ISSN O075-6407

KOBE& BUSINESSECONOMIC
REVIEiW
36th

REPORT
ANNUAL/.il)/iffiSU'El.llik.ze'

RESEARCH INSTITUTE FOR ECONOMICSAND BUSINESS ADMINISTRATIONKOBE UNIVERSITY
1990

KOBE

ECONOMIC & BUSINESSREVIEW
36th

ANNUAL REPORTl)ISIIIIBU'E'l.1";.`.!

.S
,tN"

RESEARCH INSTITUTE FOR ECONOMICSAND BUSINESS ADMINISTRATIONKOBE UNIVERSITY

1990

CONTENTS
Page
Outward Direct Foreign Investment
and Structural Adjustment in a
Small Open Economy '''''''•t'''"''•••''"'''''''"''''''''"' Chung H. LEE

1

An Approach to Transaction

Contracts with Asymmetric
Information '''''"''''''''"'''''''''''''''''''''''''''''"'''' Kazuhiro IGAwA

17

A Mathematical Note on the
Impossibility of Global Absolute Advantage '''''''' Kazuo SHIMoMuRA

27

On Reform of the International
Monetary System: A Survey ••••••••••''''''''"''''''''''"'' Hideki IzAwA

33

OUTWARD DIRECT FOREIGN INVESTMENT AND
STRUCTURAL ADJUSTMENT IN A SMALL OPEN ECONOMY

Chung H. LEE'

I. Introduction
In recent years, the world has witnessed increasing flows of direct foreign investment(DFI) from Korea and Taiwan to other developing countries of Asia. What isnoteworthy about this outward direct investment is that it is out of labor-intensive

industries in which these countries are losing comparative advantage and is thus
related to structural change taking place in their economies. Their outward DFI infact resembles Japanese DFI in developing Asian countries in the 1960s and 1970s
which was then carried out largely by firms in labor-intensive industries (Kojima

1973 and 1978). It now seems that Korea and Taiwan are replicating theinvestment experience of the Japan of the 60s and 70s when its manufacturing sector

went through a structural change from labor-intensive to capital-and knowledgeintensive industries.

Current outward DFI from Korea and Taiwan as well as the past Japanese DFI
thus pose some interesting questions on the relationship between structural change

and DFI. What are the factors motivating DFI out of those industries in which a

country is losing its comparative advantage? Does this outward DFI facilitate
structural adjustment in the country's economy? If so, is the country better off as aresult, and who gains and who loses?
Much of the literature on DFI and the multinational enterprise (MNE) is silent onthese questions as its focus has been on microeconomic issues relating to DFI. In
fact, the "modern" theory of DFI is called the theory of internalization according towhich the MNE is an institution developed to overcome market imperfections andthus to bypass markets in order to economize on the transaction cost (Rugman 1980).

Being microeconomic in its orientation, however, the theory of internalization is*The author is Professor of Economics at the University of Hawaii at Manoa and Research Associate at
Resource Systems Institute, East-West Center, Honolulu, Hawaii. Research for this paper was carried out
while the author was Guest Scholar at the Research Institute for Economics and Business Administration,

Kobe University. He wishes to thank Professors Fumio Dei, Takao Fujimoto, Kazuhiro Igawa, Koji
Shimomura, and Hideki Yoshihara for their valuable comments on an earlier version of the paper,

CHUNG H. LEE

2incapable of explaining the relationship between a country's structural change andits DFI. Furthermore, in discussing the gains from DFI the literature has focussed
on DFI's effect on allocative efficiency, x-efficiency, and technology transfer in thecase of the host country and on allocative efficiency, output, and employment in thecase of the more advanced home country. It is largely silent on how DFI may reducethe cost of and thus facilitate structural adjustment in the latter.
If much of the literature on DFI has ignored the relationship between structuralchange and DFI, the part of the literature on international trade which has examined

the problem of structural adjustment has in turn ignored DFI (e. g., Mussa 1982,

Neary 1982). There are now, however, empirical studies which show that byinvesting abroad in response to changing comparative advantage Japanese firms havefacilitated structural adjustment in the Japanese economy (Hara 1989 and 1990,

Urata 1989).
The purpose of this paper is to examine the relationship between a structuralchange brought about by a change in the terms of trade and DFI in a small open
economy and find the role that outward DFI may play in facilitating its structuraladjustment. Given that the pioneering work in this area of inquiry has been done by

Kojima, section II begins with a brief re-examination of Kojima's macroeconomic
theory of DFI. The paper then presents a simple model of a small open economy andshows a relationship between structural change and returns on capital. Section III

compares intersectoral and international mobility of capital and discusses 'capital movement takes place in the form of DFI and not as an arm's-length market
transaction. Section IV discusses the effect of labor-market conditions on capital

mobility and section V concludes the paper.

II. Structural Change and Direct Foreign inyestment

Kojima's Macroeconomic Theory of Direct Foreign Investment
How a country's outward DFI may be related to its comparative advantage was first
addressed by Kojima in his macroeconomic theory of DFI (Kojima 1973). A key point

in his theory is that Japanese DFI is from the industries in which Japan has acomparative' disadvantage and thus contrasts with U.S. DFI which is from theindustries in which the United States has a comparative advantage. Given that theconventional theory of DFI explains DFI as being motivated by the firm's possessionof firm-specific intangible capital, Kojima apparently found it incapable of explaining

Japanese DFI.

To explain DFI out of the industries in which Japan has a comparative
disadvantage Kojima proposes a "correspondence principle." According to this, awhy3
OUTWARD DIRECT FOREIGN INVESTMENT AND
STRUCTURAL ADJUSTMENT IN A SMALL OPEN ECONOMY

country's "comparative profitability" (or the ratio of profit rates in two industries) ishigh in an industry, relative to its counterpart in the other country, in which thecountry has a comparative advantage. It is then argued that capital will move out of
the industry with a low relative profit rate in one country to the industry with a highrelative profit rate in the other. It then follows that international capital movement

will be from the industry in which one country has a comparative disadvantage to theindustry in which the other country has a comparative advantage. This correspond-ence principle suffers, however, from three major conceptual problems.
The first is that a firm's investment decision is not guided by comparative
profitability or the ratio of profit rates but by a comparison of absolute profit rates.
To see this point, suppose that profit rates are higher in one country in all industries

in comparison with the other country. Then, although there may be a difference incomparative profitability capital will move out of all industries in the second country

to be invested in the first country.
The second problem with the correspondence principle is that it is formulated interms of static comparative advantage and disadvantage. The pretrade difference incost in the theory of comparative advantage refers to a difference in a static
equilibrium, and consequently the profit rate is the same for all industries whether

they are comparatively advantaged or disadvantaged. Thus even if one accepts
comparative profitability as the determinant of the direction of capital movement, one

cannot use it to explain the direction of capital movement as there will be nodifference in comparative profitability. The profit rate may, however, differ
between countries and consequently there may be capital movement from one country
to the other. But, being the same across all industries within each country the profit

rate cannot be a determinant of which industry will be inv.esting at home or abroad.

The third problem with the correspondence principle is that it is a symmetric
relationship between a pair of countries. Since the relationship between the two is
specified only in terms of comparative advantage and comparative profitability withno reference to absolute profit rates, it follows that the flow of DFI must be bilateral.

One country's comparatively disadvantaged industry with a comparatively low profit
rate is the other country's comparatively advantaged industry with a comparatively

high profit rate, and conversely. Consequently, if one country's outward DFI isfrom its comparatively disadvantaged industry, it receives at the same time DFI in its

comparatively advantaged industry from the other country's comparatively disadvantaged industry. Clearly, empirical evidence contradicts this bilateral flow of

DFI. Japan which has invested in labor-intensive industries of developing Asian
countries has not receive DFI from them in its capital- and knowledge-intensive
industries.

4

H. LEE
CHUNG

Even though the preceding discussion demonstrates that the correspondence
principle has serious problems, empirical evidence shows that Kojima's observationof the pattern ofJapanese DFI is by and large correct (e. g., Lee 1980)i). Furthermore,since the pattern of the recent outward DFI from Korea and Taiwan seems toresemble that of Japan in the 1960s and 1970s his insight into Japanese DFI and his
macroeconomic theory of DFI can be a fruitful starting point for further research in

the relationship between structural change and DFI.

Structural Change and Returns on Capital
Implicit in Kojima's theory of DFI is the assumption that the firm in an industry inwhich the country has comparative disadvantage transfers abroad new funds forinvestment and it maximizes returns on these funds wherever they may be invested.

What is, however, more likely to be taking place is that the firm, experiencing
declining or low returns on its existing stock capital, is interested in regaining higher

returns by transferring it abroad where factor prices are favorable to the technology

embodied in the capital. In other words, a firm in a declining industry becomes
multinational by reallocating its existing stock of capital across national boundaries

and not by investing only new funds abroad. This reason for DFI has been,
however, neglected in the "modern" as well as Kojima's theory of DFI.
To demonstrate this relationship between structural change and the incentive
for transferring abroad currently employed capital we assume a small open economy
consisting of exportables and importables sectors. In this economy exportables, X,

and importables, M, are produced under a perfectly competitive condition in all
markets and subject to constant returns to scale. Capital is sector-specific in the

short run whereas labor is perfectly mobile between sectors but immobile between
countries.2) Consequently, labor is subject to diminishing returns in each sector.

Figure 1, which combines certain features of the diagrams used by Mayer(1974), Mussa (1974), Neary (1978), and Corden and Neary (1982), depicts such an

economy. The total supply of labor is the horizontal distance, OMOx, and thevertical axis measures the wage rate in terms of X. VM is then the value of themarginal product of labor schedule in sector M and Vx the value of the marginal
product of labor schedule in sector X At the initial terms of trade profits are

1)

For a more detailed discussion of Kojima's macroeconomic theory of direct foreign investment, seeLee(1990).

2)

For a more fully specified model of trade and investment with specific factors see Ikemoto <1975). It

should be, however, pointed out that in his model direct foreign investment means simply theinternational movement of sector-specific capital.

OUTWARD DIRECT FOREIGN INVESTMENT AND 5

STRUCTURAL ADJUSTMENT IN A SMALL OPEN ECONOMY
maximized at the point of the intersection of these two schedules, Ao. The distance

OMLo is then the amount of labor employed in sector M and the distance OxLo theamount employed in sector X. The equilibrium wage rate is Wo, and the incomes ofcapital for the two sectors are the triangular areas between the wage line and therespective value of marginal product curves.
The effect of a deterioration in the country's terms of trade is to shift VM

proportionately upward to VM' with new equilibrium at Ai. It follows then that
employment increases by LoLi in sector M but decreases in sector X by the same

Figure 1

C

D
Al

Wl

Wo

Ao

A2

Vx
Vx'

OM
1
l
:
:

K

KM

VM•

VM
Lol
1

Ox

L, IL2
l

Ox

t
'

Ox'

1
l

Wl
rl

(-)x 1
t
'
1
1
1

'

'
'
l

l

i
t
t

Kx
Be

B2

W
(7).t

W
(-)X'
r

OM

L

Figure 2

CHUNG H. LEE

6amount. Capital income for sector X is smaller in terms of X as the wage rate is now
higher, as indicated by the smaller triangular area between Vx and the new wage line

Wi. Since M is now more expensive the capital income also decreases in terms of M.

Capital income for sector M is, however, larger than before in terms of the bothcommodities. It is clear from the figure that this sector's capital income increases interms of X. It also increases in terms of M since at the initial amount of labor, Lo, thevalue of this sector's output goes up in proportion with the change in the terms oftrade but the cost of labor increases by less. Hence, in terms of X the capital income
with the initial amount of labor increases by more than in proportion with the change

in the terms of trade and is therefore larger in terms of M than before the change.
Since to this we must add the capital income from the additional employment of LoLi
in sector M, this sector's total capital income is larger than before the change in theterms of trade.
A deterioration in the terms of trade lowers the Marshallian rent on capital insector X as its marginal product declines with less labor employed in that sector, andit induces capital to move abroad. Kojima observed this phenomenon--DFI fromlabor-intensive, declining industries--in Japan in the 1960s and 1970s, and we now
observe the same in Korea and Taiwan. What is to be noted, however, is that it isa

low Marshallian rent on existing capital and not a low profit rate which induces
capital outflow. Why this capital outflow takes place in the form of DFI and not anarm' s-length market tranSaction is, however, the subject matter for section III. For
the time being we wili simply assume that capital in sector X, although sector-specific,

is perfectly mobile between countries. Inflow of foreign capital into sector M is

assumed to be prohibited by government policy.

Caphal Outfiow and Its Effect on Economic Welfare
Capital will move abroad out of sector X until rents are equalized between home andabroad. If the economy was initially in long-run equilibrium, then capital will move
until the rent in sector X at home goes up back to the initial level. This situation isreached at point A2 in Figure 1 and point B2 off a contract curve in the
Edgeworth-Bowley box diagram of Figure 2. In Figure 1 the value of the marginal
product curve for sector X shifts down from Vx to Vx• with the outflow of capitalfrom this sector. How far it shifts down is determined by the condition that in newequilibrium the rent on capital in sector X is the same as that in the jnitial
equilibrium, the wage rate in terms ofX is the same as its initial level, and the capitalstock in sector M remains the same. This condition follows from the assumption of
perfect jnternational mobjlity of capital in sector X, which implies that its rental andthus the factor intensity in sector X are determined in the rest of the world. It also

7
OUTWARD DIRECT FOREIGN INVESTMENT AND
STRUCTURAL ADJUSTMENT IN A SMALL OPEN ECONOMY

implies that this sector's wage rate in terms of X is determined in the rest of theworld. Since labor is perfectly mobile between sectors the wage rate also goes down
in sector M. Thus, a deterioration in the terms of trade has no effect on the wage rate

in terms of X but brings about a decrease in terms of M.
An equilibrium point satisfying the above conditions is reached at point B2 in
Figure 2 where the factor intensity in sector X is the same as that at point Bo and thus

the relative factor price line for sector X, (w/r?x•, has the same slope as that in theinitial equilibrium, (w/r)x. This short-run equilibrium is reached with an outflow ofcapital from sector X equal to the distance, OxOx• in Figure 2, but with the constantamount of capital in sector M (see the appendix). The new relative factor price line for

sector M, (w/r)M•, has a lower slope, but since the wage rate is the same in terms of X
in the both sectors, as shown in Figure 1, the rent in sector M is now higher in termsof X than in the initial equilibrium.
Now we can see the effect of capital outflow on the economy which has undergone

a deterioration in its terms of trade. Capital income for sector X is the same as
before the deterioration and is therefore larger than that without capital movement.
Capital income for sector M is larger than before the deterioration and also larger

than that without capital movement as there is now more labor, OML2, employed inthat sector. Labor income for the total labor force is the same as before in terms of X

but less in terms of M. This contrasts with the case of no capital movement wherelabor gains in terms of X but loses in terms of M. Thus, in either case labor suffersfrom a terms of trade deterioration in terms of M but more so in the case of capital
mobility because then labor income is smaller in terms of X than in the case of capital

immobility.
In terms of GNP the country is better off with capital outflow from sector X than
without it. This is because the efficiency of capital allocation improves with capitalmoving from low marginal productivity at home to high marginal productivity
abroad. National income is larger although domestic output is smaller, and thus
there can be in principle an income redistribution from capital to labor which could

make everbody better off.
This gain in GNP is the triangular area, AoA iA2, in Figure 1. Since the wage rate

goes back down to Wo with capital outflow, capital income for sector M is thetriangular area between the initial wage line and VM•. Capital income for the capitalremaining at home in sector X is the triangular area between the initial wage line andVxk The combined capital income from both at home and abroad is the saihe as before
the change in the terms of trade because the rent is the same as before and the total

stock of capital in sector X, although divided between home and abroad, remains thesame. Since this income is equal to the triangular area between the initial wage line

CHUNG H. LEE

8

and Vx the income from foreign investment is the areaAoCDA2. This area is larger,
by the triangular area AoA iA2, than the area AiCDA2, the loss in GDP from capitaloutflow. Thus, the triangular area is the net gain from foreign investment and is,therefore, the reduction in the cost of structural adjustment brought about by themvestment.
III. International Mobility of Sector-Specific Capital

As noted earlier, short-run trade models which assume intersectoral immobility ofcapital also assume international immobility of capital. In this paper we haverelaxed this assumption somewhat by allowing capital in sector X to be perfectly
mobile between countries. But, obviously, the underlying implicit assumption thatthe cost of moving capital is infinitely large in one case but zero in the other is still apolar case and furthermore does not correctly reflect on the economic decision
involved in moving capital whether it is to be moved between sectors or countries.

To better understand what is involved in capital movement we should begin withthe assumption that even in the short run capital can be made to move between
sectors or countries at a cost This cost may be the explicit resource cost of moving
capital, as proposed by Mussa <1982), or it may be the loss in productivity resulting

from the use of the capital designed for one sector in another. Since capital will
move if a net benefit can be realized from its movement and if there is a larger net

benefit from international movement than from intersectoral movement, we willobserve the international movement of sector-specific capital.
The point to be noted is that capital movement, whether it is between sectors or

between countries, is a combined consequence of economic decisions and technology
and not a technological given alone. Once this point is recognized the question weneed to ask in answering why sector-specific capital can be internationally mobile

and why its movement will take the form of DFI js rather obvious: What are thefactors that determine a firm's choice between intersectoral and international

movement of such capital?
In the literature on DFI, the cost involved in moving firm-specific intangible
capital across national boundaries and thus in maximizing rents on its global use isrecognized as the reason why capital movement takes the form of DFI. Because themarket for such capital is not well developed its transfer abroad through arm's-length
market transaction is costly and is carried out instead as an internal transaction, i. e.,DFI.
If, as assumed in section II, sector-specific capital is homogeneous within the
sector and everlasting, there is in fact no reason why it cannot be transferred from

OUTWARD DIRECT FOREIGN INVESTMENT AND ' 9
STRUCTURAL ADJUSTMENT IN A SMALL OPEN ECONOMY
one country to another as an arm's-length market transaction. But, obviously, thecapital employed currently in a declining sector is second-hand capital and is by andlarge firm- and sector-specific. The market for such capital is, therefore, like thatfor used cars and deteriorates into a market for "lemons" because of the asymmetry of

information (Akerlof 1970). In such a situation the firm would find the market
systematically undervaluing its capital and would consider utilizing it internally.
When this internal utilization of capital takes place across national boundaries, weobserve DFI.
Faced with a declining or low rent on capital, the firm can transfer it either toanother country but in the same sector or to another sector within the same country.

In the first case the firm can produce and market the same product, utilizing its
present sector- and firm-specific tangible and intangible capital. The return on
capital may change little although there are additional costs to carrying out businessacross national boundaries and in an alien country. In the second case the firm willfind its capital less productive in the new sector but will not incur the cost of
carrying out business in an alien country. These costs and the income that can begenerated from the alternative uses of capital thus determine the choice between
intersectoral and international movement of capital.
There are reasons to believe that technological developments in communications
and transportation in the second half of this century have favored international overintersectoral movement of capital. In fact there is a historical antecedent. In
discussing the growth of American business firms from the 1850s until the 1920s
Chandler (1977) points out that the firms grew from small enterprises competing in
the local and regional market to large enterprises competing in the national market.

The reason for this transformation is technological:

By lowering transportation barriers, the railroads permitted many small enterprises tocoTnpete in the national market for the first time, At the same time the telegraph and thentelephone helped to make possible centralized supervision of a number of geographicallyscattered operating units. (Chandler 1977, p. 316)

We can very well see a parallel between the "multi-regionalization" of Americanbusiness during the early period of its expansion and its multinationalization
beginning in the second half of the 20th century. The technological counterparts inthe latter period are air transportation and telecommunications. Developments inthese have expanded the market globally and made "possible centralized supervisionof a number of geographically scattered operating units" but now scattered all over

the world. To put it in other words, recent developments in air transportation andtelecommunications have decreased the cost of operating a multi-unit business10 CHUNG H, LEE
enterprise across national boundaries, thus increasing DFI and the international
mobility of sector-specific capital.

IV. Labor-Market Conditions and Capital Mobility
So far the labor market was assumed to be competitive such that workers could be
easily hired and laid off. Consequently, the firm's decision either to invest abroador to invest at home was based only on returns on capital from the alternative
investments. In reality, however, the firm may not be free to lay off its workers
because of certain union contracts or government regulations, or if it does it may haveto incur extra costs. In either way there is a cost to laying off workers, and the firm

will take this into account before deciding to invest abroad.
If it invests abroad, the firm will have to lay off at least some of the workers andwill thus have to incur the layoff cost. If it moves instead into another sector, it may

not have to lay off as many workers as some of them can be carried into the new
sector. The cost of this move may be even less if the skills of the currently employedworkers are not sector-specific. Even if they are, the firm may find it advantageous

to transfer the workers into the new industry. This can happen as, although their
marginal product of labor in the new industry is less than the going wage rate, thecost of wage overpayment can be less than the layoff cost it will have to incur if it

invests abroad. Thus, if for one reason or another the firm has to bear the layoff

cost for its workers, the balance of advantage for the firm may shift toward theintersectoral movement of capital.
According to Kojima, U.S. DFI is carried out by large oligopolistic firms in theindustries in which the United States has a comparative advantage whereas Japanese
DFI was carried out by firms in the labor-intensive industries in which Japan had
comparative disadvantage. If there is a relationship between structural change andreturns on•capital, as demonstrated in section II, then we will have to ask why wehave not observed U.S. DFI out of its declining sectors. Differences in labor-market

conditions between the United States and Japan may provide an explanation.
In the case of the Japan of the late 1960s and early 1970s there was a shortageof labor in unskilled labor-intensive industries, and consequently unemployment was

not an issue that concerned either labor unions or the government. There wastherefore no need to protect the workers in these industries, and labor-market

conditions did not become an impediment to investment abroad. In the UnitedStates, however, labor unions and government regulations have made labor more
protected than in Japan and thus have made it more costly to lay off workers. U.S.
firms may have found it more advantageous to move into another industry or even to11
OUTWARD DIRECT FOREIGN INVESTMENT AND
STRUCTURAL ADJUSTMENT IN A SMALL OPEN ECONOMY

declare bankruptcy.
Another aspect to consider in the case ofJapan is the role that the internal labormarket plays when the firm invests abroad or diversifies into another line of product.

As Japanese workers tend to be trained as firm-specific generalists they could be
more easily transferred from one line of product to another than U. S. workers who
tend to be specialists. This characteristic of Japanese workers may make it easierfor the Japanese firm to move into another line of product while at the same time ittransfers abroad its sector-specific capital. It should be noted, however, that thislabor market characteristic holds true only for large firms.
Because U.S. DFI has been carried out in general by large oligopolistic firms it istaken for granted that U.S. DFI is a characteristic of an oligopolistic industry (e. g.,

Caves 1971, Hymer 1960, and Kindleberger 1969). However, we have justdemonstrated that firms even in a competitive industry would have an incentive toinvest abroad. Since costs and benefits are compared in making the decision toinvest abroad and since non-wage costs such as the layoff cost affect this decision,
firms even in a competitive industry may invest abroad if the cost of investing abroad
is sufficiently low. Thus, the fact that under the present labor-market condition U.S.

DFI is largely by oligopolistic firms should not be taken to mean that under analternative labor-market condition it would not be carried out, as in the case ofJapan,

by firms in a more competitive industry.

V. Conclusion
A structural change imposes a cost on the economy because capital--both human andnonhuman--is sector-specific in the short run, and because the change has not been
fully anticipated. If fully anticipated, investment decisions would have taken the
structural change into account and capital would be fully depreciated by the time
when it took place. It is therefore an unanticipated change that imposes a 6ost to theeconomy and thus creates the problem of structural adjustment In the model wehave presented here a structural change is not fully anticipated, and a decrease inincome on sector-specific capital is thus the cost of the change. What has been
demonstrated is that even in such a case the c6st can be reduced through direct
foreign investment. This reduction in the cost of structural change is shown as thetriangular area, AoAiA2. The economy, however, still bears some cost because themarginal product of capital is not equal across sectors. With the passage of time
capital will move into sectors M from sector X at home and abroad, again equalizing

returns on capital between sectors as well as between countries. In the meantime,
however, DFI can facilitate structural adjustment in the economy by reducing the cost

12

CHUNG H. LEEof structural change.
It should be noted here that the type of DFI discussed in this paper will stop as

the economy completes its structural adjustment. Furthermore, multinational
enterprises created by this DFI will be sensitive tg changes in wage costs, thus

becoming so-called foot-loose enterprises. They may even cease to exist as thecapital transferred abroad becomes completely depreciated.

In our formal model labor is assumed to be homogeneous. Even then we haveseen that labor will suffer from a deterioration in the terms of trade in terms of M andeven more when capital is internationally mobile. In reality, labor may be evenworse off as it is sector-specific in the short run as well but cannot move between
countries. It is obvious that when both capital and labor are sector-specific but only

capital is internationally mobile, capital outflow will reduce labor income. Consequently, the response of labor in a declining sector is likely to be different from thatof capital. Opposition to outward DFI as a cause for unemployment is exactly areflection of the frustration of labor which finds itself immobile and suffering fromwhat it perceives to be the effect of capital outflows. What our analysis
demonstrates is that a deterioration in the terms of trade is the cause of labor's loss

although DFI makes the situation worse. Since DFI is a response on the part ofcapital to avoid the effect of a deterioration in the terms of trade and since national
income is larger as a result, what needs to be done is an income transfer from capitalto labor and not the prohibition of outward DFI.
At this point we may ask if there is a case for subsidizing DFI. Since small andmedium-sized firms may know less about investment opportunities abroad than athome, they may underinvest abroad and overinvest at home. With respect toproprietary information there is, however, no reason why there would be any
difference investing abroad and investing at home. But with respect to general
information regarding the economic and political conditions of a foreign country,
which takes on the characteristic of a public good, one could argue that it would besocially more efficient for a public agency to collect and disseminate the information
freely than for private firms to do it individually. In this regard it is interesting tonote that large Japanese trading companies have contributed to DFI by small andmedium-sized Japanese firms with assistance in market intelligence, sales, anddistribution (World Bank 1988).
If there are distortions in the labor market as in the case of the layoff cost, asecond-best policy may be subsidizing foreign investment. The layoff cost increases
the cost of the international movement of sector-specific capital, but now subsidies
can be used to offset this cost. Workers will be then laid off and receive the layoff

payment which the firm pays with subsidies from the government. Now theOUTWARD DIRECT FOREIGN INVESTMENT AND 13

STRUCTURAL ADJUSTMENT IN A SMALL OPEN ECONOMY
country's GNP will exceed its GDP provided the subsidies do not introduce
distortions in other parts of the economy. Of course, a better policy would be tosubsidize directly the workers to move into other industries and eliminate the layoff
cost.

Appendix
Following the standard trade models we assume that the sectoral production
functions are represented by
X =: F( Kx. Lx ),M=G(K., LM),
where X and M denote outputs of exportables and importables, Kx and KM theamounts of capital employed in sectors X and M; and Lx and LM the amounts of labor

employed in sectors X and M, respeetively. As these functions•are assumed to belinear homogeneous,
X = Lxt7( lex )•M = LMg( leM ),where lex and leM are the capital-labor intensities in sectors X and M, respectively.

Functions f and g are twice differentiable with first derivatives, f' and g', being

positive and second derivates, f" and g", being negative.

Initially, the economy is in long-run equilibrium and perfectly competitive

everywhere. Then,rx =f'( lex ), kx=Kx/Lx (1>rM =g'( leM ), kM=KM/LM , (2)Wx =f( lex)' lexf'( lex) (3)wM=g( leM)- leMg '( leM) (4)rx = PrM and wx = PwM

Lx+LM
=L
(5)
Kx+KM =K (6)where rx and rM are the rentals in sectors X and M; wx and wM the wage rates in
sectors X and M; P the terms of trade (price ofM in terms of X); and L and K the initialendowments of labor and capital, respectively, in the economy.
Given the assumption that labor cannot move between countries, we obtain from
(5) and (6)K=(leit4-lex)L.+le.L. (7)The assumptions of a small open economy and perfect international capital mobility
for Kx imply that the rental on Kx, the factor intensity of sector X, and its wage rate

are determined in the rest of the world. Then, total differentiation of (7) and theH. LEE
CHUNG

14assumption of sector-specific but internationally immobile KM yield

dKx=LMd leM +(leM-lex)dLM• (8)Total differentiation of leM yields dLM = - (LM/leM)dleM since KM is a constant. By

substituting this in (8) we obtain

dK. =(le.L. /le.)dle.. (9)Totally differentiating (4) we obtaindwM = - leMg"dleM•
Substituting the above into (9) we get

dKx = - (lexLM/kM2g") dtvM.
Since Pwn,f = wx, the latter being determined in the rest of the world,

dP /P = - (dwM /wM). Then,dKx = (lexwMLM/leM2g") dP/P.
Since the term inside the parenthesis is negative, a deterioration in the terms oftrade (dP/P > O) leads to a decrease in the amount of capital employed in sector X.
Since this capital is not mobile between sectors the decrease is accounted for by theoutflow of capital.

References[11

Akerlof, George A., "The Market for 'Lemons': Quality Uncertainty and the Market Mechanism,"
Qttarterly Joumal of Econontics, Vol. 84, August 1970, 488-500.

[2]

Caves, Richard E., "International Corporations: The Industrial Economics of Foreign Investment,"

Economica. February 1971, 1-27.
[3]

Chandler, Jr., Alfred D., The Visible Hand, Harvard University Press, Cambridge, 1977.

[4]

Corden, W, M. and Neary, Peter J,, "Booming Sector and De-Industrialisation in a Small Open

Economy," Econcnnic Jot`mal, Vol. 92, No. 368, December 1982, 825-848,(5[Hara, Masayuki, "Internalization of Structural Adjustment: Diversification and Direct Foreign
Investment (in Japanese)," Jonmal of World Economy (in Japanese), Vol, 33, No, 8, August 1989,

25-31.
I6], "Japanese Industrial Adjustment and Foreign Direct Investment," a paper prepared forpresentation at the International Symposium on MNEs and 21st Century Scenarios, Tokyo, July 4-6,

1990,
[7]

Hymer, Stephan H., "International Operations of National Firms: A Study of Direct Investment," Ph.
D. dissertation, M. I. T., 1960.

l8]

Ikemoto, kiyoshi, "Direct Foreign Investments and the Specific Factors Model," Kobe University

Eccmomic Revietv, No, 21, 1975, 29-51.
(9]

llO]

Kindleberger, Charles P., American B#siness Abroad. Yale University Press, New Haven, 1969.
Kojima, K., "A Macroeconomic Approach to Foreign Direct Investment," Hitotsubashi Joumal of
Economics, 14, 1973, 1-21.

[11], Direct Foreign Investment: A Japanese Model of Multinational Business OPerations, New

York, Praeger Publishers, 1978.

OUTWARD DIRECT FOREIGN INVESTMENT AND 15
STRUCTURAL ADjUSTMENT IN A SMALL OPEN ECONOMY[12]

Lee, Chung H., "United States and Japanese Direct Investment in Korea: A Comparative Study,"
Hitotsubashi Jonmal of Economics, 20, 1980.

P31, "Direct Foreign Investment, Structural Adjustment, and International Division ofLabor: A Dynamic Macroeconomic Theory of Direct Foreign Investment," Hitotsubashi Joitina{ ofEcanomics. Vol. 31, No. 2, December, 1990.
[14]

Mayer, Wolfgang, "Short-Run and Long-Run Equilibrium in a Small Open Economy," lournal of
Political Econoiny, Vol. 82, No, 5, SeptemberlOctober 1974, 955-968.

[15]

Mussa, Michael, "Tariffs and the Distribution of Income: The Importance of Factor Specificity,
Substitutability, and Intensity in the Short and leng Run," Jonrnal of PoJitical Economy. Vol. 82, No. 6,

NovemberfDecember 1974, 1191-1204.
[16], "Government Policy and the Adjustment Process" in Jagdish N. Bhagwati (ed,), ImPort

ComPetition and Respmse. University Chicago Press, Chicago, 1982.
t17]

Neary, Peter J., "Short-Run Capital Specificity and the Pure Theory of International Trade,"

Economic Joumal, Vol, 88, No. 351, September 1978, 488-510.
[18], "Intersectoral Capital Mobility, Wage Stickiness, and the Case for Adjustment
Assistance" in Jagdish N. Bhagwati <ed.), Impart CotnPetiticm and ResPonse. University of Chicago

Press, Chicago, 1982.
[19]

Rugman, Alan M., "Internalization as a General Theory of Foreign Direct Investment: A[20}

Urata, Shujiro, "The Rapid Increase of Direct Investment Abroad and Structural Change in Japan,"[211.World Bank, JaPanese Dt'rect Foreign Investment: Pattems and ImPlicatians for Develcptng Conntries.

Re-Appraisal of the Literature," Weltu,irtschafttiches Archiv, Vol. 116, 1980, 365-379.

mimeo, Resource Systems Institute, East-West Center, Honolulu, 1989.

Industry Development Division, Washington, D. C,, November 1988.

AN APPROACH TO TRANSACTION CONTRACTSWITH ASYMMETRIC INFORMATION"

Kazuhiro IGAwA

This paper discusses an incentive-compatible transaction contract in an environment

where information relating to product quality is uncertain and asymmetrically
distributed. This contract is shown to improve transactions where the market
failure of asymmetric information prevails.

1

Contracts of economic transactions usually become more complicated or some times
become more difficult when seller and buyer do not posses the same information thanwhen they do. A negotiation for transaction contracts becomes then complicated as

the number of strategies increases. If a contracting method can be found which
eliminates this information asymmetry, market efficiency will improve.

The purpose of this paper is to find a contractual arrangement whereby
negotiators with informational advantages reveal their advantageous information.
This is shown in the context where a seller has perfect knowledge about the quality ofa product but a buyer has only a distribution of information relating to its quality.

There are many ways of contracts with asymmetric information. For example, theway that an economic agent with informational advantage can make use of it
monopolistically, and the way that an agent with informational disadvantage makes
use of its subjective distribution (mean, variance, and etc.) for contracts. Here, thecontract addressed in. this paper is limited to the one in which true information ishonestly revealed.

It is well known that a negotiation for one index, about which there exists
informational asymmetry between negotiators, may not proceed to final contracts andmay produce socially inefficient contracts. For example, if a mean of distribution of
the index is used for a contract in the market, economic argents with the index above(or below) the mean value will disappear frbm the market, if undervaluation (orovervaluation) reduces their gains. This will in turn lower (raise) the mean level of* I am indebted to professors K. Shimomura, C.H. Lee, H. Ota, M. Tawada and M. Oyama for their helpfulcomments.

18

KAZUHIRO IGAWA

the market and economic agents of reduced gains at the new level will disappear fromthe market. The market mechanism does not, consequently, work in an efficientway, and the market may disappear. However, if more than one index, say two
indices, are used for negotiations in one case of asymmetric information, true
information could be revealed.
In a negotiation with one index only, an agent with informational advantage will

fully use the advantage for his gains and will want to keep the advantage forever.
On the other hand, an agent with informational disadvantage will be sceptical about

the strategy of the other player and will believe only his subjective (or market)
distribution of the index. However with two indices which have the property that if

the informationally advantageous agent tries to be better off by determining one
index he must accept the other index making him worse off, it might be possible tofind a set of combinations of two indices which will induce the advantagous player toreveal honestly and freely a true index of the asymmetric information. Let us callthis choice an incentive-compatible choice. In the next section, conditions for thisincentive-compatible choice will be shown.

In the following section, a transaction between a commodity producer and its

distributor with asymmetric information will be specified, and an incentive
compatibility condition is defined. Section 3 shows the properties of contract withincentive compatibility. In the final section, applications or extensions of the model

to real-world economic phenomenan will be discussed.

2
To make the model simple, let us take the following case. Firm X has a product andwant to sell it to distributor Y, and X and Ynegotiate for transaction contracts. We

assume there are a number of firms producing similar products but of different
qualitjes, and there are many competitive distributors. Although firm X knows thequality of his own product, distributor Y has only a subjective distribution functionof quality in the market and does not know exactly the quality of firm X. In thissituation, Y should be careful about agreeing on a contract, because his sales andprofits will depend on the quality of X. Y will get profits if he buys a good quality
product at a low price but will make losses with a bad quality product of a 'high price.

To cope with the latter passibility, Y will try to include terms or conditions in thecontract for compensating the losses. This makes the negotiation for a contract
complicated and difficult.

We are now in a position to set up the mdel. We assume that the quality of
product "q" can be indexed between 0 and 1, and the higher q the better the quality.

AN APPROACH TO TRANSACTION CONTRACTS 19
WITH ASYMMETRIC INFORMATIONWe also assume for simplicity that index q indicates the probability of successful salefor distributors, that is, the probability of success is q and that of failure (1 - q).
Taking a representative firm (X) and a distributor (Y), let us consider a negotiation

for two indices: purchasing value (V) and guaranty money (G). V is the value whichis paid by Y to X and never to be refunded after transactions. G is a nominal val'
which Y gets from X in the case of Y's failure of sale, but G is zero in the case of
success. The contracted value of li and G will depend on the quality of product (inthis case the quality of firm X). As only X has the information of q, the true value ofq is not necessarily revealed in the contract.

The expected profit (II) of firm X with quality level q is expressed as(1) II = V- (1 - q) G/r- C,
where C is the present value of the cost of production and r is a discount rate to get

the present value of G. It should be.noted that values of V and G depend not'on thetrue level of q but on the quality level which is used in the transaction contract.

Firm X will try to choose and pretend to be the quality which maximizes his II. X
will reveal the true value of q if he bears all the risks that come from the difference
between the level of true q and the quality level used in the contract, because there isthen no incentive to misrepresent his quality. However, if he bears only partial
responsibility for the risk, as implied in equation (1), the incentive for misrepresenta-tion exists. Firm X is only responsible for the amount of (1 - q) G/r in the case of
failure.

As the remainder of the 'risk will be borne by distributor Y, there is an incentive

for Y to find a way to have X reveal the true q in the contract. This incentive
compatibility condition can be expressed as(2) II(q, q)>II(q', q),
where the second element in parenthesis is the true value of quality and the firstelement is the value reported in the contract. If we can find contract terms
satisfying this condition, the reported value of quality in the contracts could be thetrue one.

Explicitly expressing that value of V and G depend on the quality reported byfirm X, equation (2) can be extended as follows:(3) II(q', q) == V(q')-(1 -q) G(q')/r-C= Il(q', q') + (q -q') G(q')/r< II(q, q)
where II(qLq') is the profit of the firm of quality q' and reporting the truth of ql A

similar condition can be obtained for a firm of quality q' but reporting quality q.

That is(4) II(q, q') = V(q) - (1 'q') G(q) /r - Cue,

20 KAZUHIRO IGAWA= II(q, q) + (q'- q) G(q) /r' <II(q', q').
From inequabntes of (3) and (4), the following relations hold.

(5) (q -q') G(qV/r< II(q. q) - II(q', q') < (q -q') G(q)/r,

and thus
li. II(q '• q'), - II(q• q) = G(q) /.

q'-q q-q
Putting the left hand side of the equation as II', we get the first derivative of II withrespect to q:(6) II'=G (q)/r.
In the case that q >q', using both inequalities of (5) we get:G(q')/r == II'(q') < G(q)/r= Il'(q)This implies the second derivative of II with respect to q is positive. That is,(7) II">0.
We now find that the local expressions for the incentive compatibility condition are
the equations (6) and (7)i).
A distributor determines V and G, taking into account of relations (6) and (7),and thus using the true value of q. In the above example, an expected profit, M, of the

distributor Y can be expressed as(8) M= qV+ (1 - q) G/r-V- K. 'Here, it is assumed that a distributor does not know exactly the quality of firms, but
has the distribution function of the quality of firms as a whole in the market.2) The

first term of the right hand side of eqeation (8) is the present value of sales V

multiplied by success probability q. Here it is assumed for simplicity that an
average rate of profit is equal to the discount rate and the present value of sales is
1> Conversely, from relations (6), (7>, it follows that 'II(q, q) > II(q; q).

That is, from equation (3),II(q, q)-II(ql q)= II(q, q) - II(q '. q') - (q -q') G(qV /r= f,qt II'(x) dx - (q -q') II'(q), and the last relation holds from equation (6).
From equation (7), II' is an increasing function of q and thusf,q• II'(x) dx ) (q -q') II'(q').

Therefore,II(q, q) > II(q; q)2) :Tdjd.i,S,tl:tb.",tOpr,.M,tg,h,t.UfSl.,',e,PO,ir.t,ed,,q.' B".S,lgr,d ,o,f.[;:,e,,q,• However• it is assumed q' = q, after theAN APPROACH TO TRANSACTION CONTRACTS 21
WITH ASYMMETRIC INFORMATION

equal to the purchasing value. The second term is the discounted value of guaranty
money in the case of failure. The third is the purchasing cost and the fourth is thesales cost of the distributor.
To avoid complexities of oligopolistic games between firms and distributors, perfectcompetition among distributors is assumed. Then, we get the constraint of(9) (1 - q) (G /r- V) -K=O
since M= 0 in equation (8).
Now, there exist many combinations of V and G, which satisfy the zero profit
condition (9). For a distributor these combinations might be indifferent, but profits

of firms will be different depending on the combinations. A firm will choose a
distributor, who shows the combination of V and G which maximizes its profits.
Therefore, distributors will compete to make firms better off by showing possiblecombinations of V and G. That is, the combination of V and G, which maximizes
profits of firms, will be set by competition among distributors. This will be refered

to in the following section.

3
The model discussed in the previous section is written as follows. That is,

U= V(q)-(1 -q) G(q) /r-C (1)II'=G(q) /r (6)(1 -q) (G (q) /r' V(q))-K =O (9)To solve these equations, let us reduce the number of variables, by eliminating V and

G. From equation (9), it follows that(10) V(q)=G(q)/r'K/(1 -q)
and putting this into equation (1), we get(11) II(q)=qG(q)/r'C-K/(1'q).
Using equation (6), this can be rewritten as(12) II'(q) = ll(q)/q +C/q +K/(1 - q) q.
From this differential equation, the optimum solution of II(q) is solved, if an arbitrary

constant is determined. The determination of this is the determination of V and G
mentioned in the previous section, but will be discussed in later.ORce II(q) is solved,

G(q) will be found from equation (11), and V(q) from equation (11), in turn. These
solutions of V(q) and G(q) are the schedule of contract terms which are shown by
distributor Y to firm X. Y shows the schedule to X which then chooses q, and the

KAZUHIRO
IGAWA

22

value of V(q) and G(q) are determined. The !evel ofq chosen by X is the true Ievel ofq, because the V and G schedules satisfy incentive compatibility conditions.
Here, we are in a position to investigate properties of schedules of V(q) and G(q),taking into accont of condition (7). Differentiating equation (6) with respect to q, andusing relation (7), we get(1 3) II" = G'(q) /r > O.
This means that the higher quality the larger the guaranty money will be. This is
not curious, because the firm vvith higher quality product has a higher probability ofsuccess to sale and he is not very concerned about G, which he will pay in case of
failure, as far as V is higher. Next, differentiating equation (11) with respect to q,

and using equation (6), we get(14) G'(q)/r= K/(1 -q)2q
and, again differentiating this with respect to q, G"(q) becomes as follows.

(15) G"(q) /r = K(3q - 1)/q2 (1 -q)3
Therefore properties of G schedule are

G '(q) t-> 0 as q ?> 1/3.

That is, untill q -- 1/3, the rate of increase of G should become smaller as q increase

and it should become larger after q = 1/3. This relation is shown in Figure 1. •At

q = 1/3, a positive slope of a tangent Iine changes from decrease to increase.
The properties of V schedule are as follows. Differentiating equation (10) withrespect to q, and using equation (14), we get(16) V'(q)=K/(1 -q) q.

G

:
:
:
:
:
:
:
:

o

1/3

Fig. 1q

AN APPROACH TO TRANSACTION CONTRACTS 23
WITH ASYMMETRIC INFORMATION

Therefore V'(q) > 0, and this is reasonable because the increasing function of G
schedule is balanced by the increasing function of V. If V'(q) <0 for G'(q) >O,
every firm has an incentive to tell a low value of q, and this contradicts the incentive

compatibility condition. Comparing equations (14) and (16), we find V'(q) is smaller

than G'(q). Now differentiating equation (16) with respect to q, we get(17) V"(q) == K(2q - 1)/(1 - q)2q'

and thusV"(q)t-'0asqt->1/2.

Fig. 2V schedule is shown as in Figure 2. Comparing equations (15) and (17), we findV"(q) is smaller than G "(q). That is, for higher q the rate of increase of the guaranty

money G is higher than the one of the purchasing value V. Therefore a low quality
firm has no incentive to tell higher quality, because of relatively higher guaranty
money will be asked. Conversely, a high quality firm has no incentive to tell lower q,
because of lower V. A high quality firm is not relatively careful for the decrease ofG.

With these properties of V and G schedules of the incentive compatibility
condition, firms will tell truth in contracts. However, not only the shape of theschedules but the absolute levels should be determined, and this is the determinationof the arbitrary constant of differential equation (12).

There are many factors which determine the levels of V and G. In the above
model, we focussed only on the shapes of V and G schedules and the model has a

24

KAZUHIRO IGAWA

property that an equal increase of V and G/r is indifferent for distributor but
beneficial for a firm. This is because, for the firm V is certain but G/r is cost only,inthe case of failure. If nothing is introduced for the model, higher V and G/r are

preferable. However this can not be true in the real world. A higher value of V
may not be compatible to the demand function which a distributor confronts for sale,and higher value of G may follow higher costs of a financial management. Here, toavoid the comp' lexities of introducing demand functions and costs of management, we
assume that the profit of the lowest quality firm is zero. That is, G of the lowest
quality (qo) firm becomes G = l C + K/ (1 - qo)i r/qo from equation (11), and V(qo) is

determined by equation (10).

4
So far, transactions under asymmetric information are investigated, and here webriefly compare it with those under symmetric information. The latter is a casewhere distributors have the same knowledge about the levei q as producers have.
We can show that the results of both transactions are same, if transaction costs of

distributor are same for both cases. For the case of symmetric information in theabove model uncertainty is only probabiiity of success q. Therefore the expected
profit of a firm, whose products are sold by a distributor at the present value V, is(18) II=qV-K-C
where K is transaction costs of the distributor in the case of symmetric information.
This is because the producer pays the cost of K and get qV, taking into account of thesuccess probability and the zero profit of the distributor. On the other hand, theexpected profit of the firm in an asymmetric case is, using equations (9) and (1),(19) Il=qV-K-C.
Therefore, if transaction costs for making incentive compatible contracts are zero and
K is applicable for both symrnetric and asymmetric cases, all the results are the samefor both cases.

However, it is reasonable that the transactioh costs under asymmetric
information case are !arger than those under symmetric information case, K > K. If
this is true, the producer's profits are 16ss and thus it is socially less beneficial forlarger K. This is the costs of using the incentive compatible contracts.

A long term contract js another way to cope with market deficiency. With along term contract informational disadvantage might be reduced and risk of cheating

between transactors would be reduced. In a long term contract guaranty money
might not be necessary and incentive compatible contracts also might not benecessary, but some elements should be put in long term contracts to overcome

AN APPROACH TO TRANSACTION CONTRACTS 25
WITH ASYMMETRIC INFORMATION
possible dificiency from asymmetric information.
A long term contract uses market but a trader cannot change a partner in the
short run and it is similar as using an organization, at least during the contract

period. In the organization, the partners follow their contracts but they are
independent in many other economic behaviors. In some sense, a long term contract

is a mixture of a market and an organization.

5
With asymmetric information, a market mechanism does not work in an efficient way.
There would be many different ways of transaction to cope with the deficiency. One
way to cope with asymmetry of information is to find contract terms which reveal thetrue information, as discussed in this paper. Another way is not to use a market

mechanism and to internalize transactions. The former is the way to improve
market mechanism and the latter is the way to use organizations instead of markets orinternalize the markets. Which one to choose depends on transaction costs. If thecost of finding and using the contract to reveal information is high, an organization

which internalize the transaction will be used. A firm, losing his comparativeadvantage, makes foreign direct investments using his used capital, instead of sellingit to foreign firms, is a case in point. If the cost of setting up and maintaining anorganization and transaction costs within the organization are high, then the market

contract of revealing information will be searched for. If both of these costs are

high, many different types of games in the market will determine the ways oftransactions. It is interesting to compare transaction costs obtained by different

ways of transaction, such as the one of contract terms in this paper, ofinternalizations by organizations, and of games. This paper showed only one type oftransaction of contract term among many of them.

References[11

Baron, D. P. & R. B. Myerson, "Regulating Monopolist with Unknown Costs," Econometrica, vol. 50, No,

4, July 1982.
[2I

Bester, H., "Screening vs. Rationing in Credit Markets with Imperfect Information," The American

Economic Review, vol. 75, No. 4, September 1985.
[3]

Falvey, R. E., "Trade, Quality Reputations and Commercial Policy," Intemational Economic Revietv, vol,[4]

Myerson, R. B., "Incentive Compatibility and the Bargianing Problem," Econometrica, vol. 47, No. 1,

30, No. 3, August 1989.

January 1979.

A MATHEMATICAL NOTE ON THE IMPOSSIBILITY OF
GLOBAL ABSOLUTE ADVANTAGEi)

Kazuo SHIMoMuRA

O. In Kemp and Shimomura (1988) it was asserted that in the standard 2 Å~ 2 Å~ 2
Hecksher-Ohlin model of international trade one countiy cannot hotd a global absoluteadvantage over the other. This 'impossibility theorm' is a direct consequence of thefollowing proposition:(*) Suppose that one country enjoys a uniform proportinate expansion of' its
production set. Then the other country is necessarily better-off in the new world
equilibrium, if the latter is locally stable.

In the above paper we mentioned that this proposition is valid for any number ofcommodities. The purpose of this note is to give a formal proof of it.
1. First of all, let us describe a general equilibrium model of international trade

which is to be used for our main business here. There is a trading world which
consists of two countries, say h and f. Each of the countries can produce n + 1
tradeable consumption goods, indexed by i = O. 1..., n, by using constant-returns-to-scale production technology. The price of the ith good is denoted by Pi and the Oth

good serves as numerare; P, - 1. Assuming, furthermore, that the social utility
function of each country is also homogeneous of degree one in all consumption goods,

the general equilbrium model is described as follows:(1)eh (P) uh-rh (P)=O(2)

ef (P) uf-rf (P)=O(3)

eh` (P) uh-rh` (P)+ef` (p) uf-arf` (p)=O, i= 1, .", n1) I am grateful to Professor Murray C, kemp for allowing me to publish this note under my own name.

28 KAZUO SHIMOMURA'
where e,(P), q = h, f, the unit expenditure function of country q, r,(P), q= h. f. therevenue function of country q. p a vector of order (n + 1) Å~ 1 such that the ithelement of it is pi, i=0, 1,..., n, ehi iiiaeh/aPi, rhiiarh/api, etc. 6 is aparameter whose increase represents the uniform expansion of country f's
production set.

2. Now we shall state the proposition to be proved in this note.

PROPOSITION Suppose that the equilibrium solution to the system uniquely
exists and locally stable. Then,(i) a uniform expansion of country f's production set makes country h better-off,that is,duh(4) d6 a==1, initially > 0'and(ii) if at least one of the functions, rh(P), r/P), -eh(P) and eKP). is strictly concave withrespect to Pi, .... P., then (4) is strictly positive.

REMARK : r,(P) and -e,(P), q = h, f, are homogeneous of degree one in p. Hence,each of them can be strictly convex with respect to Pi, •••, Pn•'
3. Let us start the proof of this proposition. Differentiating (1) - (3) with uh. uf,

Pi, i=1,..., n, and a at 6=1, we have-eh, O, rhi"ehiuh, ..., rh"-eh"uh. duh OO, -ef, rfi-efiuf, ... rf"-ef"uf, duf -rf-ehi, -efi, q=2h,(r7ii-eqiiual, ... qih,(r}i"-eqi"ual dpi -rfi
(5):::--:--: :=:d6-t---t--- -• - ---t--::: :-t ::--'-eh", -ef", qih,(r}"i-eq"iuq), ... qiSTf""-eq""uq) dp. -rf"

Resorting to Cramer's rule, we have

duh dettBl(6) d6 = det[A7THE IMPOSSIBILITY OF
NOTE ON
A MATHEMATICALGLOBAL ABSOLUTEADVANTAGE
where1

rh1 -eh uh,

0• 0•
B=-

1 -ef1tif,-rf, -ef,-rf, -ef,

rf

11
::
::
::A
-rf, -ef,nn

rh -eh uh----t-)

rfn - efna------s

D

'n

and

Ai
where D is a

Uh, ""'"
-eh
11
1

-eiv

0•

rh

o,

-ef,

rf1 -ef uf, .."..,

:
'n
-eh,

:

nn

rh -eh uhnn

rf -ef uf

D

'n
-ef,
nXn such that its (i, IV

matrix of orderelement is

q2=b.(r 7ii-e,`"u,).

4. Now let us
4.1

check the signsof det [Aland det IB7 inturn.

sign /det tB]1 Consider det IB7. Subtracting the first colum from the second

one, adding the first row to the second one and considering (3), we have0, rfi-efiuf,(7)

det [B7-t----s

rf

uf

nn

rf -ef uf

11

rf-ef uf,
:

D

:

nn

rf -ef uf,! - !Lt det IB "1uf
Since rp(P) and - e,(P) are convex functions, D is positive semi-definite, i. e., forany x =' (xi, •••, xn) \ Ox'Dx > 0. Henceforth, we shall assume, without loss, that rfi

29

30

KAZUOSHIMOMURA- efiuf X 0. Now partition the matrix B" defined in (7) as follows:

O, Cl, C2'

B* i cl. dll. D2'
C2, D2, D22
q.2.h,(frqii - eqiiuq), C2 and D2 are vectors of orderwhere ci i rfi - efiuf, dll i(n-0 Å~ 1 and D22 is a sub-matrix of order (n-1) Å~ (n-1) of D. C2' and D2' are
the transposes of C2 and D2. respectively. Denotingx by (xi, X2') where X2 is a
sub-vector of order (n-0 Å~ 1 of x, for any x satisfying xici + X2'C2 = 1,

x'Dx = X2' ID22-2D2C2'/cl + dllC2C2'/(cO21 X2 =- X2'D*X2, which must be nonnegative for any x because D is positive semi-definite. It follows

that det tD'1 > 0.

Now we see

1, O, On-1' 0, Cl, C2' 1, O, On-1
O, 1, O.-i ci, dii, D2 0, 1, C2'/ci
0n-1, -C2/Cl, In-i C2, D2, D22 0n-1, 0, In-1
(8)

O. cb O.-1'= cb dll, H'
On-1, H. D'
where 0.-i is a vector of order (n -1) Å~1 such that any element of it is zero, I.-i ,isthe identity matrix of order (n-1) Å~ (n-IJ and H =' D2i-auCofci. Since

, (8)

1, O,
O, 1,

On'1

0n-b C2/cl.

In-1

implies thatOn -1

det IBV is''equal to

1,
o,

o,

0n -1'

1,-C2'/C1

On-1,

0•

In-1

1

A MATHEMATICAL NOTE ON THE IMPOSSIBILITY OF 31
GLOBAL ABSOLUTE ADVANTAGE

O, cb 0.-1•

cb Dll. H' =-ci cb 0'n-i

0n-i• H, D' H, D'=- (cD2det tD"7,which is nonpositive, since det tD'7 > 0 as was already shown. It follows from theargument to this point thatrf(cO2detlD"1(9) det IBI =>0

uf

4.2 sign /det tA]1 To see the sign of det tAl, consider the following system ofdifferential equations:bi =ai Å~ Ieh` (P)rh(P)/eh (p) - rh`(p) + ef`(p)r/p)/eKp) - rf`(p)1=- aiÅ~EDi i=1, ...nwhere a i. i = 1, ..., n, is positive and constant, For this system to be locally stable ina neighbourhood of the equilibrium point, it is necessary that

-OEDi/api, ..-.. -aEDi/ap.

ao) -det la ED/apl i! l l >0
-aED./ap.. ..-.. -aED,/ep.

Each element of this determinant is expressed as the last RHS of the following
equatlon.

(11) -aEDi/ap, = (rht' - eht'/eh) + (rft'-ef"/ef)+ (ehjrh - ehrh') eh`/ (e"2 + (ef"rf - efrfi) ef/ (ef)2= (rhij - ehijulo} + (rfii - efiuf)+ (ehiuh - rhj) eh`/eh + (e7'uf - rf) ef/ef=q=2h(r7'i - eq']uq) + (ehiuh - rhJ) eht/eh + (e7"f - rfJ? ef/ef

where the second equality is justified from (1) and (2).
Now concentrnte on det IAI. Subtracting the first row multiplied by ehi/eh andthe second row multiplied by ef/ef from the (i + 2) th row fori == 1, ..., n and taking

32 KAZUO SHIMOMURA
into account (10)and (11), we see that

det tAl= -eh, 0, rhi'ehiuhi ............, rh"-eh"uhO, -ef, rfi-efiuf, ............, rf"-ef"ufo, o, -aEDi/api,..".".".. -aEDi/ap.

o. o. -aED./api ,.""".".. aED./ap.
= - eheL,det IOED/ap7 > O,
which completes the proof of PROPOSITION.

References[1] Kemp, M. C. and K. Shimomura "The Impossibility of Global Absolute Advantage
Hecksher-Ohlin Model of Trade", Oxferd Econonzic PaPers, 1988, 575-576.

in -theON REFORM OF THE INTERNATIONALMONETARY SYSTEM: A SURVEY'

Hideki IzAwA

I Introduction
The present floating exchange rate system among the industrial countrids after thecollapse of the Bretton Woods (adjustable peg) system is characterized by the highvolatility in the short-run and the large and persistent misalignment (the deviationfrom medium-term equilibrium) of real exchange rates over 1980s, as Figure 1
shows. The dollar appreciated by roughly 50% in real effective terms from early

1980s until early 1985 and subsequently depreciated. There is no clearcut
consensus about its causes. Some economists argue that misalignment is due to thepolicy mix in the U. S., and others argue that it is due to bubbles or safe haven.

Foreign exchange market is dominated by huge capital transaction rather thancommodity trade on a daily or weekly basis. Exchange risk can be hedged inforward market. However, misalignment in real exchange rates has been costly
because they distort efficient resource allocation in the trade sector and prompt
protectionism. The U. S. economy lost international competition which led to large
trade deficit and at the same time Iarge inflow of capital (increase in external debts)

due to U. S. fiscal deficit

In this paper, we review critically the alternative propoSals for reform ofinternational monetary system rather than interpreting the behavior of exchange
rates.i)* The author was ipspired by the papers presented at the 4th international conference `The evolution of
the International Monetary System: How can Efficiency and Stability be Attained?' organized by Institutefor Monetary and Economic Studies, Bank of Japan, and a few sessions of the annual meeting of American

Economic Association in Atlanta on December 28-30, 1989,
1) Dornbusch and Frankel <1987) and Frenkel and Goldstein <1989), for example, are recent good
survey papers on this topic, See also Frankel and Froot (1990) about the explanation of the exchange
rates in 80's. They found that using survey data, the market shifts weight a"tay from fundamentalists(who forcast the exchange rates based on such models as Dornbusch's overshooting model) totechnical analyst or chartist (whose information set does not include such fundamantals as long-run
equilibrium rates), because the fundamentalists' forecasts of dollar depreciation continued to be
proven wrong over the period 1981-85, so that such change is a source of misalignment which takes
place with little basis in macroeconomic fundamentals.

HIDEKI IZAWA

34

107.89

86.30

64.72

1980I 81I

82I 83I 84I 85I 86I(source) IMF,

International Financial Statistics

Figure 1 Real87I

effective exchange rate of dollar

88I

89I

(1985 = 1oo) quarterly

data

Table 1 classifies international monetary systems (both past and proposed) by

the two criteria, flexibiiity of exchange rates and symmetry of operation. The
columns are divided by whether the in•ternational monetary system are symmetric orhegemonic. And the rows are divided by whether exchange rates are float, or fixed,

or managed. In this paper, we focus on McKinnon's proposal for fixed exchange
rates and Williamson's proposal for target zones.

Table 1 International Monetary Systems
floating

symmetry
hegemony

managedfixednationalmonetarytargets

McKinnon's

Williamson'sproposal(1973-85)

proposaltargetzones

BrettonWoodssystem

EMS(1979-)

based on Miller and Williamson (1988) p. 1032.

As Frenkel (1987) described, there are some reasons for the diversified views

about the desired exchange rate system in spite of the ongoing debate. First,
participants in the debate have not shared the presumption concerning the relevantalternative to the system they promote. Second, there are different concepts of the"equilibrium" exchange rate and not all participants in the debate share the same
concept. Third, different countries face different shocks. It is apparent that the

SYSTEM: ASURVEY35
ON REFORM OF
MONETARY
THEINTERNATIONAL

appropriate exchange rate regime depends on the nature and origin of shocks, which
we see below. Fourth, the costs of mistaken policies and the ability to correct errors

differs across countries. Fifth, countries differ from each other according to thevarious criteria (for example, the degree of factor mobility) governing the choice of

optimal currency areas. Sixth, views differ about the functions of exchange rates

and of market mechanism. There are those who maintain the speculative bubble.
On the other hand, there are also those who view exchange rate as an important gauge

which provides valuable information about current as well as future policies.
Finally, there are also different views about the advisability and effectiveness offoreign exchange intervention. In spite of the evidence that the effectiveness ofsterilized exchange intervention is very limited, there are those who still support
such intervention, since it can be effective by signalling to the market the intention ofpolicymakers.2) The foregoing reasons explain why views about the need for andthe desired characteristics of the international monetary system reform differ acrosscountries and may not converge soon.
Any operational international monetary system must solve the so-called n - 1

problem; there are n currencies and only n - 1 independent exchange rates. We
thus have one degree of freedom and its disposal must be explicitly specified. The

Bretton Woods system allocated the degree of freedom to the United States which

could pursue independent monetary policy without external constraint, but was
obliged itself to peg the price of gold at $35 an ounce. The other n - 1 countries
then committed themselves to peg thier currencies to the U. S. dollar. It should be
noted that a design of the international monetary systerR is not complete unless it

provides an explicit resolution to this n - 1 problem.
In section II, first of all, we review the theoretical literature on the exchangeintervention in a small open economy model. However, the assumption of a small
open country is too limited to cope with the issue of the international monetarysystem. Thus we use the two-country model to evaluate the relative merits of theflexible and fixed exchange rates, and compare non-cooperative and cooperative
regimes. Further, we examine the feasibility of international policy coordination

2) According to Marston (1988), there are three distinct channels through which sterilized intervention

can affect exchange rates. The first is the portfolio balance channel. As long as the domestic andforeign securities are imperfect substitutes, sterilized intervention is effective by changing thecomposition of assets in private portfolios with monetary liabilities unchanged. The other twochannels operate through announcement effects which require either market inefficiencies or superior
information on the part of the authorities. The intervention provides new information by signalling
the private market about the future monetary poticies of the authorities. This last channel works
even if the market is efficient, See Obstfeld (1988) in detail on the effectiveness of sterilizedintervention in the light of recent experience. '36

HIDEKI IZAWA

which nowadays is widely accepted. In sections III and IV, we focus on the
proposals by McKinnon and Williamson and point out their problems. Finally, in

section V, concluding remarks are mentioned. 'II The Choice of the Optimal Exchange Rate Policy andInternational Policy Coordination(i) The optimal exchange market intervention in a smal1 open economy
In this section, first of all, we summarize the debate on flexible versus fixed exchange

rate systems and review the literature on optimal foreign exchange intervention in asmall open economy. Mundell (1963) analyzed initially on the choice between acompletely fixed and a perfectly flexible exchange rate system. It shows thatmonetary policy in a small open economy under perfect capital mobility is effective inthe sense that it affects output under flexible rates, but not under fixed rates, and that

fiscal policy is effective under fixed rates, but not under flexible. This results isreinterpreted in the way that countries experiencing !arge financial disturbances
would enjoy more employment stability if exchange rates were fixed, while countries

experiencing large goods market disturbances would have more employment stability

if exchange rates were flexibte. Boyer (1978) concludes that the exchange rateshould be pegged if shocks arise in the market of intervention(the money market or

the goods market)and should be flexible if they impinge on the other market of
non-intervention. Complete fixed or flexible exchange rate is optimal only in thesevery specific cases. In general, the optimal exchange rate policy is to permit theappropriate degree of exchange rate flexibility. Roper and Turnovsky (1980) also
analyze the optimal intervention policy rule in the stochastie open macro model.
The conclusion is the same in that the polar cases of perfectly fixed and flexible rates

are not generally optimal to the economy which faces domestic and foreign
disturbances. Even if the foreign interest rate changes, a flexible rate is not theideal insulator from this foreign monetary shock for stabilization of domestic income.
The sufficient conditions for a perfect flexible rate to be optimal are that there are no

disturbances in the money market and the interest elasticity of the demand for money
is zero. On the other hand, the sufficient condition to ensure that a fixed rate is

optimal is that the disturbances occur only in the domestic money markdt. These
analyses are based on the assumption that the price of domestic output is constant ina small open economy, and the objective of exchange intervention is minimizing thevariance of output about its target level. Later, Turnovsky (1983a) analyzes the
problem in a stochstic rational expectations model of the small open economy inwhich the domestic price is endogenously determined under the assumption of

SYSTEM:A SURVEY 37
ON REFORM OF THE INTERNATIONALMONETARY

purchasing power parity. Similarly, fixed or flexible rates are not in general
optimal to minimize a weighted average of the asymptotic variances of the domestic

output and the domestic price level. The optimal intervention policy may inv61ve
either leaning against the wind or leaning with the wind, depending upon the sourcesof random disturbances impinging on the domestic economy. A fixed rate is optimalin the case that the only disturbance occurs in the domestic monetary market. A
flexible rate does not provide perfect insulation from foreign monetary disturbances.

The conclusion stiggests that the appropriate choice of intervention policy is
extremely difficult, being highly sensitive to relevant parameters in the domestic

economy as well as the random disturbances impinging on the economy.
More recently, it has been recognized that the choice between fixed and flexible

exchange rate systems depends on wage behavior, that is, whether wages are indexed
or not. Marston (1982) shows in an extended small country model taking account ofwage indexation and flexible prices that first the difference in output variation
between fixed and flexible rates depends on wage behavior in the domestic economy.
The more highly indexed is the economy, the less difference the choice of exchange
rate system makes for output variation. With full indexation, output variation is

identical•in two systems. Secondly, foreign wage behavior is also to be of key
importance, since full wage indexation abroad can insulate the domestic country

completely from foreign monetary disturbances regardless of domestic behavior,
while for other disturbances it is the relative degree of wage indexation which
determines the desirability of flexible rates.

On the other hand, it also has been recognized that the optimal degtee of wage

indexation depends on the prevailing exchange rate system. Flood and Marion(1982) showed that a small open economy with fixed exchange rates shouid adopt a
complete wage indexation whereas an economy with flexible exchange rates should
adopt a partial wage indexation in taking account of foreign disturbances, following

an optimal degree of wage indexation in a closed economy developed by Gray (1976).
For the small open economy, a fixed exchange rate system provides full insulationfrom foreign disturbances when indexation is optimal (full), but is unambiguously
inferior to a flexible rate system in term of its ability to minimize output variance.

The optimal degree of foreign exchange intervention under an exogenously given

degree of wage indexation and the optimal degree of wage indexation under an

exogenously given exchange rate systern have been analyzed independently.
However, they are interrelated and should be simultaneously determined as a joint

optimization problem in a stochastic macroeconomic model which incorporates theinternational transmission of disturbances. Turnovsky (1983b) emphasizes theinterdependence between wage indexation and exchange market intervention as

38

HIDEKI IZAWA

policy instruments of macroeconomic stabilization in a small open economy subject tostochastic disturbances. It is shown how the choice of either policy instrument
impinges on the effectiveness of the other. If the domestic wage is fully indexed todornestic cost of living, then exchange market intervention becomes ineffective instabilizing real output. Likewise, under a partjcular intervention rule wage
indexation becomes ineffective. Aizenman and Frenkel (1985) also deal with thedesign of wage indexation and foreign exchange intervention in a small open economy

subject to stochastic shocks. One of the main results is that the adoption of the
optimal set of monetary policy rules results in the complete elimination of the welfare

loss arising from the existence of nominal wage contracts and the simple indexation

rule. It shows that the number of independent indicators which govern a monetary
policy aiming at the elimination of a distortion must equal the number of independentsources of information (in their analysis, exchange rate, foreign interest rate shock,and foreign price shock), which influence the determination of the undistorted (ormarket-clearing) equilibrium, and that with a sufficient number of independent
indicators for monetary policy, there may be no need to introduce wage indexation.
By the same token, it is also shown that for an economy that is not able to choose
freely ari exchange rate system (namely, the coefficient of an exchange rate in nominal
money supply function), the welfare loss can still be eliminated by the (constrained)

monetary policy with an optimal rule for wage indexation.
More recently, Turnovsky (1987) generated the analysis of the interdependence

between the optimal degree of wage indexation and optimal monetary policy which
adjusts the money supply in accordance with observed movements in the financial

and price variables for a small open economy under a variety of assumptions
regarding: (i) the relative information available to private agents and the publicauthority; (ii) the perceived nature of the disturbances impinging on the economy(transitory or permanent). Several conclusions are worth noting. First, if bothprivate agents and monetary authority have same perfect information, then perfectstabilization for replicating the output of the frictionless economy can be achieved

either by a wage indexation adjusting to the unanticipated change in price and theunanticipated change in output as well, or by an appropriate but simply specified
monetary rule. Next, when disturbances are unanticipated with incomplete information, we should draw the distinction between those perceived as transitory (white
noise) and those perceived as permanent. In the former case, the distortion due tothe one-period wage contract can be fully eliminated, as long as private agents and themonetary authority have the same imperfect information. However, when private

agents can observe transitory shocks and the monetary authority can not, thefrictionless economy cannot be replicated because of the inferior information

SYSTEM:A SURVEY 39
INTERNATIONALON REFORM OF THE
MONETARY

available to the monetary authority. On the other hand, for the perceived permanent

shock, perfect stabilization is achieved whether or not private agents and themonetary authority have identical information. Even when private agents areunable to decide whether or not a disturbance which occurs is transitory or
permanent, perfect stabilization can be achieved with identical imperfect information

between private and public agents.
The small open economy models used often so far have advantage of analytic
simplicity and convenience. However, the assumption that a small open economy
can choose unilaterally and freely whatever the optimal exchange rate system may besince she does not influence the large economy (or rest of the world), is too restrictive

to deal with significantly the issue of the optimal international monetary systemamong the economically interdependent large (not small) industrial countries.
Therefore, we shall extend the choice of optimal foreign exchange intervention in asmall open economy into the framework of the two-country model.
(ii) The choice of foreign exchange interyention in the two-country model
Turnovsky and d'Orey (1986) provide the symmetric two-country deterministic
macroeconomic model in which each economy specializes in the production of a
distinct good and trades a common bond.

Y=ai Y' -a2(I-P)+a3( P' +S-P) (1)Y' =aiY-a2( IL P')-a3( P' +S- P) (1')
O<ai<1, a2>O, ,a3>O

M-P=B,Y-B,I
(2)
M'-P'
=B,
Y'
-B,I*
(2')
B,>o, B,>o

I== I' +S (3) (4)C=6P+(1-6)(P'+S)
C' =aP' +(1 -a)(P-S) (4t)
1/2<6<1.

7>O'

P' =7Y' (5')

notatlon:

Y = real output, measured as a deviation from its natural rate level

P = price of output

M= nominal money supply

HIDEKI IZAWA40

I = nominal interest rate
S = exchange rate, expressed in terms of units of domestic currency per unitof foreign currency
C = consumer price index
Domestic variables are unstarred and foreign variables are denoted with asterisks.
All variables except interest rates are expressed in logarithms.
' Equations (1) and (1') represent the goods market equilibrium conditions in eacheconomy. Demand for output depends on the output in the other country, realinterest rate, and the relative price (real exchange rate). Equations (2) and (2')
describe the money market equilibrium conditions, respectively. It is assumed thatthe residents of each country do not hold the currency of the other country. The
perfect substitutabitity between domestic and foreign bonds is specified by the
uncovered interest rate parity (3). Equations (4) and (4') define the consumer priceindex which is a weighted average of price of domestic output and domestic price of

foreign output. Finally, equations (5) and (5') describe the price adjustment
equations without expected rates of inflation.

Soiving for Y, Y', and S,

Y=Åë IM +Åë 2M' +Åë 3S
Y' = di 2M + di IM' -Åë3S

S= -7 ,m +V im' +V 2s
where
s= P' +S-P : real exchange rate,

m=M-P, m' =M'-P' : real money supply at home and abroad,di,- S2 (-B-+ B, j, Åë,- Z2 (-B-- B, j, Åë,- BBS3,

1+ai-a27 2Bia3?1= D, , 72= D, ,tt
D=B2(1 -ai -a27) +Bia2,
D' =P2( 1+ai- a27) +Bia2.
'

We assume that1-ai-a27>Q. It follows that D' >D>Oand hence Åëi>Åë2>O.
And the rates of CPI inflation can be expressed in terms of m, m', and s,

c == e,m + e2m. + 63s,

Ci = E2m + eim'- e3s,
where

ON REFORM OF THE INTERNATIONAL MONETARY SYSTEM: A SURVEY 41

6,=7[a Åë, +(1-6)Åë,]-7,(1 -a),e2 == 7[6 Åë2+(1-6)Åë,]+n,(1-6) >O,e, =7 Åë,(26- 1)+7,(1 -a) >O.
The policymakers are assumed to choose thier respective money supply tominimize their loss functions defined in terms of deviations in output fromequilibrium and the rate of inflation of consumer price.

L = aY2 +(1 -a)C2, O< a< 1,
L' = aY'2 +(1 -a)C'2
Given the assumption that prices move gradually at home and abroad, we assume thatprices can be observed at each time. Thus the authorities control real money
supplies, m and m'. And the nominal exchange rate is also observable instantaneously. Thus the relative price (s) is observable at each time. The optimalmonetary policies can be obtained as feedback solution in terms of s.
(1) Under non-cooperative Nash equilibrium, given the symmetry of the economies,

the moneatry rules require the equal and opposite adjustment of the real money

supply to the real exchange rate. .
M=-(Pi/(ipii-Åëi2)]S, M' =-M
where

ip n=aP i2 +(1 -a)e 2i > O,
ip i2 == adi iÅë2+(1-a)6ie2,

Pi=aÅëiÅë3+(1-a) ei63.
The coefficient of response may be positive (leaning with the wind) or negative(leaning against the wind). But, this solution is not optimal, since each policymakerdoes not take account of externalities (or spillover effect).

(2) Under cooperative equilibrium, the two policymakers collude to minimize theiraggregate joint loss function;(L+V)/2 =[a(Y2+Y"2)+(1-a)(c2+C'2)]/2
The optimal cooperative solution ism=-i(Pi'P2)1(Åën+ip22-2Åëi2)ls• m'=-mwhere
Åë22 = aÅë 22 +(1 -a)e 22 > o,P2=aÅë2Åë3+(1-a)62e3>O.

42

HIDEKI IZAWA(3) Under a perfectly flexible exchange rate system, m = m' = O.

(4) Under a fixed exchange rate system(S= O), we use a symmetric monetary

policy; m=(7212qi)s, m' =- m•
Their simulation results for a unit positive shock in the relative price (s) under aparticular parameter sets show that in general, the purely flexible exchange rate

regime performs extremely well, being nearly as satisfactory as the cooperative
solution and being substantially superior to the Nash solution and a fixed exchange
rate reglme.

(iii) International policy coordination
To begin with, we can define the term of international policy coordination; theagreement by countries to a cooperative policies which are better off relative to thenon-cooperative Nash equilibrium. And it may be probably possible to defineinternational policy eooperation quite broadly, including the exchange of information

among policymakers. However, in this paper, the two terms are used as synonyms.
The proposition that international policy cooperation always improves welfare

may not hold when we relax the assumption of full imformation.
Frankel (1988) identify serious obstacles at three stages. At the first stage,

each country must decide what specific policy should undertake. At the second
stage, the countries must negotiate how the gains from coordination are to be

distributed. At the third stage, the agreement must be enforced, including a
specification as to what should be done if the agreement is violated. Further, there
are difficulties at the first stage;(1) Where does the initial position of the domestic country lie relative to the
optimum values of the target variables?

(2) What are the correct weights to put on the various target variables?
(3) What' are the policy multipliers?3)
Nevertheless, the most of all literatures on international macroeconomic policy

coordination makes the unrealistic assumption that policy-makers know the `true'model, from which it follows in general that the cooperative solutions are superior to

the Nash non-cooperative solutions. However, it is not true once we recognize thatpolicy-makers disagree on the true model.
Frankel and Rockett (1988) provide the pessimistic result when international
policymakers do not agree on the true macroe,conomic model. Using ten econometricmodels that could represent U. S. beliefs, non-U. S. beliefs, and the true model, they3) Bryant, R., et al,, eds., {1988) provides the present level of knowledge of the empirical study on theeconomic interactions in the interdependent world economy,

ON REFORM OF THE INTERNATIONAL MONETARY SYSTEM: A SURVEY 43

find that out of 1,OOO combinations, monetary coordination improves U. S. welfare in
only 546 cases, and improves the welfare of the other countries in only 539 cases.

As Frankel and Rockett also recognize, it is not sensible to assume that eachpolicymaker acts as if he knows with certainty to which model he considers to becorrect or to which model his opponent subscribes. The problem of model
uncertainty is analyzed by,Ghosh and Masson (1988). They introduce model
uncertainty in the sense of parametar uncertainty at the small two-region macro

structual model and show that model uncertainty, far from precluding policy
coordination, may in fact provide a strong incentive for countries to coordinate thiermacroeconomic policies, in contrast to the conclusion by Frankel and Rockett.

Let us consider the effects of model uncertainty on the gains from policy
coordination in a very simple model. Policymakers are assumed to minimize theexpected welfare loss function defined over price level subject to its linear
reduced-form equation;

MinL=E ( P2 )72
M

s. t. P=eiM+e2M'+e,where P is the price level, e is a common price shock, M is the money supply in thedomestic country, and M' is the money supply in the foreign country. The
coefficient ei represents the effect of the domestic country's money supply on its

own price level, whereas e2 represents the effect of the foreign policy on thedomestic country's price level. A similar loss function and reduced form of foreign

price level apply to the symmetric foreign country;

Min V=E (P'2)12
M'

s. t. P' = eiM' + e2M +e,
Now suppose that the multipliers ei and e2 are uncertain, with means pt i, pt 2,

and o2i, o22, respectively,

The symmetric Nash solutions are given by

M= M' = - e1(pt i+A2 +o2i f#i ),On the other hand, under a cooperative regime, a single policy-maker minimizes ajoint loss function

Min W=(L+ L')/2
M, M'
And the cooperative equilibrium is given by

HIDEKI IZAWA

44

M= M' = - e/[pt i +#2 + (a 2i +o22)/(pt i + pt2) ],Therefore, unless pt i a 22 = Y2O 2i holds, then the Nash equilibria and cooperativeequilibria differ, and there would be gains from coordination. The use of policy
instrument brings the mean value of target variables closer to their bliss points but

also increases their variances around their means. Therefore the policymaker faces
a mean-variance trade-off in the use of his instruments. In Nash equilibrium, eachgovernment treats the variances from the foreign instrument as exogenous additive
uncertainty, so that the Nash equilibrium is inefficient. On the contrary, when there
is no parameter uncertainty (that is, a 2i = a 22 = O ), then the equation above•holds,

and the Nash and cooperative equilibria coincide so that there are no gains frorn

policy coordination. Here each country has one instrument and one target so thatthe two countries can achieve their the first-best outcomes without coordination.
Consider next a model in which each country has two targets, the price level andthe level of 'output, but only one instrument, the money. supply.
It is shown that the incentive to coordinate policies depends crucially on thesource of the uncertainty. When transmission effects ( pt 2) is unknown, the greater
is the uncertainty ( a 22), the greater are unambiguously the gains from coordination.

However, when the effect of domestic policies on the domestic economy (pti) is
uncertain, an increase in the uncertainty ( O 2i> may either increase or decrease theexpected value of gains from coordination. In the limiting case of a2i=oo, theoptimal policy under both Nash and cooperative solutions, is no active use of

instruments; M = M' = O.
It is shown that in simulations where policymakers explicitly recognize model

uncertainty, the expected gains from policy coordination relative to the Nashequilibrium increase considerably.
In addition to model disagreement and model uncertainty mentioned above, there
is also the issue of credibility or reputation, as shown in Table 2.

Table 2
relationshipbetweengovernments

relationshipbetween

cooperation

non-cooperation

(C)

(NC>

reputation(R)

CR

NCR

non-reputation(NR)

CNR

NCNR

governmentsand-prlvatesector(source) Currie, Levine, and Vidalis (1987) p. 76

ON REFORM OFSYSTEM:A SURVEY 45
THEINTERNATIONALMONETARY
The matrix yields four policy types. First, reputational policies correspond to
the full optimal rule. But, such policies are time-inconsistent since governments havean incentive to reoptimize later. Non-reputational policies correspond to thebackward dynamic programming optimization solution, which is time-consistent.

On the other hand, under cooperation, the two governments jointly adopt a
Pareto-efficient policy, which maximizes a weighted average of their respective

objective functions. 'Under non-cooperation, each government maximizes its own
objective function, taking as given the policy of the other government. Although thecooperative and reputational policy (CR) is the best, there is the question ofsustainability in two aspects. First, there is the issue of whether governments,
either jointly or individually, would find it advantageous to renege on the private
sector, losing their reputation and switching to a non-reputational policy. This is

the issue of time-inconsistency. Second, there is the question of whether either
government would find it advantageous to renege on the other government, switching
to a non-cooperative policy. They conclude that to obtain the gains from cooperation
requires reputation, and to obtain the benefits of reputation requires cooperation.

Rogoff (1985) and Kawai (1989), for example, show analytical argument that in
one-shot game, the outcome for both countries under the cooperative non-reputational

policy (CNR) may be dominated by one under the non-cooperative non-reputational

policy (NCNR).
Rogoff (1985) shows that increased international monetary policy cooperation
might be counterproductive, since cooperation between central banks can exacerbate
the credibility problem of central banks and vis-a-vis the private sector, and may

raise the rate of wage inflation. Kawai (1989) also provides the symmetricdeterministic two-country macro model which incorporates explicitly the credibilityof the private sector, but for the simplicity, assuming the steady state without

uncertainty. When the domestic and foreign countries commit to money supply
target and the private sector give it the credibility, the monetary authorities in thetwo countries can maximize the utilities, regardless international monetary policy
coordination or not. However, the optimal policy is time-incosistent, because oncethe private sector believes in money supply commitment leading to zero inflation and
expects zero rate of inflation, the monetary authority has an incentive to deviate fromthe initial money supply target and cause an unanticipated inflation to raise an output

higher than its natural rate so as to maximize its utility. So when the monetary
authority loses the credibility, international policy cooperation makes necessarily

decrease the utility relative to international non-cooperation (the Nash solution

among the two authorities and the private sector).

The following general result in game theory can be applied here. When all

HIDEKI IZAWA

46

players in a game cooperate, their payoffs are improved relative to those in theabsence of cooperation. But, when only asubset of players cooperate, the outcome

may be worse off than in a case where nobody cooperates.

III The Fixed Exchange Rates(i) "A International Gold Standard without Gold" by McKinnon
The proposal by McKinnon (1984, 1986, 1988) can be summarized as follows.
1. Rigidly fixed nominal exchange rates (within narrow bands) of the yen-dollar
and mark-dollar, officially announced to achieve rough purchasing power parities
among the three counties; the United States, Japan, and West Germany (represent-

ing EMS).
2. A commitment to adjust domestic monetary policies symmetrically among thethree counties to maintain these targets.
3. Rules for symmetrical, unsterilized, direct interventions to correct `disorderly

conditions' in the foreign exchanges.

4. Joint management of aggregate money growth, the sum of domestic credit
expansion as an intermediate targets within the triumvirate in order to stabilize
their common (wholesale) price level in internationally traded goods in the longer

run, as the nominal anchor for the system.
McKinnon argues that it is feasible for monetary cooperation among the three
central banks to achieve fixed parities and roughly the same rates of wholesale priceinflation, without returning to a gold standard.

(ii) The arguments against McKinnon's proposal
Dornbusch (1987, 1988) criticizes McKinnon.
The exchange rate-oriented monetary policy seems to solve the problem ofcurrency instability by accommodating money demand shifts if the dominant sourceof disturbances is shifts in money demand from one country's Mi to another's, i. e.

currency substitution. But, carrying the idea by Poole (1970) over to exchange
rates as intermediate targets, when international portfolio shifts takes the form ofshifts in the demand for bonds denominated in different currencies, the right policy

recommendation is not unsterilized intervention a la McKinnon but sterilizedintervention. In response to exchange rate appreciation, the authorities shouldintervene, leaving money supplies unchanged but increasing the supply of domestic

bonds and reducing the supp.Jy of foreign bonds. Furthermore, the remaining
problem is whether it is shifts in international portfolio or shifts in fundamentals thatare moving exchange rates. If there are real disturbances, then exchange rate

SYSTEM:A SURVEY 47
ON REFORM OF THE
INTERNATIONALMONETARY
targeting by intervention is altogether inappropriate.4>

Purchasing power parity (PPP) is not a good guide to equilibrium exchange rates
since goods among the three countries are not perfect substitutes and hence the law of

one price or spatial arbitrage are irrelevant. PPP is only appropriate to a world
where equilibrium relative prices never change, Further, with fixed exchange rates
but different rates of productivity growth in tradable goods, there may be very strong

divergences in inflation rates including non-tradable goods and services. When one
country experiences productivity growth at a rate higher than the other, they cannot

have the same rate of inflation.
In fact, there is little theoretical or empirical basis for McKinnon's proposal.

So, we compare in the symmetric two-country stochastic macro model between theflexible and fixed exchange rate systems with optimal degrees of wage indexation.
Using the model by Turnovsky and Bianconi (1989), we firstly determine the optimal
degrees of wage indexation under both flexible and fixed exchange rate systems andthen compare non-cooperative Nash and cooperative Pareto-optimal equilibria undereach system. Thus we can evaluate theoretically the McKinnon's proposal, based on

the model in which includes the fixed nominal exchange rate, purchasing power
parity, and symmetric monetary policy.
The following system is represented in terms of deviation from equilibria.
Pt = P't + S,

Yt + Y't =a1(Yt + Yt')-a2[I, -(E,Pt+1 -

(6)

Pt)]

-a2[ I't - ( EtP't+i - P't)] + Ut

(7)

O<ai<1, a2>O
M, - P, == BIY, -P2I,(8)M', - P*, = BIY', - B 2I',(8')

iEl ,, B, >O
It = l', + EtSt+1 - S,

(9)

Y, == 7 •z( P, - E, - IP,)+ V,(10)Y', =7 . z* (P', - E,-IP',) + V',

(10')

7> O,
O<m z, z' <. 1

where z=1-r, z' == 1-T•

4) See the theoretical analysis by Fukuda and Hamada (1988) on optimal monetary feedback rules of theadditive and difference systems in the symmetric two-country dynamic stochastic macro models.

48 HIDEKI IZAWA
notatlon:

Y = real output (measured in deviations from the natural rate level),

P =price of output,
S = exchange rate in terms of units of domestic currency per unit of foreign

currency,

M =nominal money supply,
I = nominal interest rate,
Et == rational expectation conditioned on information at t,

U = stochastic disturbance in world goods market,
V =: stochastic disturbance in supply,
All variable except interest rates are expressed in logarithms. Foreign variables

are denoted by asterisks (').

Equation (6) represents the purchasing power parity condition. Equation (7)describes the equilibrium condition of the world goods market. Demand for
aggregate output depends on the aggregate income in the world, the expected realinterest rates in the two economies, and the world demand shock. Equations (8) and(8') represent the money market equilibrium conditions. The perfect substitutability between domestic and foreign bonds is described by the uncovered interest rate
parity condition (9). Finally, equations (10) and (10') describe aggregate supply
functions derived from the one period wage contract model. The deviation in output
from its natural rate level is postulated to be a positive function of unanticipatedchange in the price level, as well as the stochastic supply (or productivity) shock.

The degrees of wage indexation, T and T ' which are the policy decision variables,
are incorporated in the parameters z and z', thereby influencing the slopes of therespective aggregate supply curves. For example, when wage indexations are full,r=T'=1 corresponding to z=z•=O, outputs are affected by only supply
shocks.

The stochastic variables U, V, and V' are assumed to be independently
distributed over time with zero means and finite variances. Moreover, while
demand and supply shocks are assumed to be uncorrelated, the supply shocks in two

countries may or may not be correlated.
Under such assumptions, the rational expectations solution to the model implies
that all expectations are zero, so thatEt Pt+i = EtP't+i = EtSt+i = O. for any t
The existence of nominal wage contract introduces rigidity into the economy,
thereby leading to welfare losses relative to a frictionless economy in which wages

ON REFORM OF THE INTERNATIONAL MONETARY SYSTEM: A SURVEY 49
are perfectly flexible and labor market clears. The role of wage indexation scheme
is to replicate as closely as possible the income in the frictionless economy (Yt, Y't).

Yt=[,#e, Vt•
Y't=(,#e, V't
where n is the elasticity of supply of labor with respect to the real wage.
Under non-cooperative game, the optimal degrees of wage indexation, T and T '(or z, z*) are ch6sen so as to minimi'ze the variances of output around the respective

frictionless levels, taking the behavior of the opponent as given.

Min L (z, z')= EtiY, - Y, ]2,z
Min L' (z, z' ) = E, [ Y', - Y', ]2z'Under cooperative game, z and z' are chosen so as to minimize the aggregate ofloss functions by single policymaker.
First of all, under the perfectly flexible exchange rate system, Mt = M't = O,solving for Yt and Y't from (6)-(10'),

Yt=a(z, z')Vt+b(z, z')V't+c(z, z')Ut,
Y', = b(z', z)V, +a(z', z)V't +c(z', z)Ut,
where

X2Y + X3a( X, Y) == x,xy + x, (x +y) + x, > O'
x= z, z", y=z, z', x#y,

7 xX,b( X, Y) = x,.y + x, (x + y) + X, <- O'

7x( Xsy + X6 )C(X' Y)= X,xy +X2(x+y)+ X3 -> O'
andx, =- 272( Sl [(i-ai)+a2• fil>O,x2 =Bi( i+B B, 2)[(i-ai)+2a2• Sl ]>O,

x3=2a2 1+p2P2)>o,50

HIDEKI IZAWA

X4 :-(1 'a,) 1 +p ,B2)< o,
7Bi

Xs= B, >O•
1+B2

X6= B, >O•
Solving for St under the flexible exchange rate system,

S, = ; X, [ zV,' - z'V,]+ 2B, iili X6 (V', - V, )+ Xg ( zi -z) •Ut /[XiZZ' + X2 (Z+ Z')+ X3 ]On the other hand, the solutions for outputs under the fixed exchange rate

system (S =O) with M=- M',
Yt=d(z, z')Vt+e(z, z')Vt'+f(z, z')Ut,
Y't =e(z', z)Vt +d( z', z)V't +f(z', z) Ut,
where

Si+62yd(X, Y)= 6,+a,(x+y) >O, x=z, z", y=z, z', xIy-62xe(x• y)==a,+6,(.+y) SO•
7B2x
f(X' Y) -- ai+62(x+y) -> O'
and

6i == 2a2(1 +P2 )/P2 > O,
a2Bi

)>o.
a2=7[(1-ai)+
B,
Under the flexible exchange rate system, in general, non-cooperative Nashequilibrium leads to overindexation of wage relative to the Pareto-optimal coopera-

tive equilibrium. And under the fixed exchange rate system, the non-cooperativeand cooperative equilibria coincide. Fixing the exchange rate eliminates any further
gains from cooperating on wage policy, since the externality caused by foreign wage
policy is eliminated.

Because the optimal solutions for indexations and the values of loss functions

ON REFORM OF THE INTERNATIONAL MONETARY SYSTEM: A SURVEY 51

are complex functions of the underlying parameters of the model and variances ofstochastic shocks, Turnovsky and Bianconi resort to numerical analysis to getfurther insights into the general welfare implication of the different strategic
equilibria under the different exchange rate systems. The set of parameter values
for simulation is as follows.

ai = O.65, a2 = O.25, Bi = 1.00, B2 = O.5, 7 == 1.s,n =: O.15.
In comparison between flexible and fixed exchange rate systems, the flexible rate

system with optimal indexation, in general, is superior to the fixed rate system. It

has an implication of a case against McKinnon's proposal. Moreover, theirnumerical calculation indicates that the gains from cooperation under the flexible

exchange rate are extremely small while they are zero under the fixed rate.

x

IV Target Zones5)(i) A `blueprint' by Williamson and Miller
Williamson advocates that countries should agree on target zones for exchange rates

in order to limit misalignment. Williamson and Miller (1987) state the following;

The participating countries agree that they will conduct their macroeconomic
policies with a view to pursuing the following two intermediate targets:(1) A rate of growth of domestic demand in each country calculated according to a

formula designed to promote the fastest growth of output consistent with gradualreduction of inflation to an acceptable level and agreed adjustment of the current

account of the balance of payments.
<2) A real effective exchange rate that will not deviate by more than 10 percent
from an internationally agreed estimate of `fundamental equilibrium exchange rate',
the rate estimated to be consistent with simuitaneous internal and external balance inthe medium term.
To that end, the participants agree that they will modify their monetary andfiscal policies according to the following principles:(A) The average level of world (real) short-term interest rates should be revised up(down) if aggregate growth of nominal income is threatening to exceed (fall short of)

the sum of the target growth of nominal demand for the participating countries.
(B) Differences in short-term interest rates among countries should be revisedwhen necessary to supplement intervention in the exchange market to prevent the5) See Frenkel and Goldstein (1986) 'in detail on,target zones,

52

HIDEKI IZAWA

deviation of currencies from their target ranges.
(C) National fiscal policies should be revised with a view to achieving nationaltarget rates of growth of domestic demand.
The rules (A) to (C) should be constrained by the midium-term objectives ofmaintaining the real interest rate in its historically normal range and of avoiding an

increasing or excessive ratio of public debt to GNP.

Rule (A) deals with the (n'1) problem in a McKinnonesque way (termd"McKinnon without the monetarism"), assuming that aggregate monetary policy
should be guided by the collective need of the participating countries. Rule (B)embodies the essence of the target zone system. Rule (C) endorses Keynesian fiscal
policy.

A technical difficulty in the scheme is the ambiguous notion of `fundamental
equilibrium exchange rate (FEER)'. It is difficult to estimate and internationallyagree on it since its definition involves appropriate equilibrium current balance orequivalently, the underlying capital flow. And, in reality, fiscal policy is not flexible

and there is need for correcting U. S. budget deficit.

The key point made by proponents of target zones is that such a system
encompasses the best of the both systems; the flexibility of the flexible exchange rate

system as well as the stability of the fixed exchange rate system. Monetary policy
can pursue internal objectives within a wide band. However, the same logic can beused to argue that this hybrid system encompasses the worst of both systems; theinstability of flexible rates and the unsustainability of fixed rates.
In contrast to fixed rates, the FEER is changeable as well as crawing peg in the
future so that the target zone loses credibility in the absence of an anchor and would

remain vulnerable to speculative attack.

(ii) Exchange rate dynamics in target zones
Krugman (1988) analyzes theoretically how the exchange rate behaves wjthin a band

under the credible target zone when `fundamentals' follow a random walk. The
remarkable result is that the expectation which the monetary authority will defend
the band by intervening at the upper or lower edge exerts a more stabilizing effect on

the exchange rate behavior inside the band than under the freely floating system,

even when the authority is not actively intervening.

We summarize his stochastic process model briefly.
The log of the spot exchange rate (s) is assumed to be determined by two factors:`fundamentals' (x) which evolve exogenously over time as explained below, and the
expected rate of exchange rate, E (ds/dt).

ON REFORM OF THE INTERNATIONAL MONETARY SYSTEM: A SURVEY 53

s(t)=x(t) +7 'E[ ds (t)/ dt II,] (1 1)
The fundamentals (x) is assumed to follow a diffusion process without a drift

over time. The increment of the diffusion process is represented bydx(t) =a'dz(t) (12)where dz is an increment of a standard Brownian motion or Wiener motion or white
noise, z (t) -- N (O, t). Hence, dx is independent and normally distributed with mean

zero and variance over the interval dt, o2'dt, where a is a constant. Equation(12) is the continuous type version of a random walk without drift (or time trend).

The monetary authority can control x (for example, money supply) throughintervention at edges, so that x need not follow (12) under the target zone.
The way to solve for the exchange rate dynamics inside the target zone is to look
for an equilibrium function, s = g <x) such that satisfies (11). The general solutionis

s=g(x)=x+ AeAx + Be -ax

where A =tw > O
If A = - B holds, then g (O) = O, and the target zone is symmetically centeredaround zero.

s=x+A[eAX-e-AX], A<o
The expected change in the exchange rate, E (ds/dt) = a 2 • g" (x) / 2 is negativein the upper part of the target zone, where g(x) is concave. This drags the exchange

rate below the fundamentals. Conversely, the expected change in the exchange rate
is positive in the lower part of the target zone, where g (x) is convex. This drags theexchange rate above fundamentals. Figure 2 shows the relationship between theexchange rate and fundamentals as S-shaped curve flatter than 45-degree line s (t) =x (t), which is the no-boundary saddlepath solution (the case of A = B = O)under apermanent free floating system, ruling out bubble solutions. The curve g (x) istangent to the top and the bottom of the band.
Because the market has a regressive expectation that the authority will defend
the zone in the future, the target zone has a stabilizing effect on the exchange rate

within the band, depending on parameters, 7 (the sensitivity of the spot exchange
rate to the expected rate of depreciation) and o 2 (the volatility of fundamentals).
But, when the exchange rate reaches the upper edge of the zone s, if the authorities do

not defend the band, the exchange rate will jump to the 45-degree line at x6).

HIDEKI IZAWA

54
exchangerates

45 degreline:

UpperEdgeg,s=g(x)
o

IX

:

x

r

xfun

fundamentals

LowerEdges-t(source) Krugman, P. <1988)

Figure 2

V Concluding Remarks
As Frenkel and Goldstein (1989, p. 24) point out, one of the problems in open
economy macroeconomics is that it is impossible to simultaneously achieve (1)independent monetary policy, (2) fixed exchange rates, and (3) free international
capital markets: the best one can do is to achieve any two of the three. The reform ofinternational monetary system is basically about which two to pick, From the lessonsof the Bretton Woods system, fixed exchange rates cannot be maintained without
extensive capital controls. For the industrial countries after 1973, fixed exchange

rates were dropped and flexible exchange rates were chosen to obtain autonomy ofmonetary policy (national monetarism) and to admit international capital movements.

However, because of volatility and misalignment of exchange rates, and the lack ofinternational policy coordination in the economically interdependent world economy,

several proposals have been discussed to improve the function of the internationalmonetary system. First, even if the present international monetary system is notwrong, international macroeconomic policy coordination instead of intlependent

monetary policy is .needed in the increasingly interdependent world economy.
X 6) Furthermore, Miller, Weller, and Williamson (1989) have examined the stabilizing property of target
zones even when the foreign exchange market suffers from two stylized forms of market inefficiency,that is, Blanchard's `rational bubbles' and autoregreessive `fads' attributable to noise traders <orchartists).

ON REFORM OF THE INTERNATIONALA SURVEY 55
MONETARY SYSTEM:

Similarly, whether to reestablish fixed exchange rates according to McKinnon's
proposal, or to set target zone according to Williamson, independent monetary policy

must be changed to multilateral and coordinated monetary policy. Second, although

we did not discuss in the text, Tobin (1978) recommends worldwide uniform tax on
all spot foreign exchange transactions to deter excessive international hot money
round-trip. The cost from `throwing some sand in the wheels of excessively efficientinternational money markets' should be weighed against the benefits from theefficient international capital markets or trend of international financial liberaliza-

tion. Third, from the experiences of some developing countries, the radical proposalof a dual exchange rate system also draws from the problem of volatile short-term

capital flows. Governments would establish a fixed (or rigid crawing peg withtrend) exchange rate for commercial trade transaction. But for all capital accounttransactions the exchange rate would be flexible. A separate exchange rate would
detach the capital account and deprive it from distorting influenees on trade andinflation. Fourth, as to the EC monetary integration in 1992, fixed exchange rate
within the EMS (but float outside the area) and open capital markets are paired withthe abandonment of monetary policy independence.
Needless to say, optimum currency area-the creation of a common currency for
all of the industrial countries, with a common monetary policy and a joint Bank ofIssue, as Cooper (1984) suggests-is the best way to solve n - 1 problem and is theideal vision. But, it is too radical and there seems no practical feasibility in the near

future due to national sovereignty.

As to an empirical study, McKibbin and Sachs (1988) compare the Performanceof the seven alternative international monetary arrangements using a large
simulation model of the world economy consisting of the USA, Japan, the rest of theOECD, OPEC, and the developing countries, Each government chooses its control
variables (or money supply rule) to minimize an intertemporal loss function, which isa weighted average of GDP gap, consumer price inflation, current balance, and budget

deficit. Among pure float, non-cooperation, cooperation, nominal GDP targeting,
McKinnon rule for fixed exchange rates, global Aominal GDP targeting,7} and leaning

with or against the wind, generally speaking, for the country-specific shocks, thecooperative and non-cooperative regimes under a floating exchange rate performbetter than the fixed exchange regimes. However, for an unobserved negatively7) See Frankel (1989) about international nominal targeting (INT). He argues that INT is the best
choice for nominal anchor, as well as the best choice for the performance criterion by which
compliance with international agreements can be monitored. Nominal GNP or nominal demand issuperior to other candidates such as Ml as a candidate for the nominal variable on which
policy-makers should focus, because it is far more robust to velocity shifts and other uncertainties.

56

HIDEKI IZAWA

correlated monetary shock, the fixed exchange rate regime proposed by McKinnon
performs well. While cooperative regime is superior to the others, a gain fromcooperation relative to non-cooperation is empirically small. They conclude that theperformance of each regime depends crucially on the nature and observability of theshocks hitting the world economy. However, the results are model specific.
International monetary system is, by Kindleberger's term, one of international

public goods, but there exists no world government. We need further theoreticaland empirical investigation how the international monetary system can be reformed,

especially among the three major currency blocs; the U. S., Japan, and EMS.

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169 (December, 1987) pp. 61-69,[44]

Turnovsky, S., "Exchange Market Intervention Policies in a Small Open Economy," in Bhandari, J.
and B. Putnam (eds.), Economic Interdepmdence and Flexible Exchange Rates. MIT Press (1983a) pp.

286-311.
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&
REVIEW
KOBEECONOMICBUSINESSCONTENTS
NO. 29 (1983)
An Interpretation of Conventional Accounting
Incomelnformation "''•"""''''•''""''"'-'"''''"-' "''''' ''"""'"" '''''''' '''"" IsaoNakano

AProductionSystemforTransportServices "'''""""''' ''"''' ''''"""" """""' ' TetsujiShimojo
Some Evidences between Foreign Direct Irwestments
and Foreign Exchange Rates:
A Preliminary Note "''"""''''"'-""''''•''''''''"-'-''''''''''''""`"""""''''''''''' Kazuhiro lgawa

Two Types of Railroad Regulation by Statesin the 19th Century of the U.S.
-Search for the Social Foundation of Modern
Corporate Financial Reporting- ''""'''''''"'-''''"'''"''''''''""""''""'''''''''''''' HidetoshiYamaji

NO. 30 (1984)
National Monetary Policy in an International

CapitalMarket '•"''"''''""'''""'""'''-'"'""''"''" ''''"' H"'' '''''"""" JUrgNiehans
Craft Unions, Wages and Employment "'''"'••"'''""''' '""'"' """' """' '''"' Murray C, Kemp
On the Applicability and Implementability ofthe (Finite) Compensation Principle "''''•'"""'''v'"-''""""""""'''''-''''""'•••" Murray C. Kemp
Internationalization of Japanese Commercial Banking-The Recent ExperienceofCity Banks- "'''""'''"'"''""""''''"""""""""'••'' Masahiro Fujita

Kazuya Mizushima
Ryoichi Mikitani
Efficiency of the Least Squares Estimators in

Linear Models with Idempotent CovarianceMatrix of the Error Terms ""-"""""'-`"""""'""'"'`"""""""""'"""""" Hiroshi Sadamichi
Diversification of Large Japanese
Manufacturing Firms "'"""''''"'""''''"'''"'''"'''''"''''''''''"""'''"'--''''''''•-' Hideki Yoshihara
Indexing Policies and Macroeconomic Stability in

Brazil: RationalExpectationModel "'••'''"''''""'"'""""""'''''""'"•""""'•"' ShojiNishijima
A Simple General Equilibrium Model Involving aMaximizingLabourUnion '''""""''''•"'''""••''''''''''''''''''"•"""""''"'''''' Kazuo Shimomura

NO. 31 (1985)
Toward the Negative Picture Theory of Comrnercial
Double-entry Bookkeeping and Financial Accounting -'''"'''''' ''"" """""'"'''''"'"' Isao Nakano
Stability ofthe Demand for Money: Australian Experiences """" " """' """"""" Kenichilshigaki"Empirical Study of Changes in Accounting Policy" in the Case ofJapanese Enterprises "'''""''''"''""''"'''""''••'''"""''"'''"""''''"'''''''"''"` Hidetoshi Yamaji

An Empirical Study on International Short-Term Capital
Movements inJapan '"""'''""""''''"'•'"''''••••''•'''"'•""'''''--''"""••"""'''"''''' Hideki lzawa

NO. 32 (1986)
Import Demand Structural Change in the PacificBasin Countries "'"'••••"'''""•-"''-•••••'"'"'••••'''••••••••••••••••--''••"'""""""" Seiichi Katayarna

Kenichi Ishigaki
A Synthetic Analysis of Structuralist and Monetarist
TheoryofLatinAmericanlnflation "''• -"''''•'•••'''" •••'''' •••""' ••""' '''' ShojiNishijima
Stagflation-Causesand Policies- ••••"'''•••••'"'••-••••'' ••••• •• •••••• ""'" """' ''' NobuoOkishio

A Computable General Equilibrium Model of theJapanese Economy '"''"'-""•••••'••••••••••••••••••-'•••-•••••'''•••••••'"'•••••--'-••••••-i""' Mitsuo Ezaki

NO. 33 (1988)
Agency Problems and Accounting Communication ••••'•`••••"'•••••''''••••"''•••••'"'••ny""'••"'' Isao Nakano

Strategic Corporate lnnovation and 'Japanese Management """"""""'•"""'•'•""''•"""''"""''""""'•""'"`"''•"' Hideki Yoshihara

Financial Deregulation and Financial
RelationshipsbetweenJapanandAustralia ny'"'''•"""'"`"'"''"''""-""'''`•"'""' KeniÅëhiIshigaki

Keynes' User Cost and the Theory ofInternational Trade ''""''"'••''""'t•''""•••ny"'''•'"'""••'''"'-'"'''"•'""'''•"''" Kazuo Shimomura
A Note on International Transmission ofDisturbances and Policy Interdependence
under Flexible Exchange Rates m-'"""'ny••"''''•""''''••""''"''""'""'''""''""'"" Hideki lzawa
Monetary PQIicy and Foreign Disturbances

in a Small Open Economy under Flexible
Exchange Rates and Rational Expectations •••'""••''""'••'""'•••""''••-'""••-'""'••''' Hideki Izawa
ASketch of the Theory of Trade Cycle '-'''''"'"""'''J•t""'-•'"'"'•••i'""---••'--•••••"••• Nobuo Okishio

NO. 34 (1989)
Recent Inflation of Land Prices in Metropolitan

Areas of Japan-A Case Study of Regional Accounting- '•••"''''•••"''"•••••••••••-•••••••••••••••••••••'--•• Nobuko Nosse

Little Basics and Employeeism

Japanese Management inInternational Perspective ""''"''''"'""''•••"'"'•"""''-""'''••'"''''••''""•-''""' Hideki Yoshihara
Bank's Loans to Developing Countries:
ANormative Approach '"'''"''''''••''"'''••""'''•••"''''•••"'''••''"'''••'''"'•••'""'•• Kazuhiro Igawa

Japan's Trade Diplomacy:
Yesterday, Today,Tomorrow '''''''""-''"'"''"'''''""'''""''''"'''"''''''''''"'''"''' PeterDrysdale

A Labour Union in Every Country-A Game-Theoretic Approach- "'••'''""••••'""•••••'''••••'•"'••••''"'••••''''•••••''' Kazuo Shimomura

The Costs and Benefits for Firms of
Accounting lnformation Disclosure """"""""'-•"""•••t--JJ'-•---••-----''"'•"'""' Hidetoshi Yamaji
Increasing Returns to Scale and Optimal
Investment Policy of theRegulated Firm ""'''""'"'""•''""''-"'''"-•••"'''•-""'" Seiichi Katayama

Furnio Abe
Problems and Method of Economics ""'•••"'"'•••••"'••••••"'•••••••''••••'''"'""'''"'""""' Nobuo Okishio
Industrial Organization and Internatiohal Trade-Textile Industries in theWestern Pacific Region- '"••-•'"'••••••"'"'"'''''"'"""''""''"'""•••"''''••"'''"'' Katuhiko lkeda'

NO. 35 (1990)
Some Implications of the Present-ValueBased Depreciation Within the
HistoricalCostFramework ""''"'•••"'"'`•••••ny'••••••ny''••••••••'•••••"'•••••••''•"'''"'''"" IsaoNakano

Foreign Subsidiaries as Contributors

to Parent Companies-A New Paradigm of Multinational
Enterprises--"""'''""''''"''"'"-J-••••••-••-•••••••---••-••••••"•••-•"'•••••''''••••''''•HidekiYoshihara

The Gains from Free Trade for a Monetary
Economy """"""'''''''H'''"''""••''""••'''""•••'"'"•••••••'"''''"'•••"''''•••'''''•• Murray C. Kemp
On the Optimal Timing of Foreign Aid ''••••"''•••••'"''"""''••••'''"••••••t'••••••"'••••••''•• Murray C. Kemp

NgQ Van Long
Kazuo Shimomura
A Simple Union-Ridden General
Equilibrium Modet "•"""'""'"'""""'''"'H''"""'''"""''"•'"••''•••'"""•••••-•' Kazuo Shirnomura
Industrial Policy under International
O!jgopoly '''"''''''"""""""""''""""'""'''"""''""""'"••"••••••••--•••••••ny-•••••••• KenjiKojima

Realtime Distributed Control of World Link Models
in the International Computer Networks "''"''"'"'""""'"'''"'""'••••--''••••••ny'•--••••' Ko Miyazaki

KOBE UNIVERSITY ECONOMIC REVIEW 35, 1989
Edited by Faculty of Economics,
Kobe University, Kobe, JapanCONTENTS
On the Theories of Determination of
the Real Wage Rate ••••••••••••'•••••••••••••••••••••••••H'-•••••••••••••••••••••t•••••••••••••••••• Nobuo Okishio

Monopoly and the Metamorphoses ofBusinessCycles '••••••••••••••••••••••••••••••••••••••••-•••••••••••••••••••••••••••"''""'•''' Takeshi Nakatani

On Cournot-Nash Non-Cooperative Games ••••••••••••••••'"'''•••••••••••••••••••••"""""' Toshitaka Fukuharu

On Interbranch Scientific-Technical Complexes:
A New Soviet Scientific-Technical Organization •••''"'''''•'••••••••••••••••"""""""•• Masahiko Yoshii

On a Theory Concerning International
Fiscal Policies '""""'••ny•••••"''""""'•ny•••••••••••H'-•••••••••••••••••••••••••••••••••••• KunikazuTanaka

Einige Bemerkungen zum Paradigma dertheoretischen Wirtschaftspolitik-Vom Standpunkt der universalistischen
Volkswirtschaftslehre aus "''""""''""""'""''""""••••••••••••••••t''''•••••••••••••• ToshiyaNagao

ttmlvewwNtettme"Nestte-•etd'te•t•m

The ANNALS OF THE SCHOOL OF BUSINESS ADMINISTRATIONKOBE UNIVERSITY No. 35, 1991
Edited by the School of Business Administration,
Kobe University,' Kobe, JapanCONTENTS
Collective Bargaining and Co-determination

intheFRG: TheUniquenessofCoexistence -••••-''"''"""""""•""""'""""" ShyamL.Agarwal
Senior Executive Women ofJapan '"'"""•----•••-••••••,''"''••'•••••••••••••••••"'""""" Barbara B. Bunker

The Intraday Speed of Stock Price Reaction to

Accounting Earnings Announcements: An Empirical
Evidence from the Tokyo Stock Exchange ••••••••••'"''""'''''ny'''''•••••••''"''''''''''''' Masatoshi Goto

The Friedman-Savage Hypothesis and the Downward
Sloping Liquidity Preference Schedule ""''""••••''"''"'"''""""""' Yuzo Honda and Hiroshi Ohta
Informationsfunktion des auBerordentlichen

Berichts nach dem BOrsengesetz in Japan-Eine empirische Analyse- ''''""""''''"'H''"'''"""""""""""'''"""""""""'''' Fumio Naito!tts•sesrN"•tteeNnv"•tetpmrua"tetepmr"m"e•ttteeetetetpmmaN""
KOBE UNIVERSITY LAW REVIEW 23, 1989
International Edition No. 23, 1989
Edited by Faculty of Law Kobe University, Kobe, JapanCONTENTSThe German Monopolies Commission '''"'•••••••••••••••••'"''"'••'•••••••••••••••""""'"""'' Ulrich Immenga

Scandal and Hard Reform:
Implications of a Wiretapping Case to the Controlof Organizational Police Crimes in Japan •••••••••••"'"''"""-""••••••••••"'"""""" Setsuo Miyazawa
Labor Ministry Offensive in Japan:
ACase of Autonomy of the State Agency? ••••••••••••'"`''"'••••••••••••••-••"''''""'"""''''" Ikuo Kume

RESEARCH INSTITUTE FOR ECONOMICS AND
BUSINESS ADMINISTRATION, KOBE UNIVERSITYg ),s,eeee•et,

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HISTORICAL SKETCH
In 1919, a research organization named the Institute for Commerce was founded in
Kobe Higher Commercial School, one of the chief predecessors of Kobe University,with a gift made by F. Kanematsu & Company, a leading mercantile firm in Kobe.
The organization was designed to carry on and facilitate integrated research on
business and commerce and to formulate and publish the results of these studies andinvestigations in such form as to make them available to the business community.

With the founding of Kobe University of Commerce, successor of Kobe Higher
Commercial School, in 1929, the Institute extended its research activities by adding

several divisions. One was the famous Latin-American Library, which soon became
the center of research in this field in Japan. A room for statistics equipped withvarious computing machines was established and began publication of Jityo Keizai
Tokei and Sekai Boeki Tokei annually. A filing room was prepared to deposit press

clipping files systematica!ly arranged by topics and dates. Another room wasdesigned to become the center of all possible original records and data having to dowith the beginning and progress of Japanese business.

On the campus of Kobe University of Commerce, another organization named
the Institute for Business Mechanization was founded in 1941 utilizing businessmachines donated by the IBM Corporation and others. With Professor Yasutaro
Hirai as its head a broad and forward-looking plan for business mechanization in

Japan was developed.
In 1944, Kobe University of Commerce changed its name to Kobe University of

Economics. After the War, however, the University was consolidated with threeother colleges in Hyogo Prefecture to become Kobe University. With thisdevelopment, the two Institutes were also amalgamated into the Research Institute for

Economics andBusiness Administration, Kobe University. At present, the Institute,with its twenty-two full-time professional staff members, carries on studies andinvestigations in international economics, international environment, international

comparative economics, internaitonal business, management information systems andinternational cooperation.

ORGANIZATIONThe Institute consists of six sections. Each section and its research subjects are as
follows:

1. International Economic Studies
International Economics, International Monetary Economics,

Maritime Economics, International Labor Relations
2. International Environmental Studies
Resource Development, International Organizations,International Industrial Adjustment

3. International Comparative Economic Studies
Pacific Basin I (Oceanian Economy),
Pacific Basin II (Latin American Economy),
Pacific Basin III (North American Economy)
4. International Business Studies
Comparative Business, Multinational Enterprise,International Business Finance

5. Management Information Systems
Business and Accounting Information, Information Processing System,
International Comparative Statistics

6. International Cooperation
In addition to the ordinary work of each section, several research committees,whose members are not limited to the Institute staffs, are regularily held to carry on

joint studies. At present, there are ten standing research committees, as follows:

Committee of International Economics, Committee of Maritime Economics, Committeeof Labor Market, Committee of International Studies on Economic and Industrial
Structure, Committee of World Link Model, Committee of International Comparative
Economics, Committee of International Comparative Monetary Systems, Committee ofInternational Business Finance, Committee of Management and Accounting Information Systems, and Committee of International Comparative Statistics.
For convenience and greater efficiency in carrying out its research activities,

the Institute has a general office which is responsible for 1) the collection andpreservation of a comprehensive collection of books, periodicals, pamphlets, andoriginal records and data of finance, trade, commerce, industry and businessgenerally; 2) the classification, cataloguing, indexing, arranging, annotation andcompilation of these research materials; and 3) the formulation and publication of theresults of the investigations and studies accomplished by the professional staff
members of the Institute.
As an affiliated institute, the Documentation Center for Business Analysis has
been established in 1964. It is the first systematic information facilities in the fieldof business administration in Japan that has been recognized and authorized by the
Ministry of Education. The purpose is to collect and to make intensive control of all
kinds of materials on business administration and to make them available to scholars,

universities, governments, and business world with the aid of modern documentation
techniques. 'RESEARCH INSTITUTE FORECONOMICS & BUSINESS ADMINISTRATIONKOBE UNIVERSITY
Director: Isao NAKANOSecretary: Takashi YAMAZOE

INTERNATIONAL ECONOMIC STUDIESInternational Economics
International Monetary Economics

Prof. Kazuhiro IGAwA
Prof. Kazuhiro IGAwA
Assoc. Prof. Hideki IzAwA

Maritime Economics

Prof. Hiromasa YAMAMoTo
Assoc, Prof. Masahiro ToMITA

Prof. Hiromasa YAMAMOTQInternational Labor Relations

Assoc. Prof. Kazuo SHIMOMuRAINTERNATIONAL ENVIRONMENTAL STUDIES
Prof. Hikoji KATANi O

Resource Development

Assistant Akihiro NAKAHARA
Prof. Hiroshi SADAMICHIProf. Hiroshi SADAMICHIInternational Organizations
International Industrial Adjustment

Assistant Ko MiyAzAKIProf. Akira NEGIsHI

INTERNATIONAL COMPARATIVE ECONOMIC STUDIES
Pacific Basin I

Prof. Kenichi IsHIGAKI(Oceanian Economy)

Assistant Ryuzo MIyAo
ProL Yoshiaki NIsHIMuKAI

Pacific Basin II

Assoc. Prof. Shoji NIsHulMA
Prof. Yoshiaki NIsHIMUKAIAssoc. Prof. Seiichi KATAyAMA(Latin American Economy)
Pacific Basin III(North American Economy)

Prof, Hideyuki ADAcHl

INTERNATIONAL BUSINESS STUDIES
Prof, Hideki YosHIHARA
Assoc. Prof. Kenji KoJIMAProÅí Hideki YosHIHARA
Assistant Huang LiN
Assoc, Prof. Hidetoshi YAMAJI

Comparative Business
Multinational EnterpriseInternational Business FinanceProf. Akio MoRI

MANAGEMENT INFORMATION SYSTEMSBusiness and Accounting Information
Information Processing System

Prof. Isao NAKANO
Prof. Isao NAKANo
Assoc. Prof. Komayuki ITow

International Comparative Statistics

Prof. Hiromasa YAMAMoTO
Prof. Yasuo KoNIsHI

INTERNATIONAL COOPERATION

Prof, Chung HooN LEE

Assoc. Prof, Norio OBATA
DOCUMENTATION CENTER FOR BUSINESS ANALYSIS
Office:The Kanematsu Memorial Hall

KOBE UNIVERSITYROKKO, KOBE, JAPAN