The Regional Adjustment Process

Summary

In previous chapters we were concerned with the process of adjustment over time of various groups in the economy, but these groups were not given a geographical location. In the final three chapters we shall examine how adjustment is achieved spatially, between different areas. For ease of analysis this subject will be divided into two parts. In the first part, in Chapter 16, we shall examine the process of adjustment between regions in a single country where there is a single common currency: then in Chapters 17 and 18 we shall move on to consider the process of adjustment between countries with separate monetary systems and individual monetary policies.

The main emphasis in this study of inter-regional adjustment is that it involves an interlinked process of the achievement of both flow and stock equilibria. A formal model illustrating the nature of the linkages between flow and stock relationships is set out in the Appendix; this model provides much of the analytical basis for the description of the adjustment process in the rest of the chapter. The dichotomy between expenditure-flow relationships and asset-stock adjustments is mirrored in the distinction between the analysis of the determination of the current-account balance and the analysis of how this balance is financed. Reversing the usual procedure, we consider first in Section 1 how regional current-account imbalances are financed.

In general, the existence of an integrated financial system and capital market shared by regions within a country allows regional current-account imbalances to be very easily financed, so much so that there is no analogue at the regional level to the recurring concern at national levels about the adequacy of their foreign-exchange reserves. Given the high degree of substitution between financial claims of similar kinds issued in different regions, a region does not face the same immediate financial pressure to correct a current-account imbalance as does an individual country, with a lower international elasticity of substitution between financial assets. Even so, financial pressures will develop in regions if appropriate adjustment to current-account imbalance is long delayed. If a current-account deficit is not a reflection of local investment opportunities, it will involve a growing burden of debt servicing, rising invisible account deficits, and falling incomes and wealth. Financial pressures to adjust will not appear in the guise of exhausted reserves but of an increasing unwillingness to provide further loans to the borrowers in the indebted area.

Then in Section 2 we turn back to an examination of the determinants of the current-account balance. We start with the simplest case, in which all prices, including factor prices, interest rates, etc., are determined nationally. In this case an external shock, causing say a rise in the region’s exports, will cause a multiple increase in incomes and wealth, with the ultimate adjustment required depending on the size of the marginal propensity to import. The time path to that equilibrium, explored in the Appendix, is functionally more complex, and the system may well experience oscillations in the process of adjustment. These changes in incomes and output, with wage levels given, would cause fluctuations in the level of employment or migration. These labour market developments can be painful, and there may alternatively be some flexibility in movements of relative wage rates between regions, though such flexibility is reduced by concern over parity of treatment.

Such flexibility in wage rates would restore employment in depressed regions either through a substitution of labour for capital or by raising the return to capital (and therefore new investment) in the region, even if final prices of goods remained nationally fixed. But this latter is a strong assumption, and we next examine how the current account of a region responds to changes in the prices of its goods relative to the prices of goods produced elsewhere in the country. Given the supply elasticities of production in the regions involved, and the initial trade balance, this depends on the price elasticities of demand in each region for the exports of the other regions. The higher these elasticities, the more favourable the effect on the balance of a relative reduction in prices. This concept of the price elasticity of demand is not, however, an easy one, since changes in relative prices affect incomes and supply conditions, as well as having pure substitution effects. So the increase of sales of exports and fall in imports, following a fall in relative prices, depends on an amalgam of different and even offsetting factors. In particular, if a region (country) is relatively small it ought, by lowering the prices of its products, to be able to displace goods of a similar kind produced by other regions (countries). Thus, whatever the aggregate price elasticity of demand for such goods, the price elasticity of demand facing any one region (country) should be high. In practice, however, the apparent response of trade flows to devaluations has often seemed sluggish, but I attribute this more to slow supply response than to low demand elasticities.