Terms of trade, capital accumulation and the macro-economy in a developing country: a theoretical analysis

This paper attempts to explain the terms of trade adjustment and the process of capital accumulation in a monetary model of sectoral interlinkage under rational expectation. The paper utilises a very standard dual economy framework in which industry and agriculture are two distinct sectors of production. Agriculture production is supply constrained. This may arise due to fixed endowment of land, weather condition etc. On the other hand, employment and output in the industrial sector are determined on the basis of profit maximisation in the presence of wage indexation. The asset structure of the economy includes the stock of primary commodities as one form of asset holding. Since the stock of agricultural commodities is one of the financial assets, its demand is subject to speculation which may entail fluctuating agricultural prices. Many factors have effects on fluctuating agricultural prices. These include monetary shock, parametric changes in agricultural production, changes in government expenditure etc. In this paper we discuss the comparative static effects of parametric changes of these factors. The paper shows that the short run and long run effects of any particular shock are quite different, not only quantitatively, but also qualitatively. Accordingly, the policy message of the paper is that the short run response may not be a reliable guide to the design of policy.