In Discussion Paper No. 248, Hassan Molana and Research Fellow David Vines investigate the behaviour of the world economic growth rate and the terms of trade between industry and agriculture. They extend the North-South model due originally to Kaldor, characterized by the assumptions of surplus labour and exogenous real wages in both North and South, by allowing substitution in consumption between primary commodities and industrial goods in the North. This modification has an important effect on the behaviour of the model: following an exogenous shock the extent of this substitutability determines how the terms of trade react in the short run.
Molana and Vines analyse the impact of exogenous shocks, such as an increase in the Southern output/capital ratio resulting from technical progress in the South. A rise in the South's capital productivity will change the price of Southern output, leading to a deterioration in its terms of trade. The terms of trade overshoot because initially they must clear the market for agricultural goods, in the absence of other adjustments to the factors underlying supply and demand. But gradually changes in capital stocks bear some of the burden of adjustment. The initial fall in the terms of trade is therefore larger than the ultimate fall, and corresponds to an overshooting of the terms of trade. In this case the adjustment is monotonic and stable so that the terms of trade gradually move after the initial drop towards their new balanced-growth-equilibrium level. During the adjustment process the growth rate of the North exceeds that of the South. Because the terms of trade fall so much, initially growth in the South actually falls, i.e. the shock is initially `immiserizing' for the South.
Molana and Vines conclude that in general the terms of trade overshoot their new equilibrium value in response to an exogenous shock and may also converge to a new equilibrium along a cyclical path. Stable convergence is not guaranteed: cycles will occur, for example, if in the North the price elasticity of demand for agricultural goods is `too small'

North-South Growth and Terms of Trade: A Model on Kaldorian Lines Hassan Molana and David Vines

Discussion Paper No. 248, June 1988 (IT)