General Equilibrium with Trade Balance and Real Interest Rate Parity

This paper demonstrates, in the context of a two-sector OLG neoclassicalgrowth model, conditions under which international trade in consumptiongoods alone may be sufficient for the equalization of real returns to physicalcapital across countries; that is, under which commodity arbitrage is sufficientfor real interest rate parity (RIRP). This role for repeated commodity arbitrageis established via a dynamic extension of the factor price equalization (FPE)theorem which is valid at all dates comprising the equilibrium path as well asits steady state. The results are at odds with the conventional view regardingRIRP which arises from open one-sector growth models, in which case steadystate trade balance and RIRP are irreconcilable, and are also a contradiction tofrequent assertions of long-run specialization in two-sector frameworks. An equilibriumpath for an integrated world economy yields an endogenous, time-variantcone of diversification which implies sufficient conditions for the dynamic pathsof a cross-section of economies to exhibit FPE, and hence RIRP with trade balance,at all points in time. These conditions require that the savings rates andinitial capital-labor ratios of individual countries do not deviate too significantlyfrom world averages, and that both sectors absorb capital easily. The first of theserequirements is sufficient to establish steady state FPE and RIRP in the generalspecification. The first two requirements are sufficient for the entire equilibriumpath to be characterized by FPE and RIRP in a log-linear example.