt M ci θ   ε  
We now analyze invention. The net present value, V (t ) , for an inventor
of a new consumer good at time t is
∫ (P (τ ) − 1)C (τ )e
− r (τ ,t ) (τ − t )
V (t ) = j j dτ ,
0
where
1 τ
r (τ , t ) ≡ r (ω ) dω ,
τ − t ∫t
is the average interest rate between times t and τ . If the interest rate is
constant, then the present-value factor simplifies to e − r (τ − t ) . The equation
shows that the fixed cost η for discovering a new good can be recouped
only if Pj exceeds the marginal cost of production for at least part of the
time after date t .
We assume free entry into the business of being an inventor. This im-
plies that anyone can pay the R&D cost η to secure the present value. If
V (t ) > η , then an infinite amount of resources would be channeled into
R&D at time t , hence V (t ) > η cannot hold at equilibrium. If V (t ) < η ,
then no resources would be devoted at time t to R&D. If r is constant, the
free-entry condition is
1−ε ∞
η ≥ V (t ) = ∫C e
− r (τ − t )
dτ ,
ε
j
t
where we use Pj = 1 / ε . The condition holds with equality if M& = 0 . In

this case, C j is constant and given by
C rηε (A.10.1.6)
Cj = = .
M 1−ε
If both C j and population are constant, then cij / M must also be con-
stant; hence the growth rate of ci / M must be equal to zero. Equation
(A.10.1.5) yields
C& M& ε (A.10.1.7)
= = (r − ρ ), θ + ε ≠ 1.
C M θ + ε −1
It is assumed θ + ε > 1. This assumption guarantees that the growth rate
of C is positively proportional to r − ρ . We will not further analyze be-
havior of the model because, as shown by Barro and Sala-i-Martin (1995:
Sect. 6.2), the model does not provide new insight, given the growth model
with variety of products defined in Sect. 10.2. Further analysis is referred to
Barro and Sala-i-Martin.
A.10.2 The Schumpeterian Creative Destruction
In the Theory of Economic Development published in 1911, Schumpeter

(1934) argued that development should be understood as only such
changes in economic life as are not forced upon it from without but arise
by its own initiative, from within. Schumpeter held that successful carry-
ing out of new combinations of productive services is the essence of this
process. Schumpeter’s ideas about development and creative destruction
have recently been modeled. This section represents such a model by
Aghion and Howitt (1992).28 The Aghion-Howitt model of economic
growth is based on Schumpeter’s process of creative destruction. Growth
results exclusively from technological progress, which in turn results from
competition among research firms that generate innovations. The model
assumes that individual innovations are sufficiently important to affect the
entire economy. Each innovation consists of a new intermediate good that
can be used to produce final output more efficiently than before. Research
firms are motivated by the process by the prospect of monopoly rents that
can be captured when a successful innovation is patented. But those rents
in turn will be destroyed by the next innovation, which will render obsolete
the existing intermediate good. Equilibrium is determined by a forward
difference equation, according to which the amount of research in any pe-
riod depends upon the expected amount of research next period.
We now describe the model. A period is the time between two succes-
sive innovations. The length of each period is random because of the sto-
chastic nature of the innovation process, but the relationship between the
amount of research in two successive periods can be modeled as determi-
nistic. The amount of research this period depends negatively upon the ex-
pected amount next period, through two effects. The first is that of creative
destruction. The payoff from research this period is the prospect of mo-
nopoly rents next period. Those rents will last only until the next innova-
tion occurs. The expectation of more research next period will discourage
research this period. The second effect is that of a general equilibrium in
the labor market. Workers can be used either in research or in manufactur-
ing. To maintain labor market equilibrium, the expectation of more re-
28 Since it is technically laborious, we represent the version of the model sim-
plified by Solow (2000).

search next period must correspond to an expectation of higher demand for

labor in research next period, which implies the expectation of a higher
wage rate. Higher wages next period will reduce the monopoly rents that
can be gained by exclusive knowledge of how to produce the best prod-
ucts. Thus the expectation of more research will discourage research this
period.
Like most of models in the new growth theory, the model omits capital
accumulation and assumes a constant employment. There are three classes
of tradeable objects: labor, a consumption good, and an intermediate good.
There is a continuum of infinitely-lived individuals, with identical in-
tertemporally additive preferences defined over lifetime consumption, and
the constant rate of time preference. The marginal utility of consumption is
equal to the rate of interest. There are three categories of labor: unskilled
labor, which can be used only in producing the consumption good;
(skilled) labor, which can be used either in research or in intermediate sec-
tor; and specialized labor, which can be used only in research. Each indi-
vidual is endowed with a unit flow of labor. Only one final good is pro-
duced by the fixed quantity of unskilled labor and skilled labor x . The
production function is
F (t ) = Af ( x) ,
where we omit expressing unskilled labor and f (x) is increasing
( f ' ( x) > 0) and concave ( f " ( x) < 0) . The variable A is a technological
variable. Final good is used as numeriare.
Some skilled labor is devoted to R&D. When successful, the innovation
is a new intermediate good that allows a higher value of A and thus makes
the old intermediate good obsolete. Let t stands for the t th innovation
(not time). For convenience of description, we consider that each success-
ful innovation increases the final output producible with any x by a multi-
plicative factor γ , i.e.
At +1
=γ.
At
Suppose n units of labor are devoted to R&D and innovations arrive
according to a Poisson process with arrival rate λn . It should be noted that
in the original model the specialized labor affects the arrival rate. Since the
number of specialized labor is prefixed, we omit mentioning this type of
labor. The probability of an innovation in a given short unit of time equals
λn , and the probability of no innovation is equal to 1 − λn , and the prob-
ability of two or more innovations is equal to zero. The assumption of the
Poisson process says that the probability of making an innovation of given

size depends only on n , independent of past history of innovation. In fact,
innovation is hard to model for anyone because innovations cannot be pre-
determined even in probability sense.
The innovating firm acquires a monopoly on the final production that is
useful until the next innovation. Thus the t th innovation brings a negative
externality through killing the rents of the firm that produced the (t − 1) st
innovation and a positive externality through making the (t + 1) st innova-
tion possible. A successful innovator is a monopoly of the intermediate
good and is faced with a demand curve from the final-goods industry
Af ' ( xt ) = Pt ,
where Pt is the price of the intermediate good.

We introduce Vt and Π t to respectively stand for the expected dis-
counted rents associated with the t th successful innovation and the con-
stant flow of rent expected by the t th innovator during the profitable life
of the innovation. Let ρ stand for the discount rate of the rent expected by
the t th innovator. Then the Fisher equation tells that the interest on the
value of innovation equals the current income plus the expected capital
gain (which equals λnt (−Vt ) + (1 − λnt )0 ). That is
ρVt = Π t − λntVt .
The above equation is solved as
Πt (A.10.2.1)
Vt = .
ρ + λnt
The equation says that a large value of nt reduces Vt . In other words,

research, like capital investment, is discouraged by the prospect of future
R&D. Free entry and risk neutrality in R&D guarantees that entry will oc-
cur until the cost of conducting R&D is equal to the expected value of the
innovation
wt nt = λntVt +1 + (1 − λnt ) ⋅ 0 ⇒ wt = λVt +1 . (A.10.2.2)
Labor market is cleared for every t

nt + xt = N , (A.10.2.3)
where N is the constant volume of employment. Solow holds that Eq.

(A.10.2.3) contains a major limitation of this model: “one of the true risks
of R&D is that economic conditions should be cyclically weak during the

effective life of an innovation, so that it turns out to be unprofitable be-
cause sales of final product are poor”.
The intermediate good is produced using skilled labor alone. The pro-
duction function is specified in such a way that the intermediate product is
equal to the flow of skilled labor used in the intermediate sector. With the
one-to-one technology for producing intermediate good, the monopolist
maximizes
Pt xt − wt xt = At f ' ( xt ) xt − wt xt . (A.10.2.4)
Provided that marginal revenue falls with xt , the optimal xt is a de-

creasing function of wt / At , and the best achievable value of (Π t / At ) falls
as ( wt / At ) rises. Denote this function by xt = φ (wt / At ). From Eq.
(A.10.2.3), nt is an increasing function of wt / At . We have
w 
nt = N − xt = N − φ  t  .
 At 
Solving the above equation with wt / At as the variable yields
wt (A.10.2.5)
= φ (nt ) ,
At
where φ (nt ) rises in nt . Now Eqs. (A.10.2.1) and (A.10.2.2) imply

λΠ t +1
wt = λVt +1 = .
ρ + λnt +1
Inserting Eq. (A.10.2.5) and At +1 = γAt into the above equation yields
wt γλ (Π t +1 / At +1 ) (A.10.2.6)
= .
At ρ + λnt +1
As (Π t +1 / At +1 ) is a decreasing function of ( wt +1 / At +1 ) and ( wt +1 / At +1 ) is
an increasing function of nt +1 , (Π t +1 / At +1 ) falls as nt +1 rises. Consequently,
the right-hand side of Eq. (A.10.2.6) is a decreasing function of nt +1 , de-
noted by ψ (nt +1 ) . Equations (A.10.2.5) and (A.10.2.6) imply
φ (nt ) = ψ (nt +1 ) .
This dynamic equation closes the model. As ψ (nt +1 ) falls in nt +1 and

φ (nt ) rises in nt , we rewrite the above discrete mapping the following
form
nt +1 = h(nt ), h' < 0 . (A.10.2.7)
Equilibrium is a solution of n* = h(n* ) . In general, as shown in Fig.

A.10.2.1, there will be a unique steady state. We know that nt tends to n*
if h' (n) < 1 for all n and will converge locally if h' (n* ) < 1. Once we de-
termine nt , we determine all the other variables in the system. We may
conduct usual comparative statics analysis with respect different parame-
ters in the system. Explanation about the model and its further implications
is referred to Aghion and Howitt (1992).
h(n)
450
h(n * )
n* n
Fig. A.10.2.1. A steady state in the Aghion-Howitt model
A.10.3 Growth with Improvements in Quality of Products
In the literature of economic growth with innovation and monopolistic

competition, another type of technological changes is through improving
quality of the current products.29 Assume that there are (fixed) J types of
29 This section is based on Barro and Sala-i-Martin (1995, Chap. 7) and Grossman
and Helpman (1991).

non-durable intermediate goods. As we assume that different qualities of a

particular type of intermediate input are perfect substitutes, the discovery
of a higher grade turns out to drive out completely the lower grades. The
process is characterized by Schumpeter’s creative destruction in the sense
that successful researchers tend to eliminate the monopoly rentals of their
predecessors. We consider that the duration of successful research is ran-
dom, because it depends on the uncertain outcomes from the research ef-
forts by competitors. There is no permanent monopoly position. The pro-
duction function for firm i is
J
(A.10.3.1)
Fi = AN i1 − α ∑ X ijα , 0 < α < 1,
j =1
where N i is labor input and X ij is the quality-adjusted amount employed

of the j th type of intermediate good. The potential grades of each inter-
mediate good are arranged along a quality ladder with rungs spaced pro-
portionately at interval q > 1. We normalize so that each good begins at
quality 1. The subsequent rungs are at the levels q , q 2 , and so on. Thus,
if sector j has experienced κ j improvements in quality, then the available
κ
grades in the sector are 1, q, ..., q j . Let X ijk stand for the quantity used by
the i th firm of the j th type of intermediate good of quality rung k , which
corresponds to quality q k . The overall input from a sector, X ij , is the
quality-weighted sum of the amounts used of each grade, q k X ijk . Thus, if
κ j is the highest quality level available in sector j , then the quality-
adjusted input from this sector is given by
κj
X ij = ∑q
k =0
k
X ijk ,
which implies that the quality grades within a sector are perfect substitutes
as input to production.
Assume that goods of quality 1 can be produced by anyone. The re-
searcher responsible for each quality improvement in sector j retains a
monopoly right to produce the j th intermediate good at that quality level.
In particular, if the quality rungs k = 1, ..., κ j have been reached, then the
k th innovator is the sole source of intermediate goods with the quality
level q k . The intermediate good entails a unit marginal cost of production
(in terms of output, F ). Let the cost of production of intermediate goods

be the same for all qualities q k , k = 0, 1, ..., κ j . Thus, the latest innovator
has an efficiency advantage over the prior innovators in the sector, but will
be at a disadvantage relative to future innovators. In the situation that only
κ
the best existing quality of intermediate good j with quality level q j is
available currently for the production (the other grades will not be used in
equilibrium), by Eq. (A.10.3.1) and the definition of X ij , the marginal
product of X ijk is
∂N i ακ
= αAN i1 − α q j X ijkα − 1 .
∂X ijk
If units of the leading-edge good are priced at Pjκ j and if no other qual-
ity grades of good j are available, then ∂Fi / ∂X ijk = Pjκ j . Hence, the im-
plied demand function from the aggregate of final- goods producers is
1 / (α − 1)
 Pjκ j  (A.10.3.2)
X ijk =  N.
 αAqακ j 
 
As the leading-edge producer acts as a monopolist in this environment,
the monopolistic pricing is given by
1
Pjk j = P = .
α
The monopoly price is thus constant over time and across sectors. Sub-
stituting P = 1 / α into Eq. (A.10.3.2) yields
1 / (α − 1) (A.10.3.3)
 1 
X ijk =  2 ακ j  N.

 α Aq 
In the demand functions, only κ j are changeable. As κ j changes over
time in each sector, X ijk vary over time and across sectors.
We are now concerned with situations that goods from quality rungs be-
low κ j are also available for production in sector j . We neglect the pos-
sibility that the κ j th innovator was also the (κ j − 1) th (and below) inno-
vator. If the leading-edge producer charges the monopoly price and if this
price is high enough, then the producer of the next lowest grade will pro-
∑
κj
duce to obtain non-negative profits. By X ij = k =0
q k X ijk , each unit of
the leading-edge good is equivalent to q > 1 units of the next best good;
thus if the highest grade is priced at Pjκ j , then the next grade good could
be sold at most at the price Pjκ j / q , the one below that at the price
Pjκ j / q 2 and so on. If Pjκ j / q is less than the unit marginal cost of produc-
tion, then the next best grade (and all of the lower quality grades) cannot
survive. As Pjκ j = 1 / α , the next best grade and all of the lower quality
grades are priced at most 1 / αq , 1 / αq 2 …. If 1 / αq is less than one, then
the next best producer cannot compete against the leader’s monopoly
price. Therefore, αq > 1 implies that monopoly pricing will prevail. If
αq ≤ 1, then the providers of intermediate goods of a given type engage in
Bertrand price competition. In this case, the quality leader employs a limit-
pricing strategy Pjκ j = q so as to make it just barely unprofitable for the
next best quality to be produced. Because the condition for limit pricing to
prevail αq ≤ 1, Pjκ j = q ≤ 1 / α = monopoly pricing.
When Pjκ j = q prevails, the total quantity produced is
1 / (α − 1)
 q 
X ijk =   N.
ακ j 
 αAq 
This equation and Eq. (A.10.3.3) show that if αq ≤ 1, the quantity pro-
duced under limit pricing is at least as large as the amount that would have
been produced under monopoly. In the remainder of this section, we re-
quire αq > 1. That is, the monopoly prevails. The case of αq ≤ 1 can be
similarly discussed. We thus can neglect any goods of less than leading-
edge quality and rewrite Eq. (A.10.3.1) as
N
Fi = AN i1 − α ∑ q
ακ j
X ijακ j .
j =1
Substituting Eq. (A.10.3.3) into the above equation (where N i is re-

placed by N ) and then aggregating over the firms, we get
J
ακ j / 1 / (1 − α )
F = A1/ (1 − α )α 2α /1/ (1 − α ) N ∑ q .
j =1
As N and J are constant, the growth of F is due to changes in κ j .

We may rewrite the above equation as
F = A1/ (1 − α )α 2α / (1 − α ) NQ = α − 2 X ,
where X is total quantity of intermediates produced and
J
ακ j / (1 − α ) (A.10.3.4)
Q≡ ∑q
j =1
, X ≡ A1/ (1 − α )α 2 / (1 − α ) NQ .
We now design a mechanism to determine κ j , the key element for eco-

κj −1
nomic growth. The κ j th innovator in sector j raises quality from q to
κ
q j . The flow of profit, π jκ j , associated with quality rung κ j equals
(P − 1)X jκ j
. By Eq. (A.10.3.3), π jκ j are given by
 1 − α  2 / (α − 1) κ jα / (α − 1) (A.10.3.5)
π jκ j = NA1/ (α − 1)  α q .
 α 
This profit is continued – over the interval T jκ j = tk j + 1 − t k j - from the
time of the κ j th quality improvement, tκ j , until the time of the next im-
provement by a competitor, tκ j + 1 . If the interest rate, r , is constant, then
the present value evaluated at tκ j of the profit from the κ j th quality im-
provement is
V jκ j =
[
π jκ j 1 − exp(− rT jκ j ) ].
r
Since π jκ j are known, we now determine T jκ j to finally determine
V jκ j .
Let Z jκ j stand for the flow of resources in terms of F expended by the
aggregate of potential innovators in sector j when the highest quality-
ladder number reached in that sector is κ j . Assume that the probability,
p jκ j . per unit of time of a successful innovation is related to Z jκ j and κ j
as follows
p jκ j = Z jκ j φ (κ j ),
where φ ' (κ j ) < 0 implies that as project becomes more complicated, the
probability of success in research declines. Define G (τ ) the cumulative
probability density function for T jκ j , that is, the probability that T jκ j ≤ τ .
The change in G (τ ) with respect to τ represents the probability per unit of
time that the innovation occurs at τ . An innovation at τ implies that it
had not occurred earlier, an outcome that has probability 1 − G (τ ). Ac-
cording to the definitions
dG
= [1 − G (τ )] p jκ j .
dτ
Assume that p jκ j and Z jκ j do not vary over time between innovators in
a sector. As G (0 ) = 0 , we solve
(
G (τ ) = 1 − exp − p jκ j τ . )
The propensity density for T jκ j is then given by
g (τ ) = G ' (τ ) = p jκ j exp − p jκ j τ .( )
By this equation, we can compute the expected present value evaluated
at tκ j of the profit from the κ j th quality improvement
p jκ j π jκ j
( ) ∫ (1 − exp(− rτ ))exp(− p )
∞
E V jκ j = jκ j τ dτ =
r 0
NA1 / (α − 1) (1 / α − 1)α 2 / (α − 1)q

κ jα / (α − 1)
, (A.10.3.6)
r + p jκ j
where we use Eq. (A.10.3.5).

It is assumed that potential innovators care only about the expected
value in Eq. (A.10.3.6). The expected reward per unit of time for pursuing
( )
the (κ j + 1) th innovation is p jκ j E V jκ j . Hence, the expected flow of net
profit, Π jκ j , from research currently at κ j equals p jκ j E V jκ j + 1 ( ) − Z jκ j .
By Eqs. (A.10.3.6) and p jκ j = Z jκ j φ (κ j ), we have
( )
Π jκ j = p jκ j E V jκ j + 1 − Z jκ j =
 φ (κ j )NA1/ (α − 1) (1 / α − 1)α 2 / (α − 1)q (κ j + 1)α / (α − 1)  (A.10.3.7)
Z jκ j  − 1 .
 r + p jκ j + 1 
Free entry into the research business guarantees Π jκ j = 0 . For Z jκ j > 0 ,

Π jκ j = 0 becomes
(A.10.3.8)
r + p jκ j + 1 = φ (κ j )NA1/ (α − 1)  − 1α 2 / (α − 1)q j
1  (κ + 1)α / (α − 1)
.
α 
There are two forces φ (κ j ) (meaning that innovations are increasingly
(κ )
+ 1 α / (α − 1)
difficult, with φ ' < 0 ) and q j (reflecting that the expected reward
from an innovation is increasing in κ j ) in the equation. If the first force
dominates, then more advanced sectors tend to grow relatively; and vice
versa. If the two forces exactly offset, then all sectors will tend to grow at
the same rate. To simplify the analysis, we specify φ (κ j ) as
( )
− κ j + 1 α / (α − 1)
(A.10.3.9)
φ (κ j ) =
q
, ζ > 0.
ζ
This formulas simplifies the free entry condition (A.10.3.8) as follow
NA1/ (α − 1)  1  2 / (α − 1)
r+ p=  − 1α ,
ζ α 
where p = p jκ j + 1 denotes that p jκ j + 1 is invariant in κ j . This equation
gives the probability of an innovation per unit of time as
NA1/ (α − 1)  1  2 / (α − 1) (A.10.3.10)
p=  − 1α − r.
ζ  α 
If r is constant, then p is also constant. If we substitute the above
equation for r + p into Eq. (A.10.3.6), we find the market value of the
κ j th innovation as
( )
E V jκ j = ζ q
κ jα / (α − 1)
.
The aggregate market value of firms, denoted by V , is the sum of the

above equations over N
J
κ jα / (α − 1)
V = ∑ ζq
j =1
= ζQ .
The amount of resources devoted to R&D in sector j is
p (κ j + 1)α / (α − 1)  1 / (α − 1) 1  2 / (α − 1) 
Z jκ j = = q  NA  − 1α − rζ  ,
φ (κ j )  α  
where we use Eqs. (A.10.3.9) and (A.10.3.10). The aggregate of R&D
spending, denoted by Z , is
J
 1   (A.10.3.11)
Z ≡ ∑Z jκ j = Qqα / (α − 1)  NA1/ (α − 1)  − 1α 2 / (α − 1) − rζ  .
α 
j =1  
As F , X , V , and Z are all constant multiples of Q , they have the
same growth rate
g F = g X = gV = g Z = g Q . (A.10.3.12)
ακ j / (1 − α ) ακ j / (1 − α )
∑
N
In Q = j =1
q , the term q does not change if no innova-
( )
α κ + 1 / (1 − α )
tion occurs in sector j , but changes to q j if an innovation oc-
curs. The proportionate change in this term due to an innovation is
qα / (1 − α ) . Since p is the same for all the sectors, the expected proportion-
ate change in Q per unit of time is
 ∆Q 
E   = p (qα / (1 − α ) − 1).
 Q 
We assume that N is large enough to treat Q as differentiable, and thus
we have g Q ≈ E (∆Q / Q ). With this equation and Eq. (A.10.3.10), we have
 NA1/ (α − 1)  1  (A.10.3.13)
− r  (qα / (1 − α ) − 1).
 2 / (α − 1)
gQ =   − 1α
 ζ α  
Hence, to determine the growth rates, we have to find conditions for de-
termining the rate of interest. We now turn to behavior of households to
close the model.
We now examine behavior of households. Each household maximizes
∞
 c1 − θ − 1  − ρ t
U = ∫  e dt ,
0 1 − θ 
where c is consumption per person and population growth rate is zero.
The key condition for this study from household optimization is
r−ρ
gC = ,
θ
where C is the aggregate consumption.
The economy’s overall resource constraint is
C = F − X − Z.
Substituting Eqs. (A.10.3.4) and (A.10.3.11) and Y = α − 2 X into the

above equation yields
[
C = A1/ (1 − α ) (1 − α 2 )α 2α / (1 − α ) N − pζqα / (1 − α ) Q . ]
If p is constant, g ≡ g C = g Q . From g C = (r − ρ ) / θ and Eq.
(A.10.3.113), we solve r and the growth rate g as
ρ + θ (qα / (1 − α ) − 1)[(N / ζ )A1/ (α − 1) (1 / α − 1)α 2 / (α − 1) ]

r= ,
1 + θ (qα / (1 − α ) − 1)
g=
(q α / (1 − α )
[ ]
− 1) (N / ζ )A1/ (α − 1) (1 / α − 1)α 2 / (α − 1) − ρ
.
(A.10.3.14)
1 + θ (qα / (1 − α ) − 1)
We assume that the parameters are such that g > 0 so that the free-entry
condition holds with equality and r > g so that the transversality condi-
tion is satisfied. We have thus determined the rate of interest and the
growth rate.
We have thus closed the model. The single state variable is now Q .
Given an initial value Q(0), by Eq. (A.10.3.14) and g = g F
= g X = gV = g Z = g Q = g C , we determine the growth rates as well as the
variables at any point of time. Further analysis of the model is referred to
Barro and Sala-i-Martin (1995: Chap. 7).
11 Growth, Money and Trade
Money, like blood in human body, affects and is affected by almost all as-
pects of the economic system. Forms of its existence and functions can ex-
hibit a great variety, depending on, for instance, technology, economic de-
velopmental stages, institutional structures, and man’s attitude towards the
future. Money not only provides services of the present but also plays the
role of a connector of the present and the future. Many of the most intrigu-
ing and important questions in dynamic economic analysis involve money.
The dynamic trade models so far in this book omit monetary issues, by ex-
plicitly or implicitly assuming that transactions on the economy’s real side
can be carried out frictionlessly without money.1 Introduction of money
into a non-monetary economy may alter results obtained within a non-
monetary environment.2 We have developed different models of interna-
tional trade. Nevertheless, we neglect possible role of the stock of fiat
money and of its rate of change in each trading country. As mentioned in
Chap. 5, Mundell (1960, 1963) and Fleming (1962) introduced the IS-LM
analysis of a closed economy to an open one. Nevertheless, the IS-LM
analysis is static. This chapter studies monetary issues in dynamic frame-
works.
It is generally agreed that modern analysis of dynamic interaction of in-
flation and capital formation begins with Tobin’s seminal contribution in
1965. Tobin (1965) deals with an isolated economy in which “outside
1 It is well known that in the best developed model of a competitive economy -

the Arrow-Debreu framework - there is no role for money. Although money has been
introduced into the neoclassical growth theory initially by Tobin and Sidrauski, many
important issues such as growth with heterogeneous households and economic devel-
opment with urban structure have not been properly examined as, for instance, re-
viewed by Zhang (2008a). Zhang (2008a) constructs a monetary growth theory within
the same framework as applied in this book. This chapter examines a few monetary
models with international trade.
2 See, for instance, Drabicki and Takayama (1983) and Stockman (1985). The
former demonstrates that the theory of comparative advantage breaks down in a

monetary economy with fixed exchange rates. The latter shows that changes in in-
flation can cause changes in the pattern of trade even in the absence of real
changes in comparative advantage. See also Kemp (1990).
418 11 Growth, Money and Trade
money3” competes with real capital in the portfolios of agents within the
framework of the Solow model. In Tobin’s approach, a monetary economy
has a real sector exactly like that in the Solow growth model, so that the
monetary nature of the model depends on how money is introduced into
the model. A monetary economy is characterized by that prices are ex-
pressed in money, transactions require money, and financial wealth can be
held in the form of money or financial instruments competing with money.
In the Tobin model, money is a liability of the public sector. As a depositor
of purchasing power money can be held by private agents as an alternative
form of wealth to physical capital stock. Different from a barter economy
as described by the Solow model, the Tobin model involves a problem of
deciding the optimal composition of wealth at every instant. This chapter
addresses similar issues to those in the Tobin model, but in context of in-
ternational economics. We also propose some micro foundations for
household behavior.
Mundell (1968: Chap. 18) proposes a model of international transmis-
sion effects of monetary and fiscal policy shocks in a two-country version
of what is now known as the Mundell-Fleming model. The model shows
that under floating exchange rates, positive monetary policy innovations
tend to have a “beggar-thy-neighbor” effect, raising domestic output and
reducing foreign output through the effects of real depreciation. On the
other hand, fiscal policy shocks tend to increase output in both countries.
Extended versions of the model have been frequently used to study prob-
lems of international macroeconomic policy coordination. But it has been
pointed that the Mundell-Fleming model (and many of its extensions)
failed to specify the underlying preferences and technology. As pointed out
by Obstfeld and Rogoff (1998), to understand short-run macroeconomics
in the open economy, it is important to move beyond the Mundell-Fleming
model toward a dynamic, utility-maximizing framework, where long-run
budget constraints are satisfied.
This chapter introduces some dynamic trade models with money and
exchange rates. Section 11.1 introduces Kemp’s monetary two-sector
growth model of an open small economy. The model examines how the
rate of domestic monetary expansion may affect the rate of change of the
domestic price level and relative attractiveness of physical assets and
money as repositories for saving, as well as the relative demands for con-
sumption and investment goods and the relative import-export demands for
those goods. Section 11.2 studies a small-country monetary economy with
money in the utility function (MIUF) approach. Section 11.3 examines a
small-country monetary economy with cash-in-advance (CIA) approach.
3 Outside money is the part of money stock which is issued by the government.
11.1 A Monetary Growth Model for a Small Open Economy 419
Section 11.4 develops a multi-country model with money, based on the

multi-country monetary model proposed by the author and the one-sector
multi-country trade model in Sect. 7.2. The monetary economic side is
based on the MIUF approach. Section 11.5 develops a monetary growth
model with capital, heterogeneous-households and trade. We extend the
two-country single household trade model in Sect. 8.1 to multi-country,
heterogeneous households growth trade model with money. The monetary
economic side is based on the CIA approach. Section 11.6 concludes the
chapter. Section A.11.1 presents a small open economy operating in a
world of ongoing inflation with the Ramsey approach for household be-
havior.
11.1 A Monetary Growth Model for a Small Open Economy
Kemp (1982) proposed a monetary two-sector growth model of an open

small economy, studying how the rate of domestic monetary expansion
may affect the rate of change of the domestic price level and relative at-
tractiveness of physical assets and money as repositories for saving, as
well as the relative demands for consumption and investment goods and
the relative import-export demands for those goods.4 In particular, the
model attempts to determine a rate of expansion, called the “switching
rate”. At lower rates of expansion one commodity is exported and at higher
rates the other commodity exported.
The economy under consideration is small in the sense that it has no in-
fluence on world commodity prices. It produces two commodities, a pure
consumption good and a pure investment good with labor and capital with
constant returns to scale technologies. Depreciation of capital is neglected.
Both goods are freely traded on world markets, with one unit of the in-
vestment good exchanging for a constant amount, p , of the consumption
good. The total output, F (t ), in terms of the consumption good, is assumed
to be expressed by the following function
F (t ) = N (t ) f (k (t ), p )
where k (t ) ≡ K (t ) / N (t ), and K (t ) and N (t ) stand for the inputs of capital
and labor, respectively. The partial derivative of F (t ) with regard to k (t )
4 The Kemp model is directly influenced by Ramanathan (1975), Ruffin
(1979a), and Shieh and Takayama (1980).

is positive and that with regard to p is non-negative. It is assumed that

both labor and nominal money grow at constant rates, n and µ , that is
N& (t ) = nN (t ), M& (t ) = µM (t ). (11.1.1)
It is assumed that trade is always in balance and individuals do not hold

foreign money. Changes in the stock of money, M (t ), are determined as
lump-sum transfers between the government and individuals. Disposable
income, Y , in terms of the consumption good, is given by
d (PM ) (11.1.2)
Y =F + ,
dt
where P is the price of money in terms of the consumption good (the re-
ciprocal of the domestic cost of living). It is assumed that a fixed propor-
tion, 1 − s , of disposable income is consumed. The value of investment is
pK& = F − (1 − s )Y .
Insert Eq. (11.1.2) in the above equation
pK& = sNf − (µ + π )sˆPM , (11.1.3)
where π ≡ P& / P and sˆ ≡ 1 − s . It is further assumed that the demand for

money is proportional to wealth, W ≡ PM + pK . It is assumed that the
proportionality, φ , is dependent on k , π , µ , and p . 5 In portfolio equilib-
rium
PM = φ (k , π , µ , p )W .
Substituting W = PM + pK into the above equilibrium condition
yields
PM = Φ pK , (11.1.4)
5 If we assume the demand for money is dependent on the disposable income,

Y , and the difference between the rental, r (k , p ), of capital in terms of the con-
sumption good and the inflation rate, π , as follows: M d (Y , r − π )W . Then, insert
Y = sˆNf + (µ + π )sˆPM into M d
φ (k , π , µ , p ) ≡ M d (sˆNf + (µ + π )sˆPM , r (k , p ) − π ).
11.2 A Small Open-Country Economy with the MIUF Approach 421
where Φ(k , π , µ , p ) ≡ φ / (1 − φ ). It is reasonable to require 0 < φ < 1.

The partial derivatives of Φ have the same signs as those of φ .
From k = K / N and N& = nN , we have k& / k = K& / K − n . Insert this
equation in Eq. (11.1.3)
k& sf (11.1.5)
= − (µ + π )sˆΦ − n ,
k pk
where we also use Eq. (11.1.4). Taking derivatives of (11.1.4) with re-
spect to time yields
 k&  Φ (11.1.6)
π& =  π + µ − n − η  ,
 k Φ
 π
where we also use k& / k = K& / K − n and η ≡ 1 + kΦ k / Φ . The two differen-

tial equations, (11.1.5) and (11.1.6), determine the motion of the two vari-
ables, k (t ) and π (t ). An equilibrium point is determined by
sf (11.1.7)
π = n − µ, = nsˆΦ + n .
pk
Substituting π = n − µ into the second equation in (11.1.7), we obtain
an equation containing the single variable, k . As shown in Fig. 11.1.1, the
problem has a unique equilibrium point. It is straightforward to show that the
unique equilibrium point is a saddle point. We can also check how changes in
the parameters affect the equilibrium values of the variables. We refer further
examination of behavior of the model to Kemp (1982).
11.2 A Small Open-Country Economy with the MIUF

Approach
The money in the utility function (MIUF) approach was used initially by
Patinkin (1965), Sidrauski (1967a, 1967b) and Friedman (1969). In this
approach, money is held because it yields some services and the way to
model it is to enter real balances directly into the utility function.6
Sidrauski (1967a) made a benchmark contribution to monetary economics,
6 See Eden (2005: Chap. 2) for the reasons why money is introduced into the
utility function.
challenging Tobin’s non-neutrality result. He describes his own purpose as

follows:
sf
nsˆΦ + n
pk
k
Fig. 11.1.1. Existence of a unique equilibrium
What differentiates this product is the fact that, in line with Patinkin’s presenta-
tion of the neoclassical theory of money, and with the classical Fisherian theory
of saving, it is based on an explicit analysis of individual’s saving behavior,
viewed as a process of wealth accumulation aimed at maximizing some in-
tertemporal utility function.7
He proposed a framework that explicitly allows for an endogenous treat-

ment of saving behavior. His analytical framework is developed with Pat-
inkin’s idea of ensuring a well-defined demand function for money by as-
suming that the agent’s utility is directly affected by money. Sidrauski
found that money is superneutral in steady state comparison and changes
in the inflation rate have no effect on all the real variables in the economy.8
Nevertheless, it has become evident that Sidrauski’s results are dependent
on the specific set-up of the model. For instance, the choice of Ramsey’s
version of an infinite horizon economy is essential for money to be su-
perneutral. Moreover, the superneutrality in Sidrauski’s model is no more
held if leisure is introduced into the utility function. As observed by Wang
7 Sidrauski (1967a).
8 Superneutrality of money means that the growth rate of money has no effect
on the real equilibrium.
and Yip (1992), the direction of the non-superneutrality result is related to

the signs of the cross-partial derivatives of the utility function with respect
to consumption, leisure, and real balances. Orphanides and Solow (1990:
225) describe
The main lessons were thus already implicit in the work of Tobin and
Sidrauski. For those who can bring themselves to accept the single-consumer,
finite-horizon, maximization model as a reasonable approximation to economic
life, superneutrality is a defensible presumption. All others have to be ready for
a different outcome.
Rather than following the Ramsey approach, this section introduces money
into the utility function proposed this book to show interactions between
money and economic growth.
11.2.1 The Model with the MIUF Approach
The household behavior in the Dornbush exchange-rate model in the pre-

vious section is not based on maximization. There are some trade models
for a small country with a fixed commodity supply within an open-country
model with perfect-foresight dynamic optimization.9 Since the interest rate
is fixed for a small country and the gap does not vary, the models predict
monotonic movements of foreign asset holdings. The rate of time prefer-
ence in the small economy equals the given world rate of interest is the
standard assumption in the literature of a small open economy, based on
the Ramsey approach.10 If this assumption is not accepted, the domestic
agent would end up either in infinite debt or infinite credit to the rest of the
world.11 This section is concerned with an economy similar to the small-
country trade models.12
There is a single, perishable, consumption good, and households’ finan-
cial wealth is divided between domestic fiat money and internationally
traded bonds denominated in foreign currency. The economy is small, and
9 For instance Sachs (1981, 1982), Hodrick (1982), and Obstfeld and Stockman
(1985).
10 See Turnovsky (2000: Chap. 11).
11 To solve this unrealistic assumption of the model, an alternative approach is
to make the time preference an endogenous variable (Obstfeld, 1981), basing on

Uzawa’s preference.
12 The environment we consider here is characteristic of those assumed in the
standard monetary models of small open economies (see, for instance, Kouri,
1974; Dornbusch and Fischer, 1980; Obstfeld, 1981; and Obstfeld and Rogoff,
1998).
it can influence neither the foreign currency price of the consumption good
nor the world bond rate. The exchange rate is allowed to float freely by the
monetary authority. As foreigners do not hold domestic money, the ex-
change rate adjusts to maintain equality between the real money supply
and domestic real money demand. Perfect foresight is assumed. The for-
eign price of traded goods is given in the world market. The domestic resi-
dents may hold two assets, domestic money and a traded world bond.13 We
neglect transport cost, customs, or any other possible impediments to trade.
We have perfect mobility of goods. For each good the law of one price
holds. We have absolute purchasing power parity (PPP), which means that,
measured in the same currency, the same basket of goods costs the same at
home and abroad. Thus
~
P(t ) = E (t )P (t ),
~
where P(t ) is the domestic price level, P (t ) ( = 1 ) is the foreign price level
measured in foreign currency, and E (t ) is the exchange rate. The assump-
tion of the PPP implies the following relation
π (t ) = π~ + e(t ), (11.2.1)
where π (t ) and π~ (t ) are rates of inflation of the good, respectively, in

domestic currency and foreign currency, and e(t ) ≡ E& (t ) / E (t ) is rate of
exchange depreciation of domestic currency. Assume that π~ (t ) ( = 0 ) is
invariant and fixed in the world market. Under free trade the rate of infla-
tion in the domestic economy is equal to the world rate of inflation plus the
rate of depreciation of domestic currency. There is a traded world bond
with uncovered interest parity (UIP) holding at any point of time
~
i (t ) = i + e(t ), (11.2.2)
~
where i(t ) and i are respectively domestic and (fixed) foreign nominal
interest rates.14
At each moment the household allocates its disposable income between
current expenditure and saving. Real output, f , is taken to be exogenous
13 We assume that foreigners don’t hold domestic money.

14 Generally, i (t ) = iˆ(t ) + ε (t ), where ε (t ) is expected rate of exchange depre-
ciation. This condition is called uncovered interest rate parity. Under the assump-
tion of perfect foresight, the expected rate of exchange depreciation is equal to the
actual rate of exchange depreciation rate, e(t ).
and fixed. We assume that the government’s inflation tax, e(t )m(t ), is
spent upon unproductive public services. The real disposable income is
given by
yˆ (t ) = f + a(t ) + (i (t ) − π (t ))b(t ) − π (t )m(t ), (11.2.3)
where
M EB B
a ≡ m + b, m ≡ , b≡ = ~.
P P P
The budget constraint is given by
(1 + i(t ) − π (t ))m(t ) + c(t ) + s(t ) = yˆ (t ).
Insert the definition of ŷ (t ) in the budget constraint
i (t )m(t ) + c(t ) + s(t ) = ya (t ) ≡ f + (1 + i (t ) − π (t ))b(t ). (11.2.4)
We assume that at each point of time consumers’ preferences over
money, consumption and saving can be represented by the following utility
function
U (t ) = m ε 0 (t )c ξ 0 (t ) s λ0 (t ), ε 0 , ξ 0 , λ0 > 0 .
Consumers’ problem is to choose current consumption, and savings in
such a way that utility levels are maximized. Maximizing U (t ) subject to
the budget constraints yields
im = εy a , c = ξy a , s = λy a , (11.2.5)
where
1
ε ≡ ρε 0 , ξ ≡ ρξ 0 , λ ≡ ρλ0 , ρ ≡ .
ε 0 + ξ 0 + λ0
The real wealth changes as follows15
15 It is straightforward to show that equation (5.1.7) can be expressed as follows
( ~
)
c(t ) + m& (t ) + b&(t ) = T (t ) + i (t ) − π~ (t ) b(t ) − τ (t ) − π (t )m(t ).
where we also use Eqs. (9.4.1) and (9.4.2). This equation is identical to the budget
constraint in the representative agent model for a small open economy in
Turnovsky (2000: 352). We see that given the assumptions of PPP and UIP, the
a& (t ) = s(t ) − a(t ). (11.2.6)

We have thus completed the model.
11.2.2 Dynamics and Equilibrium

~
From Eqs. (11.2.1) and (11.2.2), we have i (t ) = i + π (t ). Insert this equa-
tion in the definition of ya
(~
y a (t ) = f + 1 + i b(t ).) (11.2.7)
~
Substituting i (t ) = i + π (t ) and Eq. (11.2.7) into im = εya yields
~
( ~
)
m& = Φ (m , b ) ≡ − εf − 1 + i εb + i + µ m , ( ) (11.2.8)
where we use π (t ) = µ − m& / m where µ is the rate of change of money.

Insert s = λya and Eq. (11.2.7) in (11.2.6)
( ~
)
b& = λf + 1 + i λb − b − m − Φ (m , b ), (11.2.9)
where we use a = b + m and Eq. (11.2.8).

Equations (11.2.8) and (11.2.9) contain two variables, m(t ) and b(t ).
As the dynamic system is linear, it is straightforward to give the general
solution of the problem. Here, we are interested its equilibrium and stabil-
ity. An equilibrium point is determined by solving
( ~ ~
) (
− εf − 1 + i εb + i + µ m = 0 , )
λf + (1 + i )λb − b − m = 0 .
~
The problem has a unique solution

ε0 f εf (11.2.10)
b= ~ , m= ~
1 − ε 0 (1 + i ) (i + µ ){1 − ε 0 (1 + ~i )},
where
~
(
real rates of return on holding bonds and money are, respectively, i − π~ and )
− π = − (π~ + e ).
ε
ε0 ≡ λ − ~ .
i +µ
~
To guarantee m > 0 and b ≥ 0 , we should require 1 / 1 + i > ε 0 ≥ 0 , ( )
that is
1 ε ε (11.2.11)
~ +~ >λ≥ ~ .
1+ i i +µ i +µ
~
If i is small, then the left-side inequality is satisfied as the propensity
~
( )
to save is less than unit. For λ ≥ ε / i + µ , we see that the propensity to
hold money should be low. In the remainder of this section, we require
(11.2.11).
The two eigenvalues, φ1, 2 , are
a1 ± a12 − 4a2 (11.2.12)

φ1, 2 = ,
2
where
~ ~
(
a1 ≡ i + µ + 1 + i (λ + ε ) − 1, )
(
~
)([
~
)
~
a2 ≡ i + µ 1 + i λ − 1 − 1 + i ε < 0 . ] ( )
We conclude that the unique equilibrium point is unstable.
11.2.3 Comparative Statics Analysis
We now examine effects of changes in some parameters on the equilib-

rium.
The inflation policy

Taking derivatives of (11.2.10) with regard to µ yields
1 db ε 0µ
= > 0,
[ ~
b dµ 1 − ε 0 1 + i ε 0 ( )]
1 dm
=
~
[(
1+ i λ −1 ) ](~i + µ ) ,
m dµ [ ~
1 − ε0 1 + i ( )](~i + µ ) 2
~
( 2
)
where ε 0 µ ≡ ε / i + µ > 0. As the inflation rate rises, households tend to
hold more bonds and the sign of dm / dµ is the same as that of
( ~
) ~
1 + i λ − 1. From the definitions of i and λ , it is reasonable to require the
( ~
)
term, 1 + i λ − 1, to be negative. Hence the real money balance is reduced.
At equilibrium, we have µ = π = e . The domestic currency is depreciated.
From a = b + m and c = ξa / λ , we have
da a dc
= =
~
(
1 + i λm )
> 0.
[ (
~ ~
dµ c dµ 1 − ε 0 1 + i i + µ )]( )
The real wealth and consumption are increased.
The foreign interest rate

~
Taking derivatives of (11.2.10) with regard to i yields
1 db ε 0 ~i / ε 0 + ε 0
~ = ~ > 0,
b di 1 − ε 0 1 + i( )
~
1 dm − 2 µε + (µλ − ξ ) i + µ ( )
~ = ,
m di [ (
~ ~
1 − ε0 1 + i i + µ
2
)]( )
(
~ 2
)
where ε 0 ~i ≡ ε / i + µ > 0. As the interest rate rises, households tend to
hold more bonds and m is reduced if µλ ≤ ξ (which is reasonable to ac-
cept). The exchange rate is not affected in the long term. From a = b + m
and c = ξa / λ , we have
da a dc
= =
dµ c dµ

( )
 (ε 0 ~i + ε 02 ) ~i + µ
−
~
(
2 µε + (ξ − µλ ) i + µ 

) m
~ .
 ε ( ~
i +µ )
2
 1 − ε 0 1+ i ( )
The effects on the real wealth and consumption are ambiguous.
11.3 A Small Open-Country Economy with the CIA Approach
Section 11.2 introduced money into the utility and production functions.
With regard to the MIUF and money in production function (MIPF) ap-
proaches, Cass and Shell (1980) objected
Imbedding money in preferences or technologies does nothing to explain its

role as a store of value. Moreover such reduced forms are at best poor proxies
for their structural counterparts. Worst of all, to the extent that this maneuver is
successful, it is also likely to be misleading.
Although entering money as an argument of utility and production func-

tions has been widely accepted in the literature of monetary economics and
they overcome one of the two key criticisms of the original Tobin model,16
these models don’t provide adequate explanation of why money is held,
and thus fail to address the second key criticism of the Tobin model. In
particular, the transactions role of money is not explicitly considered. This
chapter discusses the transactions role of money. In this section, money is
held because transactions need to be settled by payment via money.
Clower (1967) proposed a model to incorporate the role of money as a
medium of exchange through the so-called cash-in-advance (CIA) con-
straint. The basic idea is to explain the role that money plays in carrying
out transactions by introduction of transaction technology.17 It is assumed
that goods cannot be exchanged for goods and only money can buy goods.
In the CIA models the role of money as facilitator of transactions is re-
flected in the rule that no transactions can take place unless the money
needed for the transaction is held for some time in advance. Stockman
(1981) developed a growth model through CIA constraints. The model
predicts that there is long-run superneutrality if only consumption expendi-
tures are subject to a CIA constraint. If investment is also subject to a CIA
constraint then steady state capital will fall when the growth rate of money
rises. It is worthwhile mentioning that Feenstra (1986) studied the relation-
ship between the MIUF and CIA approaches. He proved that under certain
regularity conditions, the maximization problem with money under a CIA
constraint may be equivalent to a maximization problem with the MIUF
approach. This implies that although it is sometimes difficult to justify the
validity of the MIUF approach, the approach may be considered as an ac-
ceptable approximation. As it has become evident now, the equivalence is
16 That is, demand is determined by maximizing utility subject to constraints.

17 The MIU approach has not been replaced by this approach partly because the
introduction of the various constraints associated with money transactions tends to
result in models which are analytically intractable.
held under specified conditions. In a recent two-sector growth model with

human capital accumulation proposed by Chang (2002), the Feenstra-like
functional equivalence between the two approaches does not hold.
This section is concerned with a trade model for a small economy within
the CIA approach.18 This section introduces money into a trade model with
tariffs. It should be noted that money has been introduced into equilibrium
models with tariffs by different authors.19
11.3.1 The Model with the CIA Approach
Consider a small open economy under a flexible exchange rte regime. We

assume that trade of assets is free without any transaction costs, which im-
plies that the real rate of interest is fixed at the world level. The economy
produces two goods, exportables and importables. The outputs of the two
goods are respectively FE (t ) and FI (t ). 20 In fact, as in Sect. 2.3, we may
consider the outputs as functions of the prices. Households’ financial
wealth is divided between domestic fiat money and internationally traded
bonds denominated in foreign currency. The economy is small, and it can
influence neither the foreign currency price of the consumption good nor
the world bond rate. For simplicity, we normalize the nominal exchange
rate to unity. Also the population is assumed to be unity. The domestic
residents may hold two assets, domestic money and a traded world bond.21
Money is introduced by assuming that a central bank distributes at no
cost to the population a per capita amount of fiat money M (t ) > 0 in order
to finance all government expenditures via seigniorage.22 The scheme ac-
18 The environment is the same as in Sect. 11.2. Some aspects of the model are
also referred to Palivos and Yip (1995, 1997a, 1997b), Friedman and Hahn (1990),
and Gali and Monacelli (2005).
19 For instance, Anderson and Takayama (1978, 1981), and Batra and
Ramachandran (1980).
20 Instead of exogenously fixed output levels, we may assume that product is
produced by combining labor and output. It is not difficult to consider this case by
referring to the factor-immobile models in Chap. 2. As this section illustrates how
money can be introduced a two-sector trade model, we accept this simplification.
It should be noted that Matsuyama (1988) proposes a two-goods trade model in
the OLG framework. See also Persson and Svensson (1985), Galor and Lin
(1994), and Backus et al. (1994).
21 We assume that foreigners don’t hold domestic money.
22 The assumption that the government’s role is only to keep the money growth
rate at a constant rate and to distribute siegniorage to the representative household

as a transfer payment in a lump-sum manner is a well-accepted assumption in the
cording to which the money stock evolves over time is deterministic and
known to all agents. With µ being the constant net growth rate of the
money stock, M (t ) evolves over time according:
M& (t ) = µM (t ), µ > 0 .
Let pE (t ) and p I (t ) stand for respectively the prices of exportables and

importables in the world market. Let p(t ) ≡ p I (t ) / p E (t ) denote the rela-
tive price of importables in terms of exportables. Assume that the nominal
price of each good grows at a constant rate (the inflation rate), π (t ).
Hence, we have p& (t ) = 0 .
Let τ and i (t ) respectively stand for a fixed tariff rate and the nominal
interest rate. Then, the nominal disposable income of the household,
yˆ m (t ), is given by
(11.3.1)
where B(t ) is nominal bond holdings, τˆm (t ) is the lump-sum rebate of tar-
iff revenues, and â(t ) is the nominal wealth defined as
aˆ (t ) = B(t ) + M (t ).
We express Eq. (11.3.1) in terms of exportables as follows
yˆ = FE + (1 + τ ) pFI + ib + a + τˆ + µm − πm − πb, (11.3.2)
where
yˆ m M B aˆ τˆ
yˆ ≡ , m≡ , b≡ , a≡ , τˆ ≡ m .
pE pE pE pE pE
We use cE (t ) and c I (t ) to represent respectively consumption levels of

exportables and importables. Let s (t ) stand for the saving out of the dis-
posable income in terms of exportables. The budget constrain is then given
by
c E (t ) + (1 + τ ) p (t )c I (t ) + s (t ) = yˆ (t ). (11.3.3)
We accept that the household is subject to the following cash-in-
advance (CIA) or liquidity constraint
literature on money and growth (for instance, Orphanides and Solow, 1990; Mar-
quis and Reffett, 1995; and Mino and Shibata, 1995).
χ E cE (t ) + χ I (1 + τ ) p(t )cI (t ) = m(t ), (11.3.4)
where χ E and χ I present respectively constant shares of purchases of ex-

portables and importables. It should be noted that in general, equality
should be replaced with ≤ . Here, we neglect possible demand for money
in capital markets. The constraint requires the individual to purchase with
money balances sufficient to finance some (fixed) part of consumption.23
Inserting Eqs. (11.3.4) and (11.3.2) in the budget constraint (11.3.3), we
have
(1 + χ Eπ )cE + (1 + τ )(1 + χ I π ) pcI + s = y( , (11.3.5)
where
(
y ≡ FE + (1 + τ ) pFI + ib + a + µm + τˆ − πb .
We assume that at each point of time the consumer’s preference over
consumption and saving can be represented by the following utility func-
tion
U (t ) = c Eξ E 0 (t )c Iξ I 0 (t )s λ0 (t ), ξ E 0 , ξ I 0 , λ0 > 0 .
Consumers’ problem is to choose current consumption and savings in
such a way that utility levels are maximized. Maximizing U (t ) subject to
the budget constraints yields
(1 + χ Eπ )cE = ξ E y( , (1 + τ )(1 + χ I π ) pcI = ξ I y( , s = λ y( , (11.3.6)
where
1
ξ E ≡ ρξ E 0 , ξ I ≡ ρξ I 0 , λ ≡ ρλ0 , ρ ≡ .
ξ E 0 + ξ I 0 + λ0
The wealth changes as follows
a& (t ) = s(t ) − a(t ). (11.3.7)
The government budget constraint is given by

M& (t ) + B& (t ) + R(t ) = i (t )B(t ) + M& (t ) + τˆm (t ), (11.3.8)
where R(t ) is the tariff revenue given by
23 This form is more general than the one applied in Stockman (1981) and the
one by Lucas and Stokey (1987). See also Laird and Yeates, 1990; Mayor and
Pearl, 1984; and Palivos et al. (1993).
R(t ) = τp I (t )[cI (t ) − FI (t )]. (11.3.9)

From Eqs. (11.3.1), (11.3.3), and (11.38)-(11.3.7), we get
p E (t )c E (t ) + p I (t )c I (t ) = p E (t )FE (t ) + p I (t )FI (t ).
This is the goods market equilibrium condition. Dividing the above
equation by pE (t ) yields
cE (t ) + p(t )cI (t ) = FE (t ) + p(t )FI (t ). (11.3.10)
11.3.2 Dynamics and Equilibrium
Before examining behavior of the system, we should specify time-

dependent exogenous variables. For simplicity, we assume i , π , FE and
FI to be constant during the study period. The prices of the two goods
change
p& E p&
= I =1+ π.
pE pI
In this section, we will omit time in expressions. We also assume that
the government fixes the rate of money growth at the same level as the in-
flation rate, i.e., µ = π . We note that the relative price is invariant in time,
i.e., p& = 0 . We now derive the dynamics of the system under these as-
sumptions.
B& + τp I [c I − FI ] = iB + τˆm .
Divide this equation by pE
τˆ = (1 + π − i )b + b& + τp(cI − FI ), (11.3.11)
where we use
B&
= πb + b& .
pE
(
Inserting Eq. (11.3.11) in the definition of y , we have
(
y = FE + (1 + τ ) pFI + a + µm + b& + τp(c I − FI ).
(
Insert (1 + τ )(1 + χ I π ) pcI = ξ I y into this equation
(
[
y = ξ FE + (1 + τ ) pFI + a + µm + b& − τpFI , ] (11.3.12)
where
−1
 τξ I 
ξ ≡ 1 − > 1.
 (1 + τ )(1 + χ I π )
(
Substituting s = λ y in (11.3.6) and Eq. (11.3.12) into Eq. (11.3.7)
yields
( )
a& = λξ FE + pFI + µm + b& − (1 − λξ )a . (11.3.13)
By their definitions, we have λξ < 1. Inserting a = b + m in Eq.

(11.3.13), we have
b& = b0 − b , (11.3.14)
where
λξ (FE + pFI ) − (1 − λξ − λξµ )m
b0 ≡ ,
1 − λξ
where we use m& = (µ − π )m = 0 . This equation involves a single time-

dependent variables, b . We require b0 > 0 , which is guaranteed, for in-
stance, if
λξ (FE + pFI ) > m .
This can be guaranteed if the initial money, M 0 , is much lower than the
national nominal output, p E FE + p I FI , at t = 0 . Hence, we have
b(t ) = [b(0 ) − b0 ]e − t + b0 . (11.3.15)
The problem has a unique solution and the solution, b(t ), approaches its
equilibrium value, b0 , in the long term. The dynamic system has a unique
stable equilibrium. In summary, we have the following proposition.
Proposition 11.3.4
Assume b0 > 0 . The dynamic system has a unique solution. The motion of
all the variables are explicitly given by the following procedure: b(t ) by
(
(11.3.5) → m = M / p E → a = m + b → y by (11.3.12) → c E , c I and s
by (11.3.5) → R by (11.3.9).
11.3.3 Tariffs and Terms of Trade on Equilibrium
We examine effects of changes in some parameters on the economic sys-

tem.
Effects of tariff
By Eq. (11.3.15), we have b = b0 in equilibrium, where
b0 ≡
(FE + pFI + µm )
− (FE + pFI + µm ) − m .
1 − λξ
Taking derivatives of this function with respect to τ yields
db λ (FE + pFI + µm ) ξ 2ξ I
= > 0.
dτ (1 − λξ )2 (1 + τ )2 (1 + χ I π )
As the tariff on importables is increased, the bonds in terms of export-
(
ables are increased. From a = m + b , a = s = λy , and Eq. (11.3.6), we
obtain
(
da dy db
=λ = > 0,
dτ dτ dτ
( (
1 dc E 1 dy 1 dc I 1 dy 1
= ( > 0, = ( − .
c E dτ y dτ c I dτ y dτ 1 + τ
The wealth and consumption level of exportables are increased; but the
effect on importables is ambiguous.
Effects of prices
We now examine effects of changes in prices. As the equilibrium values
are determined as a function of the relative price, it is sufficient for us to
be concerned with p . It is straightforward to show that the effects on the
key variables are given as follows
(
db λξFI da dy db
= > 0, =λ = > 0,
dp 1 − λξ dp dp dp
(
1 dcE 1 dy 1 dc I λξFI 1
= ( > 0, = − < 0,
cE dp y dp c I dp λξ (FE + pFI ) + λξµm p
As the price of importables (exportables) rises (falls), b is increased.

The wealth and consumption level of exportables are increased; the con-
sumption level of importables is reduced.
Effects of the Propensity to Save

The effects of the propensity to save are given as follows
db (F + pFI + µm )ρλξ
= E
 ξI + ξE
 −
ξτξ I 
,
d λ0 (1 − λξ )2  λ0 (1 + τ )(1 + χ I π ) 
(
da
=
db 1 dy
, ( =
db (ξ + ξ )λ
+ I 2E ,
dλ0 dλ0 y dλ0 dλ0 λ0
( (
1 dc E 1 dy ξ 1 dc I 1 dy ξ
= ( − E , = ( − I .
c E dλ0 y dλ0 ξ E 0 c I dλ0 y dλ0 ξ I 0
The effects are ambiguous.
Effects of the Propensity to Consume Importables

The effects of the propensity to save are given as follows
db (F + pFI + µm )λξ
= E
 λ
− +
(ξ E 0 + λ0 )ξτξ I20  ,
 
dξ 0 I (1 − λξ )2  λ0 (1 + τ )(1 + χ I π )ξ I 0 
(
da db 1 dy db λ
= , ( = − ,
dξ I 0 dξ I 0 y dξ I 0 dξ I 0 λ0
( (
1 dc E 1 dy
= (
ξ
− E ,
1 dc I 1 dy
= (
(ξ + λ )ξ
+ E0 2 0 I ,
c E dξ I 0 y dξ I 0 ξ E 0 c I dξ I 0 y dξ I 0 ξI0
As in the case of the change in the propensity to save, the effects are
ambiguous.
Effects of changes in χ I
We now examine what will happen to the system when the household
has to hold more money for purchasing one unit of importables. The ef-
fects are given as follows
db
=−
(FE + pFI + µm )ξ 2τξ I π < 0 ,
dχ I (1 − λξ )2 (1 + τ )(1 + χ I π )2
(
da dy db
=λ = < 0,
dχ I dχ I dχ I
( (
1 dcE 1 dy 1 dcI 1 dy π
= ( < 0, = ( − < 0.
c E dχ I y dχ I c I dχ I y dχ I 1 + χ I π
Effects of output of exportables
The effects of change in the output level of exportables are given as fol-
lows:
(
db da dy λξ
= =λ = > 0,
dFE dFE dFE 1 − λξ
(
1 dc E 1 dcI 1 dy
= = ( > 0.
c E dFE c I dFE y dFE
All the key variables are increased as the output is increased.
Effects of inflation rate

As we require µ = π , we should have
dµ = dπ .
The effects are give as
(
db
=
da
=λ
dy (F + pFI + µm )ξ 2ξ Iτχ I < 0 ,
=− E
d π dπ dπ (1 − λξ )2 (1 + τ )(1 + χ I π )2
( (
1 dc E 1 dy χE 1 dcI 1 dy χI
= ( − < 0, = ( − < 0.
c E dπ y dπ 1 + χ E π c I dπ y dπ 1 + χ I π
Effects of change in money supply

As m = M 0 / pE (0 ), we may consider effects of an increase in money
supply. We have the effects as follows
db
=−
(1 − λξ − λξµ ) < 0 ,
dM 0 (1 − λξ ) pE
( (
da dy λξµ 1 dc E 1 dy
=λ = > 0, = ( > 0,
dM 0 dM 0 (1 − λξ ) p E c E dM 0 y dM 0
(
1 dc I 1 dy
= ( > 0.
c I dM 0 y dM 0
This section illustrates how to introduce money with the CIA approach.
An important issue is to design an optimal tariff for the national economy.
As we have explicitly solved the dynamics, this question is not difficult if
we assume the government to maximize a social welfare function subject
to its budget constraint.
11.4 A Multi-Country Growth Model with the MIUF

Approach
This section develops a multi-country model with money, based on the

multi-country monetary model proposed by Zhang (2008a: Chap: 9) and
the one-sector multi-country trade model in Sect. 7.2. The symbols have
the same meanings as in Sect. 7.2, if without explanation. The global eco-
nomic system consists of multiple countries, indexed by j = 1, ..., J . Only
one good is produced in the system. Perfect competition is assumed to pre-
vail in good markets both within each country and between countries, and
commodities are traded without any barriers such as transport costs or tar-
iffs.
11.4.1 The Model
Suppose that each country has two outside assets: fiat money and physical
capital. We assume that each country’s money is a nontradeable asset. Let
Pj (t ) stand for nominal price of the good in country j ' s currency. In each
country money is introduced by assuming that a central bank distributes at
no cost to the population a per capita amount of fiat money M j (t ) > 0 in

order to finance all government expenditures via seigniorage. The scheme
according to which the money stock evolves over time is deterministic and
known to all agents. With µ j being the constant net growth rate of the
money stock, M j (t ), evolves over time according
M& j (t ) = µ j M j (t ), µ j > 0 .
Let M j (t ) and µ j stand for respectively the nominal money stock per
household and the constant rate of monetary expansion in country j . The
government expenditure in real terms per capita, τ j (t ), is given by
M& j (t ) µ j M j (t ) (11.4.1)
τ j (t ) = = = µ j m j (t ),
Pj (t ) Pj (t )
where m j (t ) ≡ M j (t ) / Pj (t ). We also have
m& j (t ) = (µ j − π j (t ))m j (t ), (11.4.2)
where π j ≡ P&j / Pj is the inflation rate in country j . The representative

household takes τ j (t ) as given. Since the commodity is homogeneous, ex-
change rate, Eij (t ), (the value of currency j in terms of currency i ) is
represented by Pi (t ) / Pj (t ) for i , j = 1, ..., J . Changes in exchange rates
are given by
E& ij (t ) (11.4.3)
= π i (t ) − π j (t ).
Eij (t )
We denote real interest rates by rj (t ) in the j th country. In the free

trade system, the real interest rate is identical throughout the world econ-
omy, i.e., r (t ) = rj (t ). We introduce the following variables:
m  subscript indexes for sex; m = 1, male, m = 2 , female;

N j (t )  the total labor supply in country j at time t ;
N jm (t )  the total labor supply of sex m in country j ;
T jm (t ) and Tˆjm (t )  the working and leisure time of sex m in country j ;
F j (t )  country j ’s output;
w jm (t )  the wage rate per unity of working time of sex m in country j .
The labor supplies N jm (t ) and N j (t ) are defined as follows
N jm (t ) = h jmT jm (t )Nˆ j , N j (t ) = N j1 (t ) + N j 2 (t ), (11.4.4)

j = 1, L , J , m = 1, 2 ,
where h jm are human capital index of country j ’s sex m .
As in Sect. 7.2, the marginal conditions are given by
r + δ kj = f j' (k j ), w jm (t ) = h jm w j (t ), (11.4.5)
where δ kj is the depreciation rate of physical capital in country j and
w j (t ) ≡ f j (k j ) − k j f j' (k j ).
Let kˆ j (t ) stand for the per-family physical wealth in country j . Country
j ’s per-family disposable income in real terms, yˆ j (t ), in country j is
yˆ j (t ) = r (t )kˆ j (t ) + (h j1T j1 (t ) + h j 2T j 2 (t ))w j (t ) (11.4.6)

− π j (t )m j (t ) + τ j (t ) + a j (t ),
At each point of time, a family would distribute the total available budget
among money holding, m j (t ), savings, s j (t ), and consumption of goods,
c j (t ). The budget constraint is given by
(1 + r (t ))m j (t ) + c j (t ) + s j (t ) = yˆ j (t ). (11.4.7)
Let T0 denote the total available time. The time constraint requires that
the amounts of time allocated to each specific use add up to the time avail-
able
T jm (t ) + Tˆjm (t ) = T0 . (11.4.8)
Substituting Eqs. (11.4.6) and (11.4.8) into (11.4.7) yields

(π j + r )m j + h j1 w jTˆj1 + h j 2 w jTˆj 2 + c j + s j = y aj (11.4.9)
≡ (1 + r )kˆ j + h jT0 w j + τ j ,
where h j ≡ h j1 + h j 2 .
At each point of time, households decide the four variables subject to
the disposable income. We assume that utility level, U j (t ), is dependent
on the leisure times, Tˆj1 (t ) and Tˆj 2 (t ), the consumption of commodity,
c j (t ), and savings, s j (t ), as follows
U j (t ) = m j 0 j (t )Tˆj1 0 j1 (t )Tˆj 20 j 2 (t )c j 0 j (t )s j 0 j (t ), (11.4.10)

ε σ σ ξ λ
where σ 0 j1 , σ 0 j 2 , ξ 0 j and λ0 j are respectively country j ’s propensities

to hold real money balance, to use the husband’s leisure time, to use the
wife’s leisure time, to consume goods and services, and to hold wealth.
Maximizing U j subject to (11.4.9) yields
(π j + r )m j = ε j y aj , w j1Tˆj1 = σ j1 y aj , w j 2Tˆj 2 = σ j 2 y aj , (11.4.11)
where
ε j ≡ ε 0 j ρ j , σ j1 ≡ σ 0 j1 ρ j , σ j 2 ≡ σ 0 j 2 ρ j , ξ j ≡ ξ 0 j ρ j ,
1
λ j ≡ λ0 j ρ j , ρ j ≡ .
ε 0 j + σ 0 j1 + σ 0 j 2 + ξ 0 j + λ0 j
According to the definitions of s j (t ), the per-family’s wealth accumula-

tion in country j is given by
a& j (t ) = s j (t ) − a j (t ), j = 1, L, J . (11.4.12)

the total physical wealth owned by all the countries. That is
J J J
(11.4.13)
K (t ) = ∑ K j (t ) = ∑ k j (t )N j (t ) = ∑ kˆ j (t )Nˆ j ,
j =1 j =1 j =1
where K (t ) is the total capital stock of the world economy.

This section shows that the dynamics of the world economy can be ex-
pressed as 2 J − dimensional differential equations. First, from Eqs.
(11.4.4) we obtain
f j' (k j ) = f1' (k1 ) − δ j , j ≡ 2, L, J , (11.4.14)
where δ j ≡ δ k 1 − δ kj . If f1' (k1 ) − δ j > 0 for all j = 2 , L, J and given

k1 (t ) > 0 , then the equations determine unique relations between k j and
k1 , denoted by
k j = φ j (k1 ), j = 1, L, J , (11.4.15)

dk j
f j" (k j ) = f1" (k1 ), j = 2 , L, J .
dk1
( )
As f j" k j ≤ 0 , j = 1, L, J , we see that dk j / dk1 ≥ 0 , j = 2 , L, J . That
is, φ 'j (k1 ) ≥ 0 . Hence, for any given k1 (t ) > 0 , we uniquely determine
k j (t ), j = 2 , L, J as unique functions of k1 (t ). From Eqs. (11.4.5), we
determine the wage rates as functions of k1 (t ) as follows
w jm (t ) = φˆ jm (k1 ) ≡ h jmφˆ j (k1 ), j = 1, L, J , (11.4.16)
where
φˆj (k1 ) ≡ f j (φ j (k1 )) − φ j (k1 ) f j' (φ j (k1 )).
By r + δ kj = f j' (k j ) in (11.4.5), we also express r (t ) as a function of

k1 (t ) as
r (t ) = φˆ0 (k1 ) ≡ f1' (k1 ) − δ k 1 . (11.4.17)
Insert (11.4.16) and (11.4.17) into (11.4.9)
( )
y aj = 1 + φˆ0 (k1 ) kˆ j + h jT0φˆ j (k1 ) + µ j m j , j = 1, L, J . (11.4.18)
We see that yaj (t ) can be expressed as functions of kˆ j (t ), k1 (t ) and

m j (t ). Substituting Eqs. (11.4.18) into φˆjm (k1 )Tˆjm = σ jm yaj yields
σ jm kˆ j
( ) (
T jm (t ) = Λ jm k1 , kˆ j , m j ≡ σˆ jm − 1 + φˆ0 (k1 )
φˆ (k )
)
− σ jm µ j
mj
φˆ (k )
,
jm 1 jm 1
j = 1, L , J , m = 1, 2 , (11.4.19)
where we use Eqs. (11.4.5) and (11.4.8) and
σ jm h jT0
σˆ jm ≡ 1 − .
h jm
For gender m to work outside, we should require σˆ jm > 0 . For illustra-

tion, let m = 2 . Then
  h j1  
σˆ j 2 = 1 − 1 + σ j 2 T0 .
  h j 2  
 
If
1 h j1
−1≤ ,
σ j2 hj2
then country j ’s women will not work outside irrespective of the family’s
economic conditions. As we are interested in sexual division of labor in the
world, we require
1 h jm '
−1> , m , m' = 1, 2 , m ≠ m' , j = 1, L, J .
σ jm h jm
This means that any gender in any country works outside. By Eqs.
(11.4.19), we can express T jm (t ) as functions of kˆ j (t ), k1 (t ) and m j (t ) as
well.
J 2 J
∑ k j (t )Nˆ j ∑ h jmT jm (t ) = ∑ kˆ j (t )Nˆ j .

j =1 m =1 j =1
Insert (11.4.15) and (11.4.19) in the above equation, we solve kˆ1 (t ) as

( {} )
kˆ1 = Λ k1 , kˆ , m ≡ Λ1 k1 , kˆ , m − ( {} )
 σ jm kˆ j 
1
( )
J 2
Λ (k , {kˆ}, m )
∑ n φ (k )∑ h j j 1 jm  1 + φˆ0 (k1 ) ,
φˆjm (k1 ) 
(11.4.20)
0 1 j =2 m =1

{ } ( )
where kˆ(t ) ≡ kˆ2 (t ), L, kˆJ (t ) , m(t ) ≡ (m1 (t ), L, mJ (t )) and
Λ (k , {kˆ}, m ) ≡
1 1
 J 2  σ jm µ j m j  J  1
∑ n jφ j (k1 )∑ h jm σˆ jm − ˆ − ∑ n kˆ  Λ
 j =1 m =1  φ jm (k1 )  j =2
j j
 0 (k , {kˆ}, m),
1
( {} ) h σ
( )
2
Λ 0 k1 , kˆ , m ≡ 1 + k1 1 + φˆ0 (k1 ) ∑ 1m 1m ,
m =1 φ (k )
ˆ
1m 1
Nˆ j
nj ≡ , j = 1, L , J .
Nˆ1
We see that country 1’s per-family wealth, kˆ1 (t ), can be expressed as a

unique function of the real money balances of the countries, country 1’s
capital intensity and the other countries’ per-family wealth k̂ (t ) at any { }
point of time. By Eqs. (11.4.18) and (11.4.20), we see that yaj (t ) can be
expressed as functions of kˆ j (t ), k1 (t ) and m j (t ). We express these equa-
tions as follows
( {} )
yaj (t ) = Φ j k1 , kˆ , m , j = 1, ... , J .
( {} ) (
m& j = Λ j 1 j 0 1)
ˆ k , kˆ , m ≡ µ + φˆ (k ) m + ε y .
j j aj
(11.4.21)
Substitute s = λ Φ (k , {kˆ}, m ) into wealth accumulation Eqs. (11.4.12)

j j j 1
kˆ = λ Φ (k , {kˆ}, m ) − kˆ − m − Λ
ˆ (k , {kˆ}, m ),
& (11.4.22)
1 1 1 1 1 1 1 1
&
kˆ j = Φ 1( {} )
ˆ k , kˆ , m = λ Φ k , kˆ , m − kˆ − m − Λ
j j j 1 j j j 1 ( {} )
ˆ k , kˆ , m , ( {} )
j = 2 , L, J , (11.4.23)
where we also use a j = m j + kˆ j and Eqs. (11.4.21).

∂Λ & ∂Λ ˆ
( {} ) ∂Λ ˆ
( {} ) (11.4.24)
J J
&
kˆ1 = k1 + ∑ Φ j k1 , kˆ , m + ∑ Λ j k1 , kˆ , m ,
∂k1 ˆ
j = 2 ∂k j j =2 ∂m j
where we also use Eqs. (11.4.21) and (11.4.23). Equalizing the right-hand
side of Eq. (11.4.22) and the right-hand side of Eq. (11.4.24), we have
k&1 = Φ ( {} )
ˆ k , kˆ , m ≡
1 1
 J
∂Λ ˆ J
∂Λ ˆ   ∂Λ 
−1
(11.4.25)
 λ Φ − kˆ − m − Λ
 1 1 1 1
ˆ −
1 ∑ ˆ
j = 2 ∂k
Φj − ∑
j = 2 ∂m j
Λ j   .
  ∂k1 
 j 
We will not explicitly express these derivatives and partial derivatives
as they are straightforward to obtain, but their expressions are tedious. In
summary, we obtain the following lemma.
Lemma 11.4.1
The dynamics of the world economy is given by the 2 J − dimensional dif-
ferential equations
k&1 = Φ 1 1( {} )
ˆ k , kˆ , m ,
&
kˆ j = Φ ( {} )
ˆ k , kˆ , m ,
j 1
m& j = Λ j 1( {} )
ˆ k , kˆ , m , (11.4.26)
with k1 (t ), {k j (t )}, and m(t ) as the variables. For any given positive val-
ues of k1 (t ), {k j (t )}, and m(t ) at any point of time, all the other variables
are uniquely determined by the following procedure: k̂1 by (11.4.20) →
k j , j = 2, L, J by (11.4.15) → T jm by (11.4.19) → Tˆjm = T0 − T jm →
f j = f j (k j ) → r and w jm by (11.4.5) → yaj = Φ j by (11.4.18) →
M& j = µ j M j → Pj = M j / m j → π j = P&j / Pj → c j and s j by (11.4.11) →
N j = ∑m h jm Nˆ jT jm → K j = k j N j → F j = N j f j .
2
Although we may analyze behavior of the 2 J − dimensional differential

equations, it is difficult to explicitly interpret results. Following the com-
puting procedure given in Lemma 11.4.1, we may simulate the model to il-
lustrate motion of the system.
11.5 A Heterogeneous Households Model with the CIA

Approach
Fischer (1992: 221) observes
One of the neglected aspects of the theory of international trade are the effects
of trade on personal income distribution. … A deficiency of many studies of in-
come distribution is the use of static models to analyse a phenomenon that is
distinctively dynamic in nature.
As far as the traditional approaches in growth theory are concerned, the

mission described by Fischer is mainly due to the technical difficulties as-
sociated with the traditional approaches. Applying the alternative utility
function used in this book, Zhang (2006a) develops a comprehensive the-
ory of dynamic economics with both income and wealth distribution. Nev-
ertheless, Zhang does not introduce money into trade theory with hetero-
geneous households. This section develops a monetary growth model with
capital, heterogeneous-households and trade. We extend the two-country
single household trade model in Sect. 8.1 to multi-country, heterogeneous
household growth trade model with money.24
11.5.1 The Monetary Trade Growth Model with the CIA

Approach
The system consists of multiple countries, indexed by j = 1, ..., J . Only

one good is produced in the system. Perfect competition is assumed to pre-
vail in good markets both within each country and between the countries,
and commodities are traded without any barriers such as transport costs or
tariffs. We assume that there is no migration between the countries and the
labor markets are perfectly competitive within each country. Let prices be
measured in terms of the commodity and the price of the commodity be
unity. We assume that the population of country j can be classified into
24 This section is actually based on the multi-country growth trade model with
heterogeneous households (without money) proposed by Zhang (2006a: Sect. 8.4).
This section introduces money into the model with the CIA approach. It is
straightforward to introduce money with the MIUF approach.
11.5 A Heterogeneous Households Model with the CIA Approach 447
Q j groups, indexed by q, according to their preferences, wealth, human

capital, and social status. The total number of types of households, Q , is
J
Q = ∑Qj.
j =1
A group q in country j is indexed by ( j , q ). We introduce
Q * ≡ {( j , q ) | j = 1, L, J , q = 1, L, Q j }.
Let the number of group q in country j be N jq . The aggregated labor

force N j of country j is given by
Qj (11.5.1)
Nj = ∑h
q =1
jq N jq ,
where h jq are the level of human capital of group q in country j . Coun-

try j ' s population is given by
Qj
N 0 j = ∑ N jq .
q =1
Like in Sect. 11.4, we assume that each country has two outside assets:
fiat money and physical capital. We assume that each country’s money is a
nontradeable asset. Let Pj (t ), M j (t ), τ j (t ), m j (t ), π j (t ), Eij (t ), and µ j
be defined as in Sect. 11.4. We have
M& j (t ) = µ j M j (t ), µ j > 0 ,
M& j (t ) µ j M j (t )
τ j (t ) = = = µ j m j (t ),
Pj (t ) Pj (t )
m& j (t ) = (µ j − π j (t ))m j (t ). (11.5.2)
We also have
E& ij (t ) (11.5.3)
= π i (t ) − π j (t ).
Eij (t )
We denote real interest rates by rj (t ) in the j th country. In the free

trade system, the real interest rate is identical throughout the world econ-
omy, i.e., r (t ) = rj (t ). We denote real wage by w jq (t ).
We now describe behavior of the production sections. We use produc-
tion functions to describe the physical facts of a given technology. We as-
sume that there are only two productive factors, capital, K j (t ) , and labor,
N j , at each point of time t . The neoclassical production functions are
F j (K j (t ), N j ). We introduce
F j (t ) K j (t )
f j (t ) = f j (k j (t )), f j (t ) ≡ , k j (t ) ≡ .
Nj Nj
ucts, and firms earn zero profits. The marginal conditions are given by
r + δ kj = f j' (k j ), w jq (t ) = h jq ( f j (k j ) − k j f j' (k j )), ( j, q ) ∈ Q* . (11.5.4)
where δ kj is the depreciation rate of physical capital in country j.

When deciding about the composition of their portfolios, the household
knows in advance that a certain fraction of consumption needs to be fi-
nanced by payment in cash. Assume that cash has to be held in advance of
purchasing goods. The liquidity constraint of household q in country j is
formed as25
M jq (t ) ≥ χ jq Pj (t )c jq (t ), (11.5.5)
where χ jq is a positive parameter.26 We require 0 < χ jq ≤ 1.

Consumers make decisions on choice of leisure time, consumption lev-
els of services and commodities as well as on how much to save. Let kˆ (t ) jq
25 In this section, we only consider money for purchasing consumption goods
and neglect possible money required for other purposes, such as investment.
26 According to Stockman, investment should also be taken into account. That
is, instead of (4.1.3), one should have a general constraint in the form of
( )
Ψ c , k& ≤ m . A simplified form is c + k& ≤ m . The form accepted in this study is
common in the CIA literature and it is also important for us to generate a unique
( )
steady state. If we accept Ψ c , k& ≤ m , then the uniqueness may not be guaran-
teed. Suen and Yip (2005) discuss how CIA constrains may affect the number of
steady states and their stability properties in the Ramsey approach.
stand for the per capita physical wealth of group q in country j . A con-
sumer q of country j obtains the current income
yˆ jq (t ) = r (t )kˆ jq (t ) + w jq (t ) + µ j m j (t ) − π j (t )m jq (t ) (11.5.6)
+ a jq (t ), ( j, q ) ∈ Q* ,
where a jq (t ) ≡ kˆ jq (t ) + m jq (t ). At each point of time, a consumer distrib-
utes the total available budget among saving, s jq (t ), and consumption of
goods, c jq (t ). The budget constraints are given by
(1 + χ jq π j )c jq + s jq = yajq = rkˆ jq + w jq + µ j m j + a jq , (11.5.7)
where we use constraints (11.5.5) in equality.

We assume that utility levels, U jq (t ) , that the consumers obtain are de-
pendent on c jq (t ) and s jq (t ). The utility level of consumer ( j, q ) is speci-
fied as follows
ξ λ
U jq (t ) = c jqjq (t ) s jqqj (t ), ξ jq , λ jq > 0, ξ jq + λ jq = 1,
where ξ jq and λ jq are respectively ( j, q ) ’s propensities to consume and

to hold wealth. Maximizing U j subject to the budget constraints (11.5.7)
yields
(1 + χ jq π j )c jq = ξ jq y ajq , s jq = λ jq yajq , ( j, q ) ∈ Q* . (11.5.8)
According to the definitions of s jq (t ), ( j, q ) ’s wealth accumulation is

given by
a& jq (t ) = s jq (t ) − a jq (t ) . (11.5.9)

the total physical wealth owned by all the countries. That is
J J Qj (11.5.10)
K (t ) = ∑ K j (t ) = ∑∑ kˆ jq (t )N jq .
j =1 j =1 q =1
The total demand for money is equal to the total supply

Qj (11.5.11)
N 0 j m j (t ) = ∑ m (t )N jq jq .
q =1
We now examine properties of the system.
11.5.2 The Monetary Economic Dynamics
First, from Eqs. (11.5.4) we obtain

f j' (k j ) = f1' (k1 ) − δ j , j = 2, L, J , (11.5.12)
where
δ j ≡ δ k1 − δ kj .
If f1' (k1 ) − δ j > 0 for all j = 2, L, J and given k1 (t ) > 0, then the equa-
tions determine unique relations between k j and k1 , denoted by
k j = φ j (k1 ), j = 1, L, J , (11.5.13)

dk j
f j" (k j ) = f1" (k1 ), j = 2, L, J .
dk1
As f j" (k j ) ≤ 0, j = 1, L, J , we see that dk j / dk1 ≥ 0, j = 2, L, J . That

is, φ j' (k1 ) ≥ 0. Hence, for any given k1 (t ) > 0, we uniquely determine
k j (t ), j = 2, L, J as unique functions of k1 (t ).
From Eqs. (11.5.4), we determine the wage rates as functions of k1 (t ) as
follows
w jq (t ) = φˆ jq (k1 ) ≡ h jq ( f j (φ j (k1 )) − φ j (k1 ) f j' (φ j (k1 ))), ( j, q ) ∈ Q* . (11.5.14)

J J Qj
∑ k j (t )N j = ∑∑ kˆ jq (t )N jq .
j =1 j =1 q =1
Insert Eq. (11.5.13) into the above equation

( { })
kˆ11 (t ) = Λ k1 , kˆ(t ) ≡
J J Qj Qj
∑ n jφ j (k1 ) − ∑∑ n jq kˆ jq (t ) − ∑ n1q kˆ1q (t ),

j =1 j = 2 q =1 q=2
(11.5.15)
in which
nj ≡
Nj
N11
, n jq ≡
N jq
N11
, {kˆ(t )} ≡ (kˆ 12 (t ), L, kˆ1Q (t ), L, kˆJQ (t )).
1 J
We see that group (1, 1) ’s per capita wealth, kˆ11 (t ), can be expressed as
a unique function of country 1’s capital intensity and all the other groups’
{ }
per capita wealth, kˆ(t ) , at any point of time.
From the definitions of yajq , a jq = kˆ jq + m jq , and Eqs. (11.5.4) and
(11.5.6), we obtain
( { })
y ajq = φajq k1 , kˆ(t ) + µ j m j + m jq , ( j, q ) ∈ Q* , (11.5.16)
where we apply Eqs. (11.5.14) and r (t ) = f1' (k1 ) − δ k 1 and
( { }) ( { })
φa11 k1 , kˆ(t ) ≡ [ f1' (k1 ) + 1 − δ k 1 ]Λ k1 , kˆ(t ) + φˆ11 (k1 ),
( { })
φajq k1 , kˆ(t ) ≡ [ f1' (k1 ) + 1 − δ k1 ]kˆ jq + φˆ jq (k1 ),
( j, q ) ∈ Q * , ( j, q ) ≠ (1, 1).
Insert m jq = χ jq c jq in (1 + χ jqπ j )c jq = ξ jq yajq
 1 
 + π j  m jq = ξ jq y ajq .
χ 
 jq 
Substituting Eqs. (11.5.16) into the above equations yields
φajq + µ j m j (11.5.17)
m jq = .
1 / ξ jq χ jq + π j / ξ jq − 1
With regard to country j , we multiply the equation for ( j , q ) in

(11.5.17) by N jq and then add up the resulted equations for q = 1, ..., Q j ,
then we solve
N0 jm j = ∑
Qj
(φ ajq + µ j m j )N jq
,
q =1 (1/ ξ jq χ jq + π j / ξ jq − 1)
where we us Eqs. (11.5.11). Insert π j = µ j − m& j / m j in the above equa-

tions
N0 j = ∑
Qj
(φ ajq + µ j m j )ξ jq N jq
, j = 1, ... , J ,
(11.5.18)
q =1 ξˆ m − m&
jq j j
where ξˆ jq ≡ 1 / χ jq + µ j − ξ jq . We now want to solve m& j in terms of

{ }
k1 (t ), k̂ (t ) and m(t ) = (m1 (t ), ..., m j (t )). From Eqs. (11.5.18), we see that
if ξˆ jq ≠ ξˆ jq ' for some q ≠ q ' , then m& j may have multiple solutions for
country j . For instance, if country j has two types of households with
ξˆ j1 ≠ ξˆ j 2 , then we have
N0 j =
(φ aj1 + µ j m j )ξ j1 N j1 (φaj 2 + µ j m j )ξ j 2 N j 2
+ .
ξˆ j1m j − m& j ξˆ j 2 m j − m& j
It is straightforward to confirm that the problem may have two solu-
tions. For simplicity, we require that for any j
ξˆ j ≡ ξˆ jq = ξˆ jq ' , q , q' = 1, ... , Qq . (11.5.19)
This condition is guaranteed if different groups’ propensities to save are

equal and χ jq = χ jq ' for all q , q ' = 1, ... , Qq . In the reminder of this sec-
tion, we require (11.5.19) for all the countries. Under (11.5.19), we solve
(11.5.18) as
( {} )
m& j = Λ j k1 , kˆ , m ≡ ξˆ jq m j −
Qj (11.5.20)
∑ (φ + µ j m j )ξ jq N jq , j = 1, ... , J .
1
ajq
N0 j q =1
Insert Eqs. (11.5.20) in π j = µ j − m& j / m j
π j = µj −
( { } ).
Λ m j k1 , kˆ , m
mj
Substitute the above equations into Eqs. (11.5.17)
( { } ) ξˆ (mφ
m jq = Λ 0 jq k1 , kˆ , m ≡
ajq + µ j m j )m j ξ jq
( {} )
− Λ k , kˆ , m
.
(11.5.21)
j j mj 1
We see that m jq can be explicitly expressed as functions k1 (t ), k̂ (t ) and { }

m(t ). Taking derivatives of this equation with regard to time yields
∂Λ 0 jq & ∂Λ 0 jq &ˆ (11.5.22)
m& jq =
∂k1
k1 + ∑ k jq + G jq ,
( j , q )∈Q* ,( j , q )≠ (1,1) ∂k1
where we use Eqs. (11.5.20) and
( {} ) ∂Λ 0 jq
( {} )
J
G jq k1 , kˆ , m ≡ ∑
j =1 ∂m j
Λ j k1 , kˆ , m .
Substituting (11.5.21) into Eqs. (11.5.16) yields
jq 1( {} )
ˆ k , kˆ , m ≡ φ k , kˆ(t ) + µ m
y ajq = Λ ajq 1 j j ( { }) (11.5.23)
+ Λ 0 jq (k , {kˆ}, m),
1 ( j, q ) ∈ Q* .
We see that yajq can be explicitly expressed as functions k1 (t ), k̂ (t ) { }
and m(t ).
Inserting s jq (t ) = λ jq yˆ jq (t ) in Eqs. (11.5.8) into (11.5.9), we obtain
& ∂Λ 0 jq & ∂Λ 0 jq ˆ& (11.5.24)

kˆ jq +
∂k1
k1 + ∑ k jq = Gˆ jq − kˆ jq ,
( j , q )∈Q* ,( j , q )≠ (1,1) ∂k1
where we use Eqs. (11.5.21)-(11.5.23) and
( {} )
Gˆ jq k1 , kˆ , m ≡ λ jq Λ
ˆ −Λ −G .
jq 0 jq jq
Taking derivatives of (11.5.15) with regard to time yields

& ∂Λ & ∂Λ ˆ& (11.5.25)
kˆ11 =
∂k1
k1 + ∑ k .
ˆ jq
( j , q )∈Q* , ( j , q )≠ (1,1) ∂k
jq
( { }) and Eq. (11.5.25) into the equation for

Inserting kˆ11 (t ) = Λ k1 , kˆ(t )
(1, 1), we solve
 ∂Λ ∂Λ 0 jq  &  ∂Λ 0 jq ∂Λ &
 kˆ = Gˆ − Λ .
 +
∂k1 
k1 + ∑ 
+
∂kˆ jq  jq jq
 ∂k1 ( j , q )∈Q* , ( j , q )≠ (1,1)  ∂k1  (11.5.26)
In summary, we have the following lemma.
Lemma 11.5.1
Assume that (11.5.19) are satisfied. The dynamics of the global economy
is described by the ( J + Q ) − differential equations, (11.5.26), (11.5.24)
{ }
and (11.5.20) with k1 (t ), k̂ (t ) and m(t ) as the variables. That is, the mo-
{ }
tion of k1 (t ), k̂ (t ) and m(t ) is determined by
 ∂Λ ∂Λ 0 jq  &  ∂Λ 0 jq ∂Λ  &ˆ

 +
∂k1 
k1 + ∑ 
+
ˆ 
k jq = Gˆ11Λ j − Λ ,
 ∂k1 ( j , q )∈Q , ( j , q )≠ (1,1) 
* ∂k 1 ∂k jq 
& ∂Λ 0 jq & ∂Λ 0 jq ˆ&

kˆ jq +
∂k1
k1 + ∑ k jq =
( j , q )∈Q * , ( j , q )≠ (1,1) ∂k1
Gˆ jq − kˆ jq , ( j, q ) ∈ Q * , ( j, q ) ≠ (1,1),
m& j = Λ j . (11.5.27)
{ }
For any given positive values of k1 (t ), k̂ (t ) and m(t ) at any point of
time, all the other variables are uniquely determined by the following pro-
cedure: kˆ11 (t ) by (11.5.15) → k j , j = 2, L, J by (11.5.13) →
f j = f j (k j ) → r and w jq , ( j , q ) ∈ Q* by (11.5.4) → m jq by (11.5.17) →
&
yajq by (11.5.16) → a jq = kˆ jq + m jq → c jq and s j by (11.5.8) →
Fj = N j f j .
Following the computing procedure given in Lemma 11.5.1, we can

simulate the model. As the model is too complicated, in the reminder of
this section we simulate the model when money is neglected, i.e., χ jq = 0
for all j and q .
11.5.3 The 3-Country Two-Group Economy
For illustration, we will follow the procedure given in Lemma 11.5.1 to

simulate motion of the trade system. We will consider the case that the
world consists of three countries and each country has two groups. We
specify the production functions as follows
F j (t ) = A j K j j (t )N j j , α j + β j = 1, α j , β j > 0,
α β
where A j are country j ’s productivity and α j are positive parameters.

α
From f j = A j k j j , and Eqs. (11.5.12)-(11.5.14), we have
−1 / β j
 α1 A1k1− β1 − δ j 
k j = φ j (k1 ) ≡   , j = 2, L, J ,
 α j Aj 
 
φˆ jq (k1 ) = A j β j h jqφ j j (k1 ), ( j, q ) ∈ Q* . (11.5.28)

α
As shown in Zhang (2006: Chap. 8), the motion of the non-monetary

global economy is given by
k&1 =
( ) ( { })
J Qj Qj
∑∑ n jq Λ jq + ∑ n1q Λ jq + λ11 f1 (k1 ) − λ11 Λ k1 , k + λ11φ11 (k1 )

' ˆ ˆ ˆ
j = 2 q =1 q =2
J
.
∑ n φ (k )
j =1
j
'
j 1
( ) (
k jq = Λ jq k1 , kˆ jq ≡ λ jq f1' (k1 ) − λˆ jq k jq + λ jqφˆ jq (k1 ),
&
)
( j, q ) ∈ Q * , ( j, q ) ≠ (1, 1), (11.5.29)
where λˆ jq ≡ 1 − λ jq + λ jqδ k 1 and
( ) ( )
Λ jq k1 , kˆ jq ≡ λ jq f1' (k1 ) − λˆ jq kˆ jq + λ jqφˆ jq (k1 ), ( j, q ) ∈ Q* .
An equilibrium point is given by setting k&1 = 0 and k& = 0 . That is {}
(λ 11 1
'
)
f (k1 ) − λˆ11 kˆ11 + λ11φˆ11 (k1 ) = 0 , (11.5.30)
(λ jq )
f1' (k1 ) − λˆ jq kˆ jq + λ jqφˆ jq (k1 ) = 0, ( j, q ) ∈ Q* ,
( j, q ) ≠ (1, 1). (11.5.31)
Solve Eqs. (11.5.31)
− λ jqφˆ jq (k1 ) (11.5.32)

kˆ jq = , ( j, q ) ∈ Q * , ( j, q ) ≠ (1, 1).
λ f ' (k ) − λˆ
jq 1 1 jq
Insert Eqs. (11.5.15) into Eq. (11.5.30)

J J Qj Qj
λ11φˆ11 (k1 ) (11.5.33)
∑ n jφ j (k1 ) − ∑∑ n jq kˆ jq − ∑ n1q kˆ1q +
j =1 j = 2 q =1 q=2 λ11 f1' (k1 ) − λˆ11
= 0.
Substitute Eqs. (11.5.32) into Eq. (11.5.33)

J J Qj
n jq λ jqφˆ jq (k1 ) (11.5.34)
Ω(k1 ) ≡ ∑ n jφ j (k1 ) + ∑∑ λ = 0.
j =1 j =1 q =1 jq f ' (k ) − λˆ
1 1 jq
Equation (11.5.34) determines equilibrium values of k1 and Eqs.

(11.5.32) determine the equilibrium values of kˆ jq .
To simulate the model, we specify the parameter values as follows
 A1   4   N11   2   h11  12   λ11   0.87 
               
 A2   2   N12   4   h12   5   λ12   0.78 
A   1  N   2  h   7   λ   0.80 
 3 = ,  21  =  ,  21  =  ,  21  =  
 α 1  1 / 3   N 22   8   h22   3   λ22   0.74 
               
 α 2   0 .3   N 31   1   h31   5   λ31   0.75 
 α  1 / 3   N   20  h   1   λ   0.65 
 3    32     32     32   
 δ k 1   0.07 
   
 δ k 2  =  0.06 . (11.5.35)
 δ   0.05 
 k3   
For convenience of interpretation, we call countries 1, 2 , and 3 re-
spectively as the developed economy, the industrializing economy, and the
developing economy. Groups ( j , 1) and ( j , 2 ) in country j are called the
rich group (RG) and the poor group (PP) respectively. The level of the to-
tal productivity of the developed economy is the highest; the second is the
industrializing economy; and the lowest is the developing economy. The

developed economy’s RG has the highest level of human capital and high-
est propensity to save. Its population is the same as that of the industrializ-
ing economy’s RG. The developing economy’s PD has the lowest level of
human capital and the largest number of the population. We now show that
the dynamic system has a unique equilibrium point.
We plot the function Ω(k1 ) defined in Eq. (11.5.34) as in Fig. 11.5.1.
The equation Ω(k1 ) = 0 has multiple positive solutions
k1 = 3.49, k1 = 6.09, k1 = 6.51, k1 = 8.47, k1 = 10.41,
k1 = 57.77. (11.5.36)
It can be shown that only the equilibrium point, k1 = 57.77 , is meaning-

ful, the rest are not meaningful in the sense that at any of these points, per
capita wealth of some group(s) becomes negative. Hence, the equation,
Ω(k1 ) = 0 , has a unique meaningful solution k1 = 98.84 .
Ω(k1 )
Ω(k1 )
20000
200
10000
40 50 60 70 k1
-200
5 10 15 20 25 30
k1 -400
-600
-10000
-800
-20000 -1000
a) multiple solutions for 0 ≤ k1 ≤ 30 b) a unique solution for k1 ≥ 30
Fig. 11.5.1. The existence of positive solution of Ω(k1 ) = 0
We list the simulation results as follows

 f1  15.46   k1   57.71  F1   680.12 
           
r = 0.0193,  f 2  =  4.32 ,  k 2  = 13.06 ,  F2  =  164.30 ,
 f   1.75   k   5.33   F   43.66 
 3    3    3  
 kˆ11   950.12 
   
 kˆ   196.09 
 C1   505.20   Kˆ 1  1684.77   12 
        kˆ  95.99 
 C 2  =  126.27 ,  Kˆ 2  =  417.52 ,  21  =  ,
 C   31.29   ˆ   
 22 kˆ   28.19 
 3    K 3   66.45   kˆ   18.80 
 31   
 kˆ   2.33 
 32   
 w11  123.66   c11  141.96   C11   283.97 

           
 w12   51.53   c12   55.31   C12   221.23 
 w   21.19   c   23.81   C   47.61 
 21  =  ,  21  =  ,  21  =  ,
 w22   9.08   c22   9.83   C22   78.66 
           
 w31   5.82   c31   6.50   C31   6.50 
 w   1.16   c   1.24   C   24.79 
 32     32     32   
where
C jq ≡ c jq N jq , C j ≡ C j1 + C j 2 , Kˆ jq ≡ kˆ jq N jq , Kˆ j ≡ Kˆ j1 + Kˆ j 2 .
We see that the per-capita levels of wealth and consumption and wage
rate of the RG of the developed economy are much higher than the corre-
sponding variables in the other economies. A representative household
from the GR of the developed economy holds more than 400 times wealth
and consumes more than 100 times than a representative household from
the PG of the developing economy. Also the wage rate differences are over
100 times between the poorest and the richest. The developed economy’s
output level of per-unit human capital is about 9 times higher than that in
the developing economy.
The income and wealth distribution of the world economy is given by
 Nˆ 1   16.21%   Fˆ1   76.58%   Wˆ1   80.01% 
           
 Nˆ 2  =  27.03% ,  Fˆ2  =  18.50% , Wˆ 2  =  18.44% ,
 ˆ     ˆ     ˆ   
 N 3   56.76%   F3   4.92%   W3   1.52% 
 Cˆ1   75.88%   Kˆˆ 

    1   84.73% 
  ˆˆ   
 Cˆ 2  =  19.25%  ,  K 2  =  13.18%  ,
 ˆ    Kˆˆ   2.10% 
C 4.87% 
 3   3
 
where a variable x j with circumflex, xˆ j , denotes country j ’s share of the
corresponding variable in the world economy. The developed economy has
the population share 16.21% , the industrializing economy 27.03% , and
the developing economy 56.76% . Irrespective of its small population size,
the global shares of the output, wage income, consumption and wealth of
the developed economy are respectively 76.58% , 80.01% , 75.88% , and
84.73% . The developing economy’s global shares of the output, wage in-
come, consumption and wealth are respectively only 4.92% , 1.52% ,
4.87% , and 2.1% .
We introduce variables to measure trade balances
Qj
~  Qj 
E j (t ) ≡ ∑ kˆ jq N jq − K j , E j (t ) ≡  ∑ kˆ jq N jq − K j r (t ).
q =1  q =1 
If E j (t ) > (<) 0 , we say that country j is in trade deficit (trade surplus).
If E j (t ) = 0 , we say that country j is in trade balance. We calculate the
national trade balances at equilibrium as follows
~
 E1   145.65   E1   2.81 
    ~  
 E2  =  − 78.93 ,  E2  =  − 1.52 
 E   − 66.72   E~   − 1.29 
 3    3  
The developed economy is in trade surplus and the industrializing and
developing economies are in trade deficit.
We just examined the equilibrium structure of the global economy. It is
important to follow the motion of global economy when it starts from a
state away from the equilibrium point. As we have shown by Lemma
11.5.1 how to follow the dynamic processes, it is straightforward to simu-
late the motion. We simulate the model with the parameter values speci-
fied as in (11.5.35) and the following initial conditions
k1 (t ) = 70, kˆ12 (0) = 150, kˆ21 (0) = 70, kˆ22 (0 ) = 20, kˆ31 (0 ) = 10, kˆ32 (0) = 1.
The simulation results are plotted in Fig. 11.5.2. We observe that the
variables approach to their equilibrium values in the long term. It can be
seen that from different positions, we may observe various patterns of
global economy growth over time.
70 16
f1
60 k1 14
50 12
40 10
8
30
20
6 f2
k2 4
10 t t
50 k 3 150 100 200 50 f 3 150
100 200
a) the per-capita capital inputs b) the per-capita output levels
w11
0.018
r 120
100
0.016 80
0.014 60 w21
0.012 40
w12
t 20
50 100 150 200 w 22 w31 t
50 w32100 150 200
c) the rate of interest d) the wage rates
1400 200
1200
1000 150 c11
800 k̂11 100
600
400 c12
200 k̂12
50
c21
k̂ 22 k̂ 21
100 kˆ31 , 150
kˆ32 c50
31 , c32100 c22
t t
50 200 150 200
d) the per capita wealth f) the per capita consumption levels
~
3 E1 0.7
F̂1
2 0.6
0.5
1
0.4
~ 50 100 150 200
t
0.3
-1 E3 0.2
F̂2
~
-2 E2 50 100 150 200
t
F̂3
Fig. 11.5.2. The motion of the global economy
11.5.4 Comparative Dynamic Analysis
First, we examine the case that all the parameters, except the human capi-
tal level of the RG of the developed economy, h11 , are the same as in
(11.5.35). We increase the human capital level from 12 to 13. The simula-
tion results are demonstrated in Fig. 11.5.3. In the plots, a variable ∆x j (t )
stand for the change rate of the variable x j (t ) in percentage due to changes
in the parameter value from h110 ( = 12 in this case) to h11 ( = 13 ). That is
x j (t ; h11 ) − x j (t ; h110 )
∆x j (t ) ≡ × 100,
x j (t ; h110 )
where x j (t ; h11 ) stands for the value of the variable x j with the parameter
value h11 at time t and x j (t ; h110 ) stands for the value of the variable x j
with the parameter value h110 at time t. We will use the symbol ∆ with
From Fig. 11.5.3a, we see that as the RG of the developed economy im-
proves its human capital level, the capital-labor ratios, the per-labor output
levels, and the wage rates in all the three economies are increased. The rate
of interest falls down. The per-capita wealth level and per-capita consump-
tion level of the RG of the developed economy are increased; the per-
capita wealth levels and per-capita consumption levels of the PG of the
developed economy and all the other groups are slightly affected. From
Fig. 11.5.3g, the developed economy’s trade balance deteriorates first and
then improves. The developing economy’s trade balance improves and the
industrializing economy’s trade balance deteriorates. As the RG of the de-
veloped economy improves its human capital, the global output share of
the developed economy rises and the other two economies’ shares fall
down.
As (1, 1) ’s wealth and consumption are dramatically changed and the
other groups’ are only slightly affected in comparison, we need to further
examine the effects on the per-capita wealth levels and per-capita con-
sumption levels of the PG of the developed economy and all the groups of
the industrializing and developing economies. Figure 11.5.4 shows the dif-
ferences. We see that the RG of the industrializing economy’s per-capita
wealth levels and per-capita consumption levels are slightly reduced due to
the increase in the RG’s human capital level.
∆k1
1.2 ∆k 2 0.4 ∆f1
1 ∆f 3
∆k3 0.3 ∆f 2
0.8
0.6 0.2
0.4
0.1
0.2
t t
50 100 150 200 50 100 150 200
8 ∆w1
-2.6
-2.8 6
t
50 100 150 200
-3.2 4
-3.4
-3.6 ∆r 2
-3.8 ∆w12 , ∆w21 ∆w22 , ∆w31 ∆w32
t
50 100 150 200
8 8
∆k̂11 ∆c11
6 6
4 4
2 2
∆kˆ12 , ∆kˆ21 , ∆kˆ22 , ∆kˆ31 , ∆kˆ22 ∆c12 , ∆c21 , ∆c22 , ∆c31 , ∆c32
t t
50 100 150 200 50 100 150 200
e) the per capita wealth f) the per capita consumption levels
2 1
∆E3 ∆F̂1
1 t
50 100 150 200
50
∆E1
100 150 200
t -1
-1 -2
-2 ∆ E2 -3 ∆Fˆ2 , ∆Fˆ3

Fig. 11.5.3. Group (1, 1) improves its human capital ( h11 : 12 ⇒ 13 )
0.4
∆w31 , ∆w32 0.2 0.2
0.3 ∆w12 ∆w21 , ∆w22 0.15 ∆k̂12 0.15 ∆c12
0.2 0.1 ∆k̂32 0.1
∆c32
0.1 0.05 ∆kˆ , ∆kˆ 0.05
∆c22 , ∆c31
∆k̂ 21 22 31
50 100 150 200

t 50 100 150 200
t
50 100 ∆c150
21 200
t
a) the wage rates b) the per capita wealth c) the consumption levels
Fig. 11.5.4. The other groups are affected differently ( h11 : 12 ⇒ 13 )
0.1
t t
50 100 150 200 50 100 150 200
-0.1
-0.5 -0.2
-0.3
-1
∆k3 -0.4
-1.5 -0.5 ∆f 2
∆k 2 ∆k1 -0.6 ∆f1 ∆f 3
100
5 ∆r ∆w32
80
4
60
3
2 ∆F 40
20
∆w11 , ∆w12 , ∆w21 ∆w22 , ∆w31t
1
t
50 100 150 200 50 100 150 200
c) the rate of interest and the world output d) the wage rates
100 100
∆k̂32 ∆c32
80 80
60 60
40 40
20 20
∆kˆ11 , ∆kˆ12 , ∆kˆ21 , ∆kˆ22 , ∆kˆ31 t
∆c12 , ∆c21 , ∆c22 , ∆c31 , ∆c32 t
50 100 150 200 50 100 150 200

40
20 ∆ E3 60 ∆F̂3
∆E
50 1 100 150 200
t
-20 40
-40
20
-60
∆Fˆ1100
, ∆Fˆ2
-80
∆E2 50 150 200
t

Fig. 11.5.5. Group (3, 2) improves its human capital ( h32 : 1 ⇒ 2 )
We now examine effects of change in group (3, 2 ) ’s human capital

level. The effects are plotted in Fig. 11.5.5. From Fig.s 5a and 5b, we see
that as the PG of the developing economy improves its human capital
level, the capital-labor ratios and the per-labor output levels in all the three
economies are reduced. The rate of interest rises and the global output is
increased. The wage rate, per-capita wealth level and per-capita consump-
tion level of the PG of the developing economy are increased; the wage
rates, per-capita wealth levels and per-capita consumption levels of the RG
of the developing economy and all the other groups are slightly affected.
The developing and developed economies’ trade balances improve and the
industrializing economy’s trade balance deteriorates. The global output
share of the developing economy rises and the other two economies’
shares fall down.
Figure 11.5.6 shows the differences. We see that all these groups’ wage
rates are reduced due to group (3, 2 ) ’s improvement in its human capital.
It should be noted that in terms of per-capita wealth and consumption
level, RG of the developed economy benefit mostly greatly and the other
groups may become even worse off.
4
0.1 4
t
3 ∆k̂11
3
-0.1 50 100 150 200
-0.2 2 2 ∆c11
-0.3 ∆w11 , ∆w12
-0.4
-0.5 ∆w21 , ∆w22 ∆k1ˆ12 , ∆kˆ21 , ∆kˆ22 , ∆kˆ31 ∆kˆ321 ∆c11 , ∆c21 , ∆c22 , ∆c31
-0.6 ∆w31 50 100 150 200
t t
50 100 150 200
a) the wage rates b) the per capita wealth c) the consumption level
Fig. 11.5.6. The other groups are affected differently ( h32 : 1 ⇒ 2 )
It is straightforward to examine the effects of change in any other

group’s human capital on the global economy. Because of the limit of
space, we concentrate our comparative dynamic analysis on the richest
group and the poorest group of the global economy.
We now allow the RG of the developed economy to increase its propen-
sity to save. The effects on the global economy are plotted in Fig. 11.5.7.
As the RG of the developed economy increases its propensity to save, the
capital-labor ratios, the per-labor output levels, and the wage rates in all
the three economies are increased. The rate of interest falls down. The per-
capita wealth levels and per-capita consumption levels of all the groups
(except the RG of the industrializing economy) are increased; the per-
capita wealth and per-capita consumption level of the RG of the industrial-
izing economy are reduced. The developed economy’s trade balance dete-
riorates. The industrializing economy’s trade balance improves first and
then deteriorates. The developing economy’s trade balance improves. The

global output share of the developed economy rises and the other two
economies’ shares fall down.
2.2
6 ∆k1 2 ∆ f1
∆k 2 1.8 ∆f 3
5
∆k3 1.6 ∆f 2
1.4
4 1.2
t
t 50 100 150 200
50 100 150 200 0.8
2.2
-19
2 ∆w11 , ∆w12
-19.5
-20 ∆r 1.8 ∆w21 , ∆w22
-20.5 1.6
-21 1.4 ∆w31 , ∆w32
-21.5 1.2
t t
-22.5 50 100 150 200 50 100 150 200
0.8
10
∆k̂11 1 ∆c32
8 0.5 ∆c12
∆c22 , ∆c31
6
50 100 ∆c150
21 200
t
-0.5
4
-1
∆c11
∆kˆ12 , ∆kˆ22 , ∆kˆ31 , ∆kˆ32
2 -1.5
t -2
50∆k̂ 21 100 150 200
15 0.1
∆ E3 ∆F̂1
10 t
50 100 150 200
5 -0.1
∆E1 t -0.2
50 100 150 200 ∆F̂3
-5 -0.3
∆E2 -0.4
∆F̂2
-10

Fig. 11.5.7. Group (1, 1) increases its propensity to save ( λ11 : 0.87 ⇒ 0.88 )
The effects of an increase in group (3, 2 ) ’s propensity to save on the

global economy are plotted in Fig. 11.5.8.
0.5
0.16
0.45 ∆f1
0.14
0.4 ∆k1 ∆k 2 ∆f 3
0.35 0.12
0.3 ∆k3 50
∆f 2 100 150 200
t
0.25 0.08
t
50 100 150 200 0.06
50 100
∆F 150 200
t 0.16
0.14 ∆w11 , ∆w12
-0.5
0.12 ∆w31 , ∆w32
-1
∆r ∆50
w21 , ∆w
100 150 200
t
22
-1.5 0.08
0.06
c) the rate of interest and global output d) the wage rates
∆c32
25 ∆k̂32 t
20 -2.5 ∆c50
11 , ∆c12 , ∆c21 , ∆c 22 , ∆ c31
100 150 200
15 -5
10 -7.5
-10
5
∆kˆ11 , ∆kˆ12 , ∆kˆ22 , ∆kˆ22 , ∆kˆ31 t
-12.5
50 100 150 200
20 0.01
∆E3 ∆F̂3
15
t
10 50 100 150 200
5 -0.01
∆ E2 t
∆F̂1
-0.02
50 100 150 200
-5 ∆F̂2
∆E1 -0.03

Fig. 11.5.8. Group (3, 2) increases its propensity to save ( λ32 : 0.65 ⇒ 0.7 )
We now allow the RG of the developed economy to increase its popula-

tion. The effects on the global economy are plotted in Fig. 11.5.9. As the
RG of the developed economy increases its population, the capital-labor
ratios, the per-labor output levels, and the wage rates in all the three
economies are increased. The rate of interest falls down and the global
output rises. The per-capita wealth level and per-capita consumption level
of the RG of the developed economy are reduced; the per-capita wealth
level and per-capita consumption level of the RG of the industrializing
economy are slightly reduced; the per-capita wealth levels of all the other
groups are increased. The developed economy’s trade balance initially de-
teriorates and then improves. The industrializing economy’s trade balance
initially improves and then deteriorates. The developing economy’s trade
balance improves. The global output share of the developed economy rises
and the other two economies’ shares fall down. It should be noted that as
the RG of the developed economy increases its population, all the other
groups benefit.
We now allow the PG of the developing economy to increase its popula-
tion. The effects on the global economy are plotted in Fig. 11.5.10. As the
PG of the developing economy increases its population, the capital-labor
ratios, the per-labor output levels, and the wage rates in all the three
economies are reduced. The rate of interest rises and the global output
rises. The per-capita wealth levels and per-capita consumption levels of the
RG of the developed economy are increased; the per-capita wealth level
and per-capita consumption level of the RG of the industrializing economy
are slightly increased; the per-capita wealth levels of all the other groups
are reduced. The developed and industrializing economies’ trade balances
improve. The developing economy’s trade balance deteriorates. The global
output share of the developing economy rises and the other two econo-
mies’ shares fall down.
11.6 Global Economy with Money, Capital, and Knowledge
This chapter proposed a few monetary growth models with international

trade. There is a vast literature on monetary growth and international
trade.27 It can be seen that the OSG framework provides an effective
framework for analyzing different issues related to growth, trade, and
money. It is possible to introduce the ideas about multiple sectors, hetero-
geneous groups, multiple regions in each country, research, education, and
27 Zhang (2008a) provides a comprehensive study of monetary growth econom-

ics.
human capital proposed in the previous chapters into the trade models in
this chapter.
1.5 ∆k1 0.5 ∆f1

∆k 2 ∆f 3
1.25 0.4
1 ∆k3 0.3
∆f 2
0.75
0.2
0.5
0.25 0.1
t t
50 100 150 200 50 100 150 200
0.5 ∆w11 , ∆w12

4 ∆F ∆w31 , ∆w32
0.4
2 ∆w21 , ∆w22
0.3
t
50 100 150 200 0.2
-2 0.1
-4 ∆r t
50 100 150 200
t t
50 100 150 200 50 100 150 200
-0.5
-1 -1
∆k̂11 -1.5 ∆c11
-2 -2
-2.5
-3 -3
-3.5
∆E3 1
2
∆F̂1
1 t
50 100 150 200
t -1
50 ∆E1
100 150 200
-1 -2
-2 -3
∆ E2 ∆Fˆ2 , ∆Fˆ3
-3 -4

Fig. 11.5.9. Group (1, 1) ’s population is increased ( N11 : 2 ⇒ 2.2 )
t t
50 100 150 200 50 100 150 200
-0.025 -0.01
-0.05 -0.02
-0.075
-0.03
-0.1
-0.04
-0.125 ∆k3 ∆f 2
-0.15 -0.05 ∆f 3
-0.175 ∆k1 ∆k 2 -0.06 ∆f1
t
0.5
∆r -0.01
50 100 150 200
-0.02
0.4
-0.03
0.3 ∆F -0.04 ∆w21 , ∆w22
-0.05 ∆w31 , ∆w32
t -0.06 ∆w11 , ∆w12
50 100 150 200
0.3
0.3
0.25
0.2 0.2
0.15
0.1
∆k̂11
0.1 ∆c
0.05
t t
50 100 150 200 50 100 150 200
4
∆E1 ∆F̂3
2 6
50 100 ∆E2150 200

t
-2 4
-4
2
-6
-8 ∆E3 ∆Fˆ , ∆Fˆ2 t
50 100 1 150 200

Fig. 11.5.10. Group (3, 2) ’s population is increased ( N11 : 20 ⇒ 22 )
Appendix
A.11.1 A Monetary Growth Model of a Small Open Economy

with the Ramsey Approach
We are concerned with a small open economy operating in a world of on-

going inflation. The model is referred to Chap. 2 in Turnovsky (1997). The
basic features are also referred to Dornbusch and Fischer, 1980). The
economy has a single traded good produced by a single factor of produc-
tion, labor, and two assets, domestic money and traded bonds. The domes-
tic economy consumes the good, the foreign price of which is given in the
world market. The economy consists of three types of agents, firms, con-
sumers, and the government; each of these agents has perfect foresight. All
consumers and firms are identical. In the absence of any impediments to
trade, purchasing power parity is described by p = q + e , where p is the
rate of inflation of the good in terms of domestic currency, q is the exo-
genously fixed rate of inflation of the good in terms of foreign currency,
and e is the rate of exchange depreciation of domestic currency.
Domestic money is held only by domestic residents, but not by foreign-
ers. There is a traded world bond with uncovered interest parity holding at
all times. Thus i = i * + ε , where i is the domestic nominal interest rate,
i * is the exogenously fixed foreign interest rate, and ε is the expected rate
of exchange depreciation. Under perfect foresight, ε = e . As mentioned by
Turnovsky, the assumptions about the purchasing power parity and the un-
covered interest parity are not necessarily held empirically. Nevertheless,
they are only accepted for simplicity of analysis.
The representative consumer chooses his level of consumption, labor
supply, real money balances, and holding of the traded bond by solving the
following intertemporal optimization problem
∞
Max ∫ U (c, l , m, g )e − β t dt , U c > 0 , U l < 0 , U g > 0 ,

0
subject to the budget constraint and the initial conditions

c + m& + b& = (1 − τ )(wl + Π ) + (i * − q )b − (q + e )m − T ,
Appendix 471
M0 E (0)B0 B0
m(0 ) = , b(0) = = ,
P(0) P(0) Q0
where
c — real consumption;
g — real government expenditure;
m — real money balances;
M — nominal money balances;
b — real stock of traded bonds;
B — nominal stock of traded bonds;
l — supply of labor;
w — real wage rate;
Π — real profit, paid out to consumers;
β — exogenously fixed rate of time preference;
P — domestic price level;
Q — foreign price level;
E — nominal exchange rate;
τ — rate of income tax;
T — real lump-sum taxes.
The utility function U is assumed concave in its arguments. It is as-

sumed that for given values of c , g , and l , the marginal utility of money
balances satisfies
sgn (U m ) = sgn (m* − m ),
where m* is the corresponding satiation level of real money balances

(Friedman, 1969). The symbol, syn(⋅), means that if real money holdings
is less (more) than these satiation balances, the marginal utility of holding
money is positive (negative). The introduction of money in the utility func-
tion is to capture the three roles – a store of wealth, medium of exchange,
and a unit of account - of money in the economy. We take the approach
that money is directly introduced into the utility function rather than an-
other approach that explicitly models the process of transactions. The
budget constraint is expressed in real flow terms. Households are paid at a
real wage rate, w , and receive profit, Π , with the total factor income be-
ing taxed at the rate τ . Households are subject to lump-sum taxation, T .
They also hold traded bonds, denominated in foreign currency and paying
a nominal interest rate i * , and domestic money balances, the real rates of
return on which are (i * − q ) and − p = − (q + e ), respectively. The real
interest rate (i * − q ) is assumed positive.
Households determine c , l , m , and b with g , e , q , Π , w , i * , E , Q ,
and P as given. The Hamiltonian is
H ≡ e − βtU (c, l , m, g )
[ ]
+ λe − βt (1 − λ )(wl + Π ) + (i * − q )b − (q + e )m − T − c − m& − b& ,
where λ (t ) is the costate variable associated with the agent’s budget. The
optimality conditions are
U c = λ , U l = − (1 − τ )wλ , U m = (i * + e )λ ,
λ& = λ [β − (i * − q )]. (A.11.1.1)
The conditions U c = λ and U l = − (1 − τ )wλ , respectively, state that

the marginal utility of consumption equals the marginal utility of wealth,
and the marginal utility of leisure equals the marginal utility of the con-
sumption forgone, priced at the opportunity cost of a unit of leisure. The
third equation, which can be rewritten as
− p = (i * + e ) − p = i * − q ,
Um
λ
asserts that the real rate of return on money, which equals the utility from
the consumption of money services plus its real return as income earning
asset (− p ) must equal the real return on holding traded bonds. The last
equation, which can be rewritten as
λ& *
β− = i − q,
λ
says that the rates of return on money and traded bond equal the rate of re-
turn on consumption. The transversality conditions, ruling out explosive
behavior of the model, are
lim λme − βt = lim λbe − βt = 0 . (A.11.1.2)
t →∞ t →∞
Behavior of firms and the government

Labor is the only input factor. The firm’s profit is given by
Appendix 473
Π = F (l ) − wl , F ' > 0 , F " < 0 .

Maximizing profit yields
F ' (l ) = w . (A.11.1.3)
The government’s flow budget constraint is
m& + a& = g + (i * − q )a − (q + e )m − τ (wl + Π ) − T , (A.11.1.4)
where a ≡ A / P = real stock of traded bonds issued by the domestic gov-

ernment, and A = nominal stock of bonds. The equation says that the real
government deficit, which equals its expenditures plus the real interest ow-
ing on its debt, less the revenues raised through inflation, income tax, and
lump-sum taxation, are financed either by issuing more bonds or by print-
ing more money.
From the household’s budget constraint, Π = F (l ) − wl , and Eq.
(A.11.1.4), we obtain
n& = F − c − g + (i * − q )n , (A.11.1.5)
where n ≡ b − a is the net stock of traded bonds of the domestic econ-

omy. In the case of n < (>) 0 , the nation is a debtor (creditor).
The government has five policy instruments available: M , A , τ , T , and
g , and four of which can be chosen independently. First, assume that the
domestic nominal money supply grows at a fixed rate, φ , i.e.
m& = (φ − q − e )m .
Under this policy, Eq. (A.11.1.4) becomes
a& = g + (i * − q )a − φm − τ (wl + Π ) − T . (A.11.1.6)
We have determined the equilibrium where all agents optimize, all mar-
kets clear, and there is perfect foresight so that all expectations are real-
ized. We now examine steady state of the system. A steady state of the
system is given by
φ = q + e , U c = λ , U l = − (1 − τ )F ' λ ,
U m = (i * + φ − e )λ , F − c − g + (i * − q )(b − a ) = 0 ,
g + (i * − q )a − φm − τ (wl + Π ) − T = 0 .
These six equations determine c , l , m , λ , e , and one of the policy in-

struments, φ , T , τ , or g .
12 Trade Patterns and Dynamics
Half of science is asking the right questions.

Roger Bacon1
The first five chapters of the book are concerned with the traditional static
trade theories. We are then concerned with dynamic trade theories, treating
static trade theories as special cases of dynamic theories. To study dy-
namic issues related to international trade, this book proposes an alterna-
tive approach to the traditional approaches. The numerous models pro-
posed in this study demonstrates that the approach in modeling household
behavior proposed in study is effective in analyzing many dynamic issues,
in comparison to, for instance, the Ramsey approach. When speaking
about developing a new theory, I am aware of the following criteria of a
theory proposed by Kuhn.2 “A theory should be: (1) accurate within do-
main; (2) consistent internally and with other currently accepted theories;
(3) a broad scope allowing its consequences to extend beyond the particu-
lar observations, laws or subtheories it was initially designed to explain;
(4) simple but able to bring order to the phenomena that in its absence
would be individually isolated and, as a set, confused; and (5) fruitful to
disclose new phenomena or previously unnoted relationships among those
already known.”3 This book presents an international trade theory based on
the traditional models. The main deviation from the traditional approaches
is the alternative utility function which helps us to solve many important
problems with a consistent manner.4
1 http://www-groups.dcs.st-andrews.ac.uk/~history/Quotations/Bacon.html.
2 Kuhn (1977).
3 Zhang (1999: 402-403).
4 This approach has already been applied to non-monetary growth theory
(Zhang, 2005a), monetary growth theory (Zhang, 2008a), urban economics

(Zhang, 2002b), interregional economics (2003a). Basing on the approach, Zhang
(2006a) also provides a comprehensive growth theory with income and wealth dis-
tribution. It can be seen that this approach has provided a basis for constructing a
higher economic theory, treating all the important economic theories as special
cases.
476 12 Trade Patterns and Dynamics
The book has been organized in the order that is characterized of evolu-
tion of international trade theory. First we are concerned with static com-
petitive trade theory. Then, we study static monopolistic trade theory. Both
competitive and monopolistic competitive trade theories can be classified
further by global factor mobility and immobility. After examining the ba-
sic ideas of static trade theories, we extend the static vision to the dynamic
one. We are concerned with endogenous growth of two factors, capital and
knowledge. Again, we divide the theories into perfectly competitive and
monopolistically competitive economies. The perfectly competitive econ-
omy under government intervention is basically based on Zhang’s ap-
proach. In this approach, both knowledge growth and capital accumulation
are analyzed in a single compact framework. The models of monopolistic
competition are mainly concerned with growth, trade and innovation. In
this approach, it is not easy to take account of both capital accumulation
and innovation within a single framework. In almost all the models of this
approach, capital accumulation has been neglected.
The book is focused on the basic economic mechanisms of international
trade. We have omitted many important topics in trade theory, even though
many of these issues can be discussed with the analytical frameworks and
basic concepts used in this book. We now mention a few straightforward
directions for extending this book.
Functional generalizations
Given rapid development of pure and applied mathematics as well as
mathematical economics,5 it is possible to make any economic theory in
more general than its current form by generalizing some of its functional
forms or “connections”. For instance, utility and production functions used
in our analyses can take more general forms. One can directly apply ad-
vanced mathematics to generalize many results in this book.
Synthesizing the basic models in this book
In things to be seen at once, much variety makes confusion, another vice of

beauty. In things that are not seen at once, and have no respect one to another,
great variety is commendable.
Christopher Wren6
5 In the theme, Mathematical Models in Economics of The Encyclopedia of

Life Support Systems by the UNESCO edited by Zhang (2006d), applications of
mathematics to different fields in economics are introduced.
6 http://www-groups.dcs.st-andrews.ac.uk/~history/Quotations/Wren.html.
This book proposed some trade models. In principle, almost all the
models can be connected with each other in the sense that we can build a
more general model which includes the models as special cases. Neverthe-
less, more general models may be analytically too complicated and few
new insights can be obtained. In fact, as shown in Chap. 2, it is difficult to
determine terms of trade and patterns of trade even when the world consists of
only two countries, and each country has two production sectors with two fac-
tors with differences in preference and technology with the Cobb-Douglas
production and utility functions. This means that even working with an almost
most simple economic world with properly defined technology and utility
functions will cause analytically difficult problems. The Oniki-Uzawa trade
model is beautiful and extension of the model to multiple countries and multi-
ple sectors is straightforward. But almost none meaningful extension of the
model has been done perhaps because of analytical intractability. The Oniki-
Uzawa model tells, to some degree, why trade theory has seldom dealt
with countries both with demand and supply in a single framework. Each
“school” of trade theory picks up some factors and neglects many others.7
Risks, uncertainty, expectations and stochastic processes
It seems that to make a correct conjecture about any event whatever, it is neces-
sary to calculate exactly the number of possible cases and then to determine
how much more likely it is that one case will occur than another.
Jacob Bernoulli8
This book builds many models with certainty. In reality, decisions in-
volve risks and uncertainties. For instance, an important issue in monetary
economics is related to the announcement effects of anticipated monetary
policy upon behavior of economic systems. Basing on the literature on the
topic,9 we can examine the issues within the models proposed in this book.
As the literature in economics with risks, uncertainties and expectations is
vast, it takes a long space even to make a basic introduction to the litera-
ture.
Trade and distributional justice

It is a matter of fact that economies are different in almost every way.
Nevertheless, it is a basic tenet of democracy that countries are of equal
7 Our approach opens a new way to studying different trade problems.

8 http://www-groups.dcs.st-andrews.ac.uk/~history/Quotations.
9 Chang and Lai (2000), for instance, provide examples about how to examine
the announcement effects of anticipated monetary policy upon behavior of economic

systems.
worth. This value should be reflected in the economic, social, and political
structures of democratic societies. In modern times, the economic reality
of many democratic societies is characterized by inequality. Thoreau
(1817-1862) asserted:10 “It is a mistake to suppose that, in a country where
the usual evidences of civilisation exist, the condition of a very large body
of the inhabitants may not be as degraded as that of savages. I refer to the
degraded poor, not, now, to the degraded rich.” As globalization is spread,
relationships between trade and justice does seem to have increasingly im-
portant. It is often argued that even when democracy brings greater ine-
qualities, it increases the absolute income of the poor. This study offers
almost no discussion on issues of distributive justice. The theory of dis-
tributive justice is about “how a society or group should allocate its scarce re-
sources or product among individuals with competing needs or claims.11”
The word justice actually can be used in a wide variety of ways, so that it
tends to be interpreted with a great degree of latitude when referring to
concrete phenomena. Modern (mainstream) economics has little to offer
about the dynamics of inequalities and poverty. As analytical economics
lacks proper dynamic frameworks for addressing distributive issues with in-
ternational trade, it can be seen why modern economics does not make essen-
tial contributions to the theory of distributive justice. As our analytical
framework deals with growth and income and wealth distribution, the eco-
nomic theory proposed in this study may provide some new insights into in-
terdependence between trade, justice and distribution.12
Scale effects of endogenous population

From the literature of classical economics we know at least four input
factors which may exhibit increasing or decreasing returns to scale effects
in economic dynamics: infrastructures (of transportation and communica-
tion systems), institutions, knowledge and population. This book intro-
duced endogenous knowledge and capital. Nevertheless, we did not dis-
cuss implications of population growth of heterogeneous households. For
instance, it is not difficult to see that the impact of trade upon the long-run
welfare of the world may be complicated in economic systems with en-
dogenous population. If we allow the world population to be affected by
10 Thoreau (1817-1862, 1910:31). An excellent introduction to traditional theo-

ries of value and distribution from perspectives of ideology and economic theory
is given by Dobb (1973).
11 Roemer (1996: 1).
12 Further directions to distribution issues are referred to Atkinson and Bour-
guignon (2000), Marglin (1984) and Zhang (2006a).

economic conditions, trade between countries is perhaps economically

harmful to the world in the long term under certain circumstances.
Networks and infrastructures

In order to take infrastructure structures for transportation and commu-
nication into account, it is necessary to explicitly take account of space.
Channels, roads, railways and airline systems, which may be effectively
treated as parameters in short-term analyses, determine the mobility and
the costs associated with movements of people and goods. In a long-term
analysis, it is necessary to examine decision-making processes involved in
construction and maintenance of infrastructures.
Knowledge and human capital

There are so many ways of knowledge creation and diffusion that no
single book can provide a comprehensive study about interdependence of
knowledge and economic dynamics. For instance, no theoretical model is
proposed to connect research amenity (in comparison to other jobs’ ameni-
ties) and international trade within a compact framework. If sophisticated
research is ‘boring’, a free society may not carry out sophisticated research
when the research results have no immediate profitable markets. It is obvi-
ous that some professions are associated with more pleasures or less suf-
ferings than others. People may get different levels of job amenity in doing
science and working in a manufacturing factory. Wage rate is not a single
factor that determines choice of profession. People may prefer a profession
with low payment but high job amenity level to one with high payment but
low job amenity level. It seems that the role of job amenity in affecting
professional choice and labor distribution has increasingly become impor-
tant in post-industrial societies. As many economies are experiencing rapid
improvement in living conditions and rapid changes of attitudes towards
various kinds of jobs, professional choice has increasingly become com-
plicated. It may be argued that how people feel about doing science will
strongly affect labor distribution between research and production.
Variety of capital, people and natural resources

It is not difficult to relax the assumption of a single kind of capital. The
introduction of multiple capital goods will cause analytical difficulties
even for growth problems without trade as demonstrated in Zhang (2005a).
It should be noted that the traditional neoclassical growth theory did not
succeed in dealing with growth issues with multiple capital goods in the
sense that the consumer behavior was not properly modeled. Although we
developed multi-group trade models, our classification of labor force was
simplified. Different kinds of labor force may enter production functions in

different ways. We neglected issues related to natural resources and envi-
ronment. The issues related to trade, resources and capital accumulation
should be further examined.13
Preference structures
Utility functions may be taken on various forms. Except common issues
related to forms of utility functions, we may also introduce preference
change. For instance, when we write a utility function in the form of
U (t ) = C ξ S λ , we may introduce endogenous preference changes by al-
lowing ξ and λ to be changeable in the long term.14
Government policy
Governments may intervene economic systems in different ways. It is
important to examine the impact of various government interventions on
tariffs over time and space. For instance, economic issues related to inter-
national integration and block formation are currently important issues in
trade theory. Various possible taxes on imports and exports are important
for analyzing trade flows and global economic growth. It is well known
that tax structures have also important implications for growth and income
and wealth distribution.
Unemployed production factors

We assumed that production factors such as labor force, capital and land
are always fully employed. These assumptions should be relaxed. In par-
ticular, one of the central topics in growth theory is related to dynamics of
unemployment of labor force. Many possible factors for unemployed have
been proposed in the literature of economics.15
13 For the traditional approaches related to the topics, see Brander and Taylor
(1997), Sachs and Warner (1999), Mäler (2000), Ayong Le Kama (2001), Gerlagh
and Keyzer (2004), and Wirl (2004).
14 See Zhang (2005a, 2008a). For preference changes in the Ramsey growth
models, see Uzawa (1968), Boyer (1978), Shi and Epstein (1993), Epstein and
Hynes (1983), Seckin (2001), and Mansoorian (1998).
15 Zhang (1993d, 2005a) provides various reasons for unemployment and also
developments some growth models with unemployment in the OSG framework.

See also Bhagwati and Hamada (1974), Ashenfelter and Layard (1992), and Aghion
and Howitt (1994). For disequilibrium economics, see Clower (1965), Benassy
(1975, 1982), Green and Laffont (1981), Malinvaud (1977), and Negishi (1985,
1989).
Conditions of capital mobility and people migration

We assumed that perfect competition of the international capital market
makes the interest rates identical across the world economy. But due to
factors such as transaction costs, risks and institutions, rates of interest
may not be equalized among nations. It is necessary to specify some prin-
ciples of capital mobility among nations. How migration is endogenously
determined is a complicated issue. We may also introduce international
tourism (i.e., the utilization of the service sectors by foreigners) into our
modeling framework.
Outside and inside money, fixed versus flexible exchange rates, mone-
tary policy rules and changes in transactions technology
This book is mainly concerned with models in which all money is as-
sumed to be of the outside form, standing for non-interest-bearing gov-
ernment debt. In reality a large part of money supply is of the inside form,
for instance, bank deposits – representing claims to the private sector. Ag-
gregated over the private sector, outside money is part of net wealth of the
private sector, whereas inside money is not. The importance of the distinc-
tion between inside and outside money was recognized early in the mone-
tary growth literature.16 It is expected that dynamics of inside and outside
money should have been changed due to the economic development and
technological changes. Most of our dynamic models are concerned with
flexible exchange rates. It is important to examine what will happen when
exchange rates are fixed. Moreover, we did not make any comprehensive
study of money supply. The assumption that the money supply is exoge-
nous has been commonly accepted in the literature of theoretical monetary
economics. Also, payment systems have gone through a major transforma-
tion in the last two decades in many parts of the world. The development
of the technology to transfer information has increased substitutability be-
tween deposits and currency in transactions. It has been observed that the
cost of transactions has been substantially reduced due to the technological
changes. Innovations in financial markets have created and will continue to
create new methods of transacting, such as credit cards, debit cards, instant
cash machines, etc.
Spatial structures and urbanization

This book does not deal with spatial economic structures. Although the
author has made some preliminary but original contributions by applying
the analytical framework proposed in this study, further extensions should
16 For instance, Johnson (1969), Marty (1969), and Saving (1970, 1973) discussed
effects of outside and inside money in static frameworks.

be carried. Again, our analytical framework enables us to deal many dy-

namic issues of spatial economies, which cannot be effectively examined
by the Ramsey and Solow approaches.
We only mentioned a few possible ways for extending and generalizing
our study. The list can be easily refined and continued. I quote from Zhang
(1999: 406) to conclude this book: “Over-simplification in scientific eco-
nomics tends to result in misleading conclusions; over-complication tends
to lead to uselessness. This book is concerned with economic issues as
broad as possible but not so broad that we cannot scientifically analyze
them. A rich idea does not live alone. A rich theory is like the central
grand square from which multiple roads start to lead to remote places. It
will take much longer space to explore possible implications of the ideas
represented in this book. Anyhow, the economist never completes his
work.”
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Index
Abdel-Rahman HM 209 Aghion P 12, 403, 407, 480

Abe K 63, 64, 71 agriculture 130, 343, 388
Abel AB 136, 140, 153, 355 sector 131
absentee land ownership 207 Altenburg L 71
absolute advantage 3, 24 Amano A 72
account surplus 166 amenity 206, 208, 219
current 146, 158, 166 job 479
accounting 136 region 226
expenditure approach 136 research 479
income approach 136 analytical framework v
product approach 136 Ramsey’s v
Acharyya R 175 Solow’s v
AD-AS model 152 Anderson RK 430
AD curve 153 Anderson WP 209
advanced 13 Andersson AE 209
country 13 Andersson F 227
region 20, 226, 242, 413 anticipated monetary policy 477
sector 125 APC 236
advanced mathematics 276 Appleyard DR 42
Agénor PR 323 approach to consumer behavior 285
agglomeration 11, 78, 88, 203, 226, alternative 15, 338
242 arbitrage-free rate of return 233
Chamberlinian 108, 129 Arrow KJ 12, 323, 328
economy 88 Arrow-Debreu general equilibrium
force 89 framework 176
industrial 11 Arthur WB 285
regional 11, 222 Ashenfelter O 480
urban 11 asset market 148
agglomerative force 132 asymptotical stability 184
aggregate 83, 87, 287, 409, 414 Atkinson AB 478
consumption 235, 385, 415 Auerbach AJ 63
demand 130 average propensity to consume
disposable income 235 (APC) 236
intermediate 395 Ayong Le Kama AD 480
R&D spending 44 Azariadis C 178, 238, 326
supply 179, 376
aggregate demand (AD) curve 153 Backus DK 430
508 Index
Balassa B 90 Brody A 285

Baldwin RE 129, 204-5, 227, 242 Browning M 255
Bardhan PK 5 Bruce N 7
Barro RJ 161, 163, 399, 402, 407, 415 Brumberg R 238
Barten AP 227 budget deficit 139
barter economy 418 Burmeister E 178, 16, 238, 239
Batra RN 42, 52, 107, 430
Batten DF 205 Calvo GA 164
Bayindir-Upmann T 227 Campbell JY 255
Becker GS 12, 257 Canning P 205
Becker RA 191 Capello R 204
Beladi H 52, 125 capital accumulation 6, 12, 15, 188,
Ben-Zvi S 94 193, 204, 211, 238, 245, 255,
Benarroch M 103, 106 287, 297, 305, 315, 335, 340,
Benassy JP 480 398, 430, 476
Benhabib J 395, 396 dynamics 7
Benigno G 192, 205 movement 14
Benigno P 192, 205 one-sector global growth 241
Bensusan-Butt DM 286 OSG model 239, see also OSG
Berger MC 209 model
Bernanke BS 136, 140, 153, 355 small open economy 193
Bertrand TJ 118 capital adjustment cost 233
better off 39 capital-intensive 38, 49, 88, 290,
Bhagwati JN 3, 72, 118, 286, 480 300
bifurcation 326 capital mobility 108, 118, 204, 281
parameter 133 perfect 19, 117
supercritical pitchfork 133 capital movement 6, see also
Black J 286 international capital movement
Blau FD 255 Casas FR 44, 107
Blomquist GC 209 cash balance 135
Blomström M 13 cash-in-advance (CIA) 429
blueprint development 389 Cass D 187, 429
Blume L 182 CES function 390
Böhm V 227 CES-price index 131
Boldrin M 326 Chamberlin E 10
Boomsma P 205 Chamberlian monopolistic
Borck R 227 competition 11
Borkakoti J 27, 40 Chamberlinian-Ricardian model 17,
Boucekkine R 366 78
Bourguignon F 478 Chang WW 31
Bowen HP 51 Chang WY 430, 477
Boyer M 480 Chappell D 161
Brander JA 90, 193, 480 Chari VV 324, 328
Brecher RA 118, 319, 324 Chen Z 395
Bresnahan TF 338 Chen ZQ 319, 324
Brezis ES 328 Chiang AC 179
Index 509
Chiappori PA 255 marginal 43, 77, 80, 83, 91, 131,

Chipman JS 8, 54 402
Choudhri EU 319, 324 market entry 394
CIA 429 migration 210, 390
classical economist 11 opportunity 28, 148, 472
Clower RW 429, 480 production 4, 17, 24, 32, 360, 400
clustering 204 productivity 375
Cobb-Douglas 40, 63, 193, 241, R&D 376, 402
285, 477 share 44
demand function 74 trade 18, 88, 130, 388
preference 87 transaction 73, 80, 288, 430, 481
production function 33, 57, 95, transport 18, 72, 86, 90, 108, 132,
108, 265, 297, 306, 342 204, 227, 247, 256, 438
utility function 183, 237 variable 14
Combes PG 226 cumulative interest factor 382
commercial policy 11, 14 current account balance 171
commodity bundle 228 deficit 194, 213
comparative advantage 4, 11, 30, 49, in balance 194, 213
54, 71, 88, 104, 287, 375 surplus 194, 213
absolute 29 current income 139, 180, 193, 212,
model 48 236, 240, 248, 298, 307, 327,
R&D 380 405, 448
theory 16, 23, 26 currency 153
complement 51, 84, 133
complementarity 133, 343 Darity W 255
completeness 228 Das SP 107, 117
computable general equilibrium Davis DR 51, 85, 125
model 205 Day RH 326
concavity 184 de la Croix D 366
constant elasticity of substitution Debreu G 178
(CES) function 390 deflationary pressure 171
continuity 228 Dei F 118
continuum of goods 73 democracy 477
convex production possibility 10 Der W 107
convexity 184 development 14, 77, 205, 270, 324,
Corden WM 40 304, 481
core-periphery model 108, 129 East Asia 334
core trade theorems 64 economics 399
cost economist 398
capital adjustment 233 opportunity cost 336
comparative 9, 25, 32 sustainable 337
country-specific 8 development of trade theory 15
factor 8, 242 Devereux MB 5, 242
fixed 83, 91, 402 Diamond DB 209
imitation 381 Diaz-Alejandro CF 118
holding money 148 discount rate for utility 185
510 Index
discount rate 190, see also rate of small country economy 192, 200
time preference trade 15, 177, 373
discounted utility 190 world economy 264, 326, 352,
disposable income 135, 157, 181, 369, 442, 475
208, 214, 235, 258, 299, 308, dual-economic model 243
315, 327, 341, 356, 420, 431, dual approach 33, 40, 42, 71, 99, 108
440, 194, see also income Dutch Disease 40
distribution 58 Duraton G 226
capital 7, 87, 132, 241, 249
consumption over the life cycle Eaton J 7, 10, 241, 313, 324
238 economic
human capital 132 analysis 8, 417
income 33, 175, 324, 446 progress 6
labor 34, 87, 293, 479 structure 56, 285, 388
natural 162 economic development 14, see also
policy 346 development
population 215, 235 economic geography 204, see also
time 227, 260, 329 new economic geography
wealth 269, 446, 478, 480 economic growth 6, 9, 77, 124, 135,
distributional justice 477 205, 226, 255, 347, 395, 403,
division of labor 5, 9, 286 407
global 294, 303 Chinese-dominated economies
international 9, 26, 243 335
sexual 255, 257, 443 complexity 373
Dixit A 3, 11, 14, 33, 52, 77, 131, determinant 256
392 driving force 373
Dixit-Stiglitz model 14, 389 global 310, 317, 480
Dixon HD 14 international 185
Dobb M 478 Japanese 335
Dobell AR 178, 184, 238, 339 Korea 335
Doi J 285 mechanism 374
Dollar D 324 multi-regional open small 203,
domestic technology investments 226
175 national 200
Dornbusch R 73, 140, 164, 423, 470 spatial 205
Down K 161 sustained 338
Drabicki JZ 417 theory 185, 238
dynamics 7, 261, 338 with externalities 395
capital-labor ratio 186 economic theory 6, 23, 241
current account 232 general 314, 476
economic 11, 177, 210, 327 neoclassical 185, 228, 337
international trade 176 new 12, 241, 398, 404
interregional 192, 217, 221 economy of scale 3, 8, 78, see also
monetary economic 450 return to scale
population 8, 209 Eden F 421
price 166 Edmonds EV 175
Index 511
education 15, 255, 306, 326, 328, expenditure velocity 162

337, 467 expected transactional benefit 148
effective rate of return 14 export 3, 17, 32, 46, 50, 58, 70, 90,
Ehrlich I 366 116, 138, 145, 231, 288, 322,
elastic demand 21 418
elastic supply 243 biased growth 117
elasticity 244, 401 industry 40
demand 86, 169, 374 net 156
export demand, 158 export biased 117
import demand 158 exportable 165, 179, 430, 435
price 390 external economy 9, 14
substitution 82, 130, 390, 393 externality 89, 103, 209, 241, 336,
utility 208 374, 395, 405
Elliot GA 73
emigration 125, 133 factor endowment 3, 5, 10, 17, 23,
endogenous population 478 35, 39, 46, 52, 70, 78, 107, 113,
Engel C 103 164, 242, 374
entry 80, 492, 413, 478 distribution 60, 97
entry-exit process 77 immobile 108, 113
Epifani P 85, 88 relative 23, 35, 59
Epstein LG 480 factor price 5, 7, 33, 37, 72, 111,
equilibrium 3, 30, 42, 66, 144, 180, 176, 241, 302, 346
244, 313, 350, 392, 428, 433 international equalization 46, 89,
free international trade 56, 84 111
long-run 78, 132, 153, 398 relative 88, 89
model 63, see also general trade factor-price equalization theorem 4,
equilibrium model 46, 52
multiple 327, 330, 351 factor price insensitivity lemma 36,
short-run 77, 153 43, 115
stability 9, 245, 334 Faini R 1
trade 53, 84, 88 FDI 133
unique 9, 62, 93, 245, 254 Feenstra RC 34, 42, 49, 51, 125, 429
unstable 334, 387 Feldetein M 63
world trade 61 Field AJ Jr 42
Ertürk K 255 Filatrella G 328
Ethier WJ 4-5, 10-1, 31, 107, 40, 72, financial
375 asset 164, 478
Euler theorem 180 instrument 418
Evenson RE 398 market 7, 391, 481
exchange rate 135, 153, 163, 166, resource 346
170, 313, 418, 424, 481 wealth 423
fixed 135 Findlay R 6, 13, 20, 31, 241, 243
floating 135, 418 Fischer B 446
nominal 153, 161 Fisher equation 405
real 153, 161 Fischer S 7, 73, 140, 164, 197, 423,
exit 80, 397 470
512 Index
Flam H 73 geometric 49
Flatters F 118 Gerlagh R 480
Fleming JM 417 Glaeser EL 209
flexible-exchange-rate-system 153 global services 1
floating-exchange-rate-system 153 globalization 1, 176, 388, 478
Forslid R 227 GNP 203
four fundamental trade theorems Gobillon L 226
108, see also core trade golden standard 135
theorems Gombi I 229, 231
Francois JF 11 Gomme P 255
Frederick S 191-2 Graham FD 19
free trade 14, 24, 36, 45, 84, 117, gravity theory 205
163, 203, 257, 307 Green JR 179, 480
equilibrium 89 Grinols EL 10
system 51 gross domestic product (GDP) 42
Frenkel JA 7, 197, 246 gross regional product (GRP) 212
Friedman BM 430 Grossman GM 12, 41, 375, 376,
Friedman M 238, 421, 471 381-2, 389, 391, 396, 407
Froyen RT 238 Grossmann V 12
Fujita M 85, 129, 205, 210, 391, 399 GRP 212, see also gross regional
Fujiwara K 85 product
fundamental identity of national Grubel HG 33, 90
income accounting 136 Grubert H 30
Fung KC 94 GTAP model 205
Guilló MD 193
gain from trade 3, 9, 23, 25, 31, 71,
79, 81 habit 231
Galí J 192, 205, 430 formation 233
Galor O 229, 255, 366, 430 Hahn FH 93, 430
Gandolfo G 5, 32-3, 52 Hamada K 118, 480
Gao T 391, 388 Hannesson R 193
GDP 54, 136, 194, 212, 336, see also Hanson GH 125
gross domestic product Harris R 193
world 50 Heckscher E 4, 46-7
gender 231, 255, see also sexual Heckscher-Ohlin 395, see also
division of labor international trade theory
gap 255 factor 11
inequality 255 model 4, 61, 396
general-equilibrium v, 23, 103, 152, theorem 47, 107, 116
176, 204 theory 4, 33, 45, 52, 85, 241
analysis 4 Heckscher-Ohlin-Samuelson model
long-term 4, 16, 53 49, see also HOS model
model 56, 395 Heckscher-Ohlin-Vanek model 49,
general-equilibrium product-cycle see also HOV model
model 374, 381 Helpman E 10, 12, 14, 33, 82, 94-5,
general trade equilibrium model 49 375, 376, 381-3, 389, 391, 396,
Index 513
407 policy 427

Henderson JV 129, 204, 209 inflationary pressure 171
Hewings GJD 205 infrastructure 479
Hicks J 140 innovation 9, 343, 373, 381, 391,
hierarchical pattern 11 398, 403, 478
high-income country 14, see also diffusion 9
advanced probability 404
Hodrick RJ 423 process 374
Hoehn JC 209 product 374
Hommes CH 326 input-output system 205
Hopenhayn H 324, 328 instantaneous sub-utility function
HOS model 49, see also Heckscher- 378
Ohlin-Samuelson model institution 8, 15, 52, 135, 149, 207,
HOS model 49, see also Heckscher- 385
Ohlin-Vanek integration 14, 480
housing sector 19, 177, 205, 226 trade pattern 205
Howitt P 12, 403, 407, 480 intellectual property rights (IPRs)
human capital 12, 129, 178, 257, 381
279, 324, 373, 391 intermediate 392, 403
accumulation 328, 430 goods 392
source 326 input 392
Hynes JA 480 product 11, 137, 374, 406
public 64
Ianchovichina 205 sector 406
iceberg international economics 6, 46, 203,
cost 130, 388 418
transport cost 130 international movement of
Ide T 95, 99, 101-2 capital 13, 18, 107, 118, 177
Ikeda S 231, 246 commodities 45
imitation 381 factors 1, 5, 71, 176
immiserizing growth 117, 121 goods 1, 176
immobility of factors 16, 107, 128, international specification 32
476 international trade 1, 6, 10, 23, 26,
imperfect competition 13, 77, 204 30, 51, 63, 90, 164, 175, 286,
import 3, 22, 58, 157, 418 320, 467, 475
import biased 117 benefit 27, 32
importable 430, 435 condition for 3, 26
Inada condition 186, 320 financial market 391
indifferent 228 free 26, 55
inequality 125, 175 model 255, 326, 417
gender 255 manufactures 368
wage 18, 125 pattern 1, 3, 5, 8, 15, 25, 286, see
inflation 135, 150, 417, 472 also trade pattern
domestic 155, 422 international trade theory v, 1-2, 11,
expected 135 15, 46, 107, 117, 374, 446, 475
foreign 155 classical 3, 16, 23, 25
514 Index
Heckscher-Ohlin 17, 32, 52, 63, Kenen PB 5, 72

77, 95 Kennedy C 323
pure 4, 6, 14, 46, 77, 241 Keynes JM 171, 191
theorem 176 Keynesian 143
interregional 77, 185, 192, 373, see approach 143
also multi-regional consumption function 235
intertemporal consumption-saving 7, theory of consumption 235
242 Keyzer MA 480
intervention 6 Kikuchi T 82, 85
intraindustry trade 11, 90, 94 Klenow P 133
investment 7, 144, 233, 245, 340, Kletzer K 193
405 Knight FH 10
desired 144 knowledge 6, 257, 324, 340, 367,
foreign 11, 133 467
goods 7, 230, 258, 289, 295, 308, accumulation 12, 117, 324, 345,
358, 419, 429 374
inventory 137 creation 8, 339, 343
sector 298 diffusion 15
IPRs, see intellectual property rights endogenous 6
IS-LM model 16, 135, 158, 417 production 345
Isard W 205 utilization 8, 326, 340, 359
Ishikawa S 63 knowledge-based 12
Kolko J 209
Jensen BS 12 Koolmann R 192, 205
Jensen RC 205 Koopmans TC 185
Jha R 63-4, 140 Kortum S 324
Johansson B 209 Kouri PJK 164, 423
Johnson HG 3, 5, 7, 31, 41, 44, 51-2, Krugman PR 10-1, 14, 27, 78-9, 82,
72, 243, 286, 481 87, 90, 94, 157, 175, 227, 242,
Jones RW 241 323, 324, 328, 390, 399
Jones-Neary model 40 Krusell P 328
Jonung C 1, 95, 125, 255 Kugler M 133
Jouini E 191 Kuhn TS 475
Jovanovic B 328 Kuncoro A 204
Judd KL 376 Kuznets S 285
justice 478 Kydland F 255, 430
Kaempfer WH 41 labor
Kahn LM 255 productivity 9, 27, 103, 356
Kakimoto S 118, 207, 209 theory of value 24
Kar S 125 labor supply 252, 287, 385, 439
Karp L 328 curve 141
Kehoe P 430 endogenous labor supply 20, 243,
Keller W 175 255
Kemp MC 6, 10, 95, 241, 419, 417, function 141
421 labor-
Index 515
abundant 37
augmenting 243 MacDougall GDA 6, 241
intensive 38 Mäler KG 480
Laffont JJ 480 Malinvaud E 480
Lai CC 477 Manasse P 175, 323
Lai ELC 381 Manning R 63
Laird S 432 Mansoorian A 480
Lam D 255 manufacturing 130, 243, 390, 403
land 6, 107, 115, 121, 211 marginal cost 83
intensive 114 marginal-cost pricing 375
market 205 Marglin SA 478
ownership 207 Marjit S 125, 175
rent 108, 122, 204, 206, 220, 241 market structure 12, 13, see also
rich 52 perfect competition,
use pattern 205 monopolistic competition
using 52 markup 83
land-labor ratio 114 Markusen JR 10, 41, 51, 94-5
Landesmann M 285 Marquist MH 431
Lane PR 192, 205 Marshall A 3, 52
law of one price 424 Marshallian
Layard R 480 offer curve 3
Leamer EE 34, 50-1, 107 stability 103
learning by doing 9, 324, 339, 345, Martin PJ 130, 242, 324
356, 374 Martin R 118, 129, 204-5
Lee H 328 Marty AL 481
Lee SD 107, 117 Mas-Colell A 179
Leontief WW 285 Maskus KE 381
Leontief paradox 51 Matsuyama K 14, 73, 326, 430
Lerner AP 4, 33, 45 Matthews RCO 10
less developed 13, 24, 242 Maurer R 12
Lewis WA 243, 285 Mayer W 41, 95
Licandro O 366 Mayor TH 432
license 381 McCall L 255
Lin SK 430 McCallum BT 140, 148, 163, 173
Linder hypothesis 51 McCulloch N 175
Liso ND 328 McDougall R 200, 205
Lloyd PJ 90 McKay A 175
Loewenstein G 191-2 McMillan J 63
long-run aggregate supply (LRAS) Melvin JR 10, 41, 95
curve 153 Meng Q 395
lot size 206, 216 mercantilism 2, 26
LRAS curve 153 Metzler LA 73, 172
Lucas RE 12, 373, 432 migration 51, 133, 210, 247, 256,
Ludvigson S 255 446, 481
Lui F 366 labor 11
Lyapunov’s theorem 184 Mill JS 3, 52-3
516 Index
Mino K 431 Morishima M 285

MIUF approach 421, 429 Mountford A 286
mobility of factors 5, 107, 111, 133, multiple equilibria 8, 14, 121, 330,
177, 476, 481 351
capital 14, 108, 118, 128, 177, multi-regional 177, 203, 467, see also
242, 246 interregional
classical mobility assumption 5, Mundell RA 49, 107, 135, 176,
72 417-8
complement 51 Mundell-Fleming model 418
goods, 424 Mundell substitutability 177
human capital 129 Mundell-Tobin effect 135
international 5, 49, 118, 176 Murphy K 255
labor 138 Mussa M 7, 33, 41, 241
Modigliani F 238
Monacelli T 192, 205, 430 Nahuis R 175
monetary Nakajima T 323
authority 167 Napp C 191
commodity 161 Nardini F 324
contraction 160 Neary JP 33, 40-1
economics 162, 429, 477, 481 Negishi T 3, 10, 52, 54, 480
expansion 161, 439 Nelson RR 12, 324
growth theory 192, 446 network 479
institutions 135 new economic geography 204, 227,
issue 161 242, 392
model 22, 164, 238, 467 new trade theory 13, see also trade
policy 477 theory
standard 161 Nijkamp P 204
system 161 Nikaido H 285
transfer 167 Nishimura K 37, 285, 326, 395-6,
unit 161 398
variable 18, 176 Nocco A 324
money 18, 22, 135, 161, 173, 378, nominal 148
417, 422, 447, 467 appreciation 155
cost of holding 148 demand for money 148
demand 148, 151 depreciation 155
growth 420 exchange rate 153, 161
inside 481 interest rate 148
neutral 160 money supply 150
outside 418, 481 value 148
price 168 wealth 164, 171
purpose of holding 148 non-linear programming 54
supply 2, 148, 151, 160, 167, 438 nonmonetary 149
money in the utility function non-Ponzi game condition 232
(MIUF) approach 421 non-tradable 5, 64
monopolistic competition 11, 77, 373 Norman V 3, 33, 52
monotonicity assumption 182 Nyarko Y 328
Index 517
Persson I 255
Obstfeld M 7, 27, 157, 192, 205, 231, Persson T 430
242, 418, 423 Pflüger M 129, 227
O’Donoghue T 191-2 Phelps ES 12
Ohlin B 4, 10, 46-7, 203 planning 26
Ohyama M 163, 170 Pleeter S 191
Okamoto H 63 Poisson arrival rate 383
oligopolistic price competition 375 Polachek S 255
oligopoly 77, 90, 399 pollution 103, 209, 335
OLG, see overlapping generations damage 103, 105
model local 103
Oliva MA 73 transboundary 78, 103
one-sector growth (OSG) model portfolio
177, see also OSG equilibrium 420
O’Neill J 255 preference condition 172
Ono Y 246 PPP, see purchasing power parity
Oniki H 6-7, 286 preference 3, 21, 82, 203, 226, 260,
Oniki-Uzawa model 6, 241, 297, 429, see also taste
322, 373 additive 404
Oosterhaven J 205 change 188, 219, 275, 364, 480
opportunity cost 25, 28, 148 Cobb-Douglas 87
leisure 472 difference 253, 305, 390, 477
optimization 32 homothetic 377
organic growth 9 identical 55, 70, 86, 104, 130, 254,
Orphanides A 423, 431 346, 377
OSG order 228
approach 177, 184, 235, 238 rate of time 186, 190, 243, 320,
framework 177, 242, 467, 480 404, 423, 471
model 178, 237, 321 recursive 8, 243
Ottaviano G 324 relation 228
overlapping generations (OLG) structure 228, 480
model 7, 229, 241 present-value shadow price 186
price
Palivos T 430, 532 arbitrage 165
Panagariya A 10, 72, 95 equality 206
Parente S 328 index 83, 155
Park WG 343 structure 15
Pasinetti LL 285 product-cycle model 381
path-dependent 326, 333 production function 5, 12, 43, 64,
Patinkin D 421 72, 131, 140, 179, 193, 206,
Pavcnik N 175 230, 244, 252, 258, 266, 288,
Pearl LR 432 341, 371, 391, 404, 448, 476
Perez-Sebastian F 193 Cobb-Douglas 33, 57, 64, 95,
perfect capital mobility 19, 242, 246 108, 118, 126, 298, 307, 375
perfect competition 8, 13, 241, 298, homogenous of degree one 180
373, 438, 481 neoclassical 36, 40, 60, 117, 179,
518 Index
184, 288, 315, 448 qualified labor force 327

production possibility 28 quality-ladders model 381
frontier 10, 28, 42 quality of products 407
productivity 29, 103, 175, 223, 266, quasiconcave 182
455, see also labor productivity quotas 118
country-specific 275
growth 395 Rader T 178, 191, 229
improvement 203, 226 Ramachandran R 430
intermediate 393 Ramanathan R 419
marginal 243, 245 Ramsey approach v
region 215 Ramsey F 185
relative 29 Ramsey growth theory vi
research 377 R&D 1, 13, 374, 376, 383, 391, 414
sector 64 cost 402
total factor 141, 375, 456 policy 325
profit 17, 34, 57, 77, 376, 385, 411, productivity 344
471 random process 383
monopoly 400 Rankin N 14
profit-maximizing 78, 88, 244, Rapoport H 133
373, 376 rate of time preference 8, 186, 190,
zero 258, 448 412, 471, see also discount rate
profit-maximizing approach 33, see Rauch JE 129, 324
also dual approach Razin A 246
propensity to real 38, 148, 176, 439 see also
consume goods 208, 441, 448 exchange rate
consume housing 220 balance 421, 428
consume lot size 208 capital 418
hold foreign currency 167 currency depreciation 158
hold money 427, 441 demand for money 147
own wealth 188, 208, 441, 449 disposable income 425
save 176, 198, 214, 427, 436, interest rate 7, 38, 144, 146, 149,
456, 465 155, 200, 430, 439, 447
use husband’s leisure time 441 investment 144
use wife’s leisure time 441 money 146, 148, 150, 424, 441,
poverty 175 471
public 63, 167, 325 national income 32
good 20, 63 output 124
input 63, 69 return 4, 38, 47, 114, 472
intermediate input 64 supply of money 148
purpose 208 wealth 165, 425, 428
sector 64, 418 reciprocal demand 6
service 208 curve 293
supply 67, 69 function 290, 301
purchasing power parity (PPP) 424 theory 4
Purvis DD 51 Reffett KL 431
reflexibility 228
Index 519
reformist 192 Ryder HE 7

regional 12, 132, 177, 203, 243, 335
amenity 177 Sachs JD 423, 480
integration 11 Saiz A 209
regulation 26 Sala-i-Martin X 399, 402, 415
relative demand 29 Samuelson PA 4, 7, 37-38, 46, 73,
relative price structure 75 113, 190, 241, 323
research 12, 203, 256, 325, 339, Sato R 12, 324
363, 376, 403, 479 saving 7, 139, 173, 180, 185, 195,
fund 346 208, 230, 246, 299, 418
policy 326, 340, 363 desired 144
returns to scale 8, 79, 177, 329, 334, government 139
375, 393, 419 national 139
constant 8, 43, 82, 99, 204 private 139
decreasing 10, 96, 101, 327, 344, saving rate 12, 239, 289, 335
478 constant 289
external 11 exogenous 12
increasing 8, 78, 86, 96, 101, 121, Saving TR 481
327, 344, 478 Sawyer WC 33
non-constant 8 Sazzieri R 285
variable 78, 95, 117 Schultz TW 324
Ricardian Schumpeter JA 403
factor 11 Schumpeterian creative destruction
model 4, 23, 26, 37, 46, 73 403
theory 6, 9, 25, 52, 63, 82, 241 scientist 430
Ricardo-Viner model 40 Seckin A 480
Ricci LA 129 second-order condition 182
Richardson BV 204 sectoral efficiency 14
Rios-Rull JV 328 Segerstrom PS 383
Rivera-Batiz LA 14, 73 Seiguido S 255
Robinson J 172 Sen P 195, 231, 233
Robson AJ 12 sexual division of labor 255, 443
Rodriguez CA 133, 164 shared land ownership 207
Roemer JE 478 Shell K 429
Rogers CA 130 Shi SY 7, 242, 480
Rogoff K 192, 205, 231, 418, 423 Shibata A 431
Romer D 188 Shieh YN 419
Romer PM 12, 14, 324, 373, 375, 377 Shigoka T 326
Rosenstein-Rodan PN 398 Shimomura K 85, 285, 395-6, 398
Rostow WW 285 Shone R 326
Ruane PR 40 short-run 153
Ruffin RJ 42, 419 analysis 143
Rupert P 255 dynamics 173
Rybczynski TM 4, 40, 47 equilibrium 153, 160, 166
Rybczynski theorem 4, 18, 40, 45, macroeconomics 418
107 short-run aggregate supply (SRAS)
520 Index
curve 153 Takayama A 95, 99, 101-2, 188,

skilled 127, 389 286, 417, 419, 430
Sidrauski M 421-2 Tamura R 255
Simon CP 182 tariff 2, 38, 72, 118, 205, 247, 256,
small open economy 7, 40, 96, 177, 430, 435, 438, 480
192, 226, 242, 419, 470 beneficial 10
economic geography 204 effect 72
multi-regional 177 income 72
Solow model vi, 239 optimum 3
Solow R 238, 398, 403, 423, 431 rate 72, 431
Song EY 192, 326 Tassel EV 255
spatial economic structure 481 taste 3, 47, see also preference
specific-factor 41, 241 different countries 3, 117
trade model 5, 7, 125 identical 47, 74
specification 8, 11, 14, 286 heterogeneous 63
international 32, 388 homothetic 47
production 388 Tawada M 193
Spence M 399 tax 64, 138, 141, 152, 233, 327, 341
spillover effect 11, 70 competition among regions 227
public good 70 income 64, 144, 328, 336, 344,
Sprinkle RL 33 371
Sraffa P 285 inflation 425
SRAS curve 153 lump sum 145, 232, 471
Srinivasan TN 72 rate 65, 336, 369, 471
static trade theory 16, 42, 373, 475 revenue 138
Steininger KW 72 structure 480
Stiglitz JE 11, 14, 77, 392 Taylor MS 193, 480
Stockman AC 417, 423, 429, 432 teaching 326
Stokey NL 73, 324, 328, 432 Technological 149
Stolper W 38, 46 change 6, 9, 12, 76, 142, 225,
Stolper-Samuelson theorem 38, 114 324, 373, 392, 407, 481
strategy 342 difference 9, 26, 31, 51, 85, 204,
interaction 77 320
pricing 410 dynamism 343
studying 326 endogenous 12, 325
subjective discount rate 377, see exogenous 12, 375
also discount rate for utility progress 11, 243, 403
Suen MH 448 technologically advanced sectors
Suga N 82 125
supply and demand linkage 130 technology 3, 8, 21, 48, 63, 103,
supply-oriented theory 52 176, 200, 245, 323, 342, 358,
Sveikauskas L 51 374, 383, 399, 419, 481
Svensson LEO 5, 72, 107, 430 choice 14
Swan TW 238 diffusion 175, 323, 381
symmetric 228 fixed 27
general purpose 343
Index 521
index 84 Trajtenberg M 338

internationally identical 5, 37, 52, transaction 148, 181
70, 79, 111, 116, 287, 396 cost 73, 80, 287, 297, 306, 417,
linear production 104 429, 481
market 384 money 471
new 323, 398 process 471
transfer 13, 381, 386 transitivity 228
terms of trade 3, 6, 18, 26, 33, 52, Trefler D 51
73, 106, 163, 170, 241, 244, Tsiddon D, 328
287, 306, 435, 477 Tsutsui S 12, 324
Thille H 103, 106 Turner M 204
Thisse JF 129, 205, 391 Turnovsky ST 191, 193, 233, 423,
Thompson H 42 425, 470
Thoreau HD 478 Turrini A 177, 323
time two-country model 13, 163, 320
available 257, 329 dynamic 13
constraint 259 two-good and two-factor trade
distribution 328 model 52
leisure 256, 259, 269 two-sector 7, 23, 33, 56, 291
student 329 model 42, 63, 241, 430
traveling 255 monetary 418
work 254, 329 neoclassical growth theory 7
Tirole J 94 two-sector, three-factors model 7,
Tobin J 135, 417 241
Tobin model 418 two-way trade 11
Tolley GS 209
Tomes N 255 unemployed 173
trade pattern 1, 3, 7, 10, 49, 52, 56, production factors 480
63, 67, 83, 95, 133, 205, 246, unemployment 52, 143, 480
254, 320, 358, 388, 475, see insurance 138
also international trade, university 326
interregional unskilled 125, 127, 391, 404
determinant 3, 17, 23 Upton C 209
equilibrium 10 use-of-saving identity 139
fixed 173 utility equalization 210
multiple 8 utility-maximizing 56, 65, 116, 418
trade policy 13, 175, 325 Uzawa H 6-7, 12, 286, 323, 328, 480
trade theory 4, 8, 13, 23, 33, 286,
297, 446, see also international variety of consumer products 399
trade theory Venables AJ 82, 87, 96, 129, 175,
classical 9 323, 390
monopolistic 476 Viner J 41
neoclassical 5, 52
new 13, 373 wage equalization 210
traditional 14, 112 Wang JY 13
volume 49 Wang P 422, 432
522 Index
Wang Z 205
Warner AM 192
Warner JT 480
Weaver N 328
Weil D 255, 366
Weinstein DE 51
Weizsäcker CC 323
welfare 9, 24, 78, 103, 117, 190,
381, 438
Westphal LE 398
Whinston MD 179
Wilson CA 73
Winter SG 12, 175, 324
Winters LA 174
Wirl F 480
Wong KY 5, 12-3, 41-2, 49, 51, 72,
90, 93, 107, 176
Woodland AD 33
worse off 39, 118
Yabuchi S 118
Yang GF 381
Yano M 326
Yeates AJ 432
Yip CK 423, 430, 448
Zeng DZ 82
Zhang J 432
Zhang WB 15-6, 64, 117, 129, 238,
178, 184-5, 203-4, 207-8, 226-
7, 238, 242, 247, 252, 286, 326,
333-4, 336, 338, 381, 388-401,
417, 438, 446, 455, 467, 475-6,
478-80, 482
Ziad A 227

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What is the book about?

What is the book about?

What topics does the book cover?

What topics does the book cover?

Wei-Bin Zhang

Capital, Knowledge, Economic Structure,

International Trade Theory

ISBN 978-3-540-78264-3 e-ISBN 978-3-540-78265-0

© 2008 Springer-Verlag Berlin Heidelberg

Cover design: WMX Design GmbH, Heidelberg

Printed on acid-free paper

The development of international trade theory has created a wide array of

approach tends to become analytically intractable when economic issues re-

1 International Trade and Trade Theory 1

2 Classical International Trade Theories 23

3 Trade with Imperfect Competition 77

4 Trade with Factor Mobility 107

4.3 A Trade Model with Emigration 125

5 Money, Exchange Rate, and Trade 135

6 Growth of Small Open-Economies with Capital

7 One-Sector Global Growth Models with Capital

8 Growth, Trade Patten and Structure 285

9 Growth and Trade with Capital and Knowledge 323

10 Trade Dynamics with Innovation and Monopolistic

11 Growth, Money and Trade 417

12 Trade Patterns and Dynamics 475

In recent years, global economy has experienced a tremendous increase in

1 See, for instance, Faini (2005).

1.1 A Brief Introduction to International Trade Theory

2 Mercantilism as a whole cannot be considered a unified theory of economics. It

than output and employment.

by the amount of treasury. He held that a nation’s wealth was reflected in

8 See also Heckscher and Ohlin (1991).

The Heckscher-Ohlin theory provides simple and intuitive insights into

9 See Gandolfo (1994a, 1994b).

11 Fischer and Frenkel (1972).

cisions with the use of recursive preferences. These preferences make it

ple equilibria and instability as economists had accepted the existence of a

monopolistic competition. They often link trade theory with increasing-

cal change, and international capital movements. It includes capital accu-

capital accumulation is not formally examined in the formal modeling of

1.2 The Purpose and the Structure of the Book

This book is concerned with dynamic relations between international divi-

sive manner. It is largely based on Zhang’s previous book, A Theory of In-

tries. Looking economic activities around, we observe that the f actor-

International factor mobility has received little attention in the literature

cumulation of knowledge capital in the world at large. Section 10.5 intro-

known generalization of the Ricardian model to encompass a continuum of

2.1 Adam Smith and Absolute Advantage

2.2 The Ricardian Trade Theory

in techniques of production. According to this theory, technological differ-

absolute value of the line’s slope equals opportunity

produce of an extra unit of cloth.

The production possibility frontiers show the combinations of goods

Otherwise, if PW / aW > (<) PC / aC , the economy will specialize in the

We have demonstrated that countries with different technologies will

in which aij is country i ’s labor requirement per unit output in sector j ,

in which Y j is country j ' s real national income measured in terms of good

The Ricardian model assumes that production costs are independent of

2.3 The 2 × 2 × 2 Trade Model and the Core Theorems in