will increase productive activity in the United States relative to the rest of the
world. Domestic asset values will increase relative to asset values in the rest of
the world, and the United States will experience an inflow of capital. Given a
floating exchange rate system, the balance of payments is always zero, and the
trade balance mirrors the capital account. Thus, the deterioration in the trade
balance will mean an improvement in the capital account.
The approach predicts that an appreciation of the real exchange rate will result
in an increase in domestic production, higher domestic asset values, and a
decrease in both imports and exports as fractions of GNP. However, since there is
a net capital inflow, the trade balance must deteriorate. Hence, the increase in
exports will be less than the increase in imports. The U.S. experience of the 1980s is entirely within this view.
The valuable comments and suggestions of Rudolph Hauser and Michael Banton are
The real exchange or terms of trade rate measures the value of goods produced in one
country (e.g., the United States) in terms of goods produced in another country (e.g., Germany). The real exchange rate is calculated by first converting the foreign CPI into
dollars by dividing it by the exchange rate (foreign currency units per dollar). Then the
dollar-denominated foreign CPI is divided by the U.S. CPI to obtain the real exchange
The relative stock return is calculated as follows: The domestic percent change in the
stock price index is converted into dollars; these calculations are reported in Table 22.2
From the dollar-denominated foreign stock markets, the U.S. stock price performance is
subtracted. This gives rise to the foreign stock market nominal excess return. Subtracting
the U.S. inflation rate yields the real rate of return between each of the foreign countries
and the United States.
There is an extensive academic literature on the conditions under which factor prices
may equalize factor returns. See, for example, Paul A. Samuelson, "International Trade
and the Equalization of Factor Prices," Economic Journal 58 ( June 1948), pp. 163-84.
For the effect of factor mobility in the equalization of factor prices, see Robert A. Mundell
, "International Trade and Factor Mobility," American Economic Review 47, no. 3 ( June 1957), pp. 321-35.
R. A. Mundell, "International Trade and Factor Mobility."
See, for example,
Moshe Hagigi, "Industry Versus Country Risk in International
Investments of U.S. Pension Funds," Financial Analysts Journal, September/October
1988, pp. 70-74.
Arthur B. Laffer, "Minding our Ps and Qs: Exchange Rates and Foreign Trade," A. B. Laffer Associates, April 14, 1986.
Victor A. Canto and
Arthur B. Laffer, "Great Britain Moves to the Supply-Side," A. B. Laffer Associates, November 2, 1988. See also Chapter 16.