Sunday, April 29, 2007

The Price Level and International Trade

Dani Rodrik can't quite wrap his head around how international trade reduces inflationary pressure.

Basically he argues that since exporting something means additional demand, doesn't that mean that prices go up?

How can the price level go up form international trade?

It can't. For concreteness, I use Rodrik’s example of Argentina and the US in Beef. International trade causes Argentina to export Beef to the US.

US consumers pay in dollars. Those dollars are exchanged for pesos at some point. If the Argentine Beef producers turn around and buy equal international value of Other Stuff from the US then prices in pesos in Argentina for Other Stuff will fall but Beef will remain the same.

If the Argentine Beef producers try to save it instead of spending it there will be inflation, however this inflation will simply be due to the over-saving of the Beef producers (inflationary investment glut).

If the Argentine Government gives out pesos in exchange for dollars, and then spends those dollars on American goods, the price level in Argentina will rise because the price of Beef rises in pesos and the price of Other Stuff remains the same (assuming the same government domestic consumption). However in this case there exists inflationary fiscal pressure from the government (it is minting currency).


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