TERMS OF TRADE: THE AGRICULTURE-INDUSTRY INTERACTION IN THE CARIBBEAN

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1 (Draft- February 2004) TERMS OF TRADE: THE AGRICULTURE-INDUSTRY INTERACTION IN THE CARIBBEAN Chandra Sitahal-Aleong Delaware State University, Dover, Delaware, USA John Aleong, University of Vermont, Burlington, Vermont 05405,USA Abstract Propositions in the Lewis and Kaldor s models will be tested using data from Caribbean countries for the period The Caribbean countries are Jamaica, Trinidad and Tobago, and Barbados. The models of Arthur Lewis and Kaldor emphasize the dual economy, the autonomy of agricultural growth, and the functional relationship between the terms of trade and industrial output. The role of technology in economic development will also be an integral part of the research since Lewis viewed technology as a more forceful engine of growth relative to trade. Technology and its relationship to growth and equity is an underlying topic that will be examined in the analysis of the dual economy. These topics will be evaluated using univariate and multivariate times series methods. The generalized autoregressive conditional heteroskedasticity (GARCH) models and cointegration in the vector autoregression (VAR) models with Gaussian errors, seasonal dummies, and constant terms are some of the methods that will be used to test the propositions in the Lewis and Kaldor models. It seems that the terms of trade and agricultural output are interdependent, that Kaldor's proposition that the demand for industrial output is a function of agricultural demand. Finally, Lewis's proposition that industrial output is determined by cost or supply will be tested. Keywords: dual economy, Lewis model, Kaldor model, Cointegration, GARCH, VAR models. Presented at the 6 th Sir Arthur Lewis Conference, Governance Institutions and Economic Growth: Reflections on Sir Arthur Lewis Theory of Economic Growth, March 17-18, 2005,University of the West Indies, Mona, Kingston 7, Jamaica, West Indies. 1

2 1. INTRODUCTION Agricultural surplus plays a crucial role in economic development as given in Meek (1962). There seems to be no consensus of opinion on how this mechanism works. Lewis (1954), in his seminal paper on Economic Development with Unlimited Supplies of labour proposed that agricultural surplus sets the upper limit to the growth of industrial development. He assumed unlimited supply of labour at a constant real wage in terms of agricultural surplus, which is identified predominantly with the food supply to the industrial sector. Since the growth rate of agriculture is an upper bound for the growth rate of industry, any increase in the growth rate for industry will lead to a increase in the demand for food, which will lead to a food price increase. With the constancy of real wage rates in terms of food, this will lead to a proportionate increase in the industrial wage rate, reduction in profits and decline in growth rate of the industrial sector. Hence, the price mechanism between the two sectors, will lead to favourable terms of trade for agriculture and would restore equilibrium between the two sectors. Using the same assumptions on constant real wages in terms of food, Kaldor in a series of papers (1967,1989,1996) said that the price in industry is proportional to the its wage rate and will rise proportionally to its wages which will rise as the price of food increases. The net effect would be price increases in the economy. The terms of trade will be autonomous and will not be able to restore the equilibrium between the two sectors. Favourable terms of trade for agriculture will increase the buying power of agriculture sector and will lead to an increase in the demand for industrial products. The role of the terms of trade, (p = p a /p i ) which is the ratio of agricultural price (p a ) to industrial price (p i ), are opposite in the Lewis and Kaldor models. If p a > p i, industrial profits and growth are reduced in the Lewis supply model, while in the Kaldor demand drive model, there is an increased demand which lead to increased growth in industry. In the model that relates industrial growth as a function of the terms of trade, the correlation would be negative for the Lewis model and positive for the Kaldor model. Note this analysis is based on the two sector models and ignores the real world with an open economy with the service sector, foreign trade, the role of government, and low wages in the industrial sector. Bhaduri et al (2004) in The Dual Role of the Terms of Trade: The Indian Experience of Agriculture-Industry Interaction, developed the two sector model and tested it empirically with the time series data of gross domestic product (GDP) at constant prices for agriculture, industry and the terms of trade for India from There were many assessments of the Lewis model in the Caribbean, in particular see Downes (2004), Mark Figueroa (2004) and the references in these papers. Downes (2004) gave an assessment of Arthur Lewis and industrial development in the Caribbean. Downes (2004) discussed Lewis strategy, and, in particular, Lewis 1954, seminal paper on Economic Development with Unlimited Supplies of labour. Downes said, Lewis strategy is based on a set of premises: 2

3 (i) (ii) (iii) (iv) (v) surplus labour market size labour cost financial investment risk aversion The surplus labour premise is probably the most important one. Lewis argued that the case for industrial development in the Caribbean rested on the over-population existing in the region. The population to land ratio was too high for agriculture to support the growth in the labour force. Given the high levels of unemployment and under-employment, especially in Barbados, Jamaica and the Windward and Leeward islands, there was an urgent need to create jobs off the land. He saw industrial development complementing agricultural development in raising the standard of living and providing productive employment. Downes (2004) also discussed the present and possible future industrialization strategy in the Caribbean. Mark Figueroa (2004) in W. Arthur Lewis VS the Lewis Model: Agricultural or Industrial Development? considered what Lewis sought to do in his (1954) article and outlined the lessons to be derived from his national and world economy models. He compared the Lewis Model with Lewis to explain the variance in the interpretations. He also said that industrialization was not Lewis s primarily focus and that he did pay particular attention to agriculture. In this article, we will test empirically the two- sector model for the Caribbean. In a later article we will discuss the results for Latin America. In section 2, we will discuss the dual model, then in section 3, the time series data of gross domestic product (GDP) at constant prices for agriculture, industry and the terms of trade for Jamaica, Barbados, and Trinidad and Tobago, from 1960 to In section 4, the data will be fitted to univariate and multivariate autoregressive models, and the results will be discussed. In section 5, we gave some conclusions. 2. THE DUAL MODEL Bahaduri et al (2004) gave the conditions for equilibrium for balanced trade between agriculture and industry. Before we gave the conditions, let X mn be the demand for (in equilibrium, also supply of) goods of sector m by (to) sector n (m = a, i; n = a, i). Let X m be the output of sector m (m = a, i). Let η mn be the partial elasticity of surplus (export) of sector m with respect to output of sector n. Therefore, η mn = (X n /X mn )( X mn / X n ). Let ε mn be the partial (price) elasticity of surplus of sector m (import of sector n) with respect to the terms of trade, defined as the ratio of agricultural to industrial price, p = p a /p i. Therefore ε mn =(p/x mn )( X mn / p). We define g j as the growth rate of sector j (j = a, i, p). 3

4 1. p a X ai = p i X ia, 2. X ai = X ai (X i, p) and 3. X ia = X ia (X a, p) The subscripts i and a refer to agriculture and industry respectively. We assume that there are two sectors agriculture and industry. In the real world we have the effect of foreign trade, the growth of the service sector and also the role of government prices We may rewrite the equations in terms of growth rates as follows. (1a) g ia= g p + g ai (2a) g ai = ai g i + ai g p (3a) g ia = ia g a + ia g p Combining (1a) to (3a) we obtain, the industrial growth rate g i as a function of the growth rates of agriculture, g a, and the terms of trade, g p, (4) g i = αg a + βg p. Here α = (η ia /η ai ) is positive in the models of both Lewis and Kaldor, and, β = [(ε ia ε ai 1)/η ai ] is negative in the model of Lewis, but positive in that of Kaldor. We are assuming that as p i increases, the increase purchasing power in agriculture will lead to purchase of industrial goods and prevent large industrial inventories in the long run. To validate (4), the two sectors are dependent, and each purchases the others surplus. Kaldor assumed and Lewis implied the independence of the agriculture sector. 3. GDP DATA To test our model in equation 4, we will use the annual time series data of gross domestic product (GDP) at constant prices for agriculture, industry and the terms of trade for Jamaica, Barbados, and Trinidad and Tobago, from 1960 to Other countries in the Caribbean and Latin America were also analyzed, but will not be reported at this time. Data of gross domestic product at constant and current prices for Jamaica, Barbados, and Trinidad and Tobago were obtained from the World Bank for the period 1960/61 to 2001/02. Data on components of annual GDP for each country were also available. The constant price annual GDP data for agriculture and manufacturing components were at 1995/96 prices. From agricultural GDP at current and constant price, the agricultural price deflator was obtained for each country. Agriculture includes forestry and fishing products. Similarly, the industry s GDP at current and constant prices were used to obtain the industrial price deflator. The terms of trade indicator is the ratio of the agricultural price deflator divided by the industrial price deflator. All the annual data come from one source and no adjustment to any of the indicators was necessary. We, thus, have three important 4

5 variables, agricultural GDP at constant prices, industrial GDP at constant prices and the terms of trade. 4. DATA ANALYSIS RESULTS AND DISCUSSION The natural logarithm scale reduced the variability of the three time series. Descriptive statistics, means and standard deviations of all three variables in logs and their growth rates are given in Table 1. Except for the trade of terms (p), both agricultural and industrial outputs are normally distributed on the logarithmic scale. Table A.1; Jamaica Means, Standard Deviations, Skewness, Kurtosis and Normality Test 1960/61 to 2001/02 (40 observations) Name of the variable Mean Standard Deviation Skewness Kurtosis Normality Anderson Darling Test P-Value Log X i Log X a Log p g i g a g p Table A.2; Barbados Means, Standard Deviations, Skewness, Kurtosis and Normality Test 1960/61 to 2001/02 (40 observations) Name of the variable Mean Standard Deviation Skewness Kurtosis Normality Anderson Darling Test P-Value Log X i * Log X a Log p * g i g a g p * 5

6 Table A.3; Trinidad and Tobago Means, Standard Deviations, Skewness, Kurtosis and Normality Test 1960/61 to 2001/02 (40 observations) Name of the variable Mean Standard Deviation Skewness Kurtosis Normality Anderson Darling Test P-Value Log X i Log X a Log p * g i * g a g p *Normality violated on asymptotic test. log X i = log of industrial output at constant prices (of 1995/96) log X a = log of agricultural output at constant prices (of 1995/96) log p = log of agricultural to industrial price deflator, 1995/96 = 100 g i = growth in industrial output approximated by first differences of log X i g a = growth in agricultural output approximated by first differences of log X a g p = rate of change in price deflator approximated by first differences of log p. For Jamaica, since table A.1 shows the ratio of mean of agricultural to industrial prices is greater than one (i.e. approximately ), the terms of trade for agriculture for this series is favorable. The growth in the industrial sector is about.13% per annum while the growth in agricultural sector is about.73% per annum. The terms of trade (agricultural price deflator divided by industrial price deflator) are normally distributed. For Barbados, table A.2 shows that the terms of trade have become unfavorable for agriculture. Ratio of mean of agricultural to industrial prices is less than one, it is approximately Here, the growth in industry on an average is about 1.4% per annum while that of agricultural sector is declining on an average percent value of approximately 1.7%. For Trinidad and Tobago, table A.3 shows that the terms of trade is favorable for industry. The growth in the industrial sector is about 1.7% on an average per annum while the growth in agricultural sector is about 1.1%. 6

7 Graphs. For each country the two graphs exhibit a positive time trend with respect to both the output variables Log X i and Log X a and no significant trend for the terms of trade variable, Log p. 7

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13 Further Analyses Equation 4 was fitted for Jamaica, Barbados and Trinidad and Tobago. The model was misspecified and fitted poorly, since an examination of the Tables 1A, 1B and 1C showed the presence of non-normality. Also an examination of the scatter plots for each country, showed a positive trend for each of the output variables, Log X i, Log X a and no significant trend for the terms of trade variable, Log p. To account for the deterministic trend, we modified the model and fitted the model with a trend term. (5) g i = µ + δ t +α g a + β g p where t is the trend term, µ is a constant, and α and β are defined in equation (4). Equation 5 fitted poorly. All the variables were now tested for stochastic trend using the Augmented Dickey-Fuller (ADF) test for unit root. For each country, and for Log X i, Log X a and, Log p, we fail to reject the null hypothesis of a unit root. As the scatter diagrams showed the times series are not stationary. However the growth rates g i, g a, and g p are stationary, since the null hypothesis of a unit root was rejected at the significance level of 1 %. The results of the Augmented Dickey-Fuller are given in Tables 1A for Jamaica, Table 1B for Barbados and Table 1C for Trinidad and Tobago. Using SAS, models with and without time trends were estimated and for the terms of trade results were similar for both so we have presented the unit root test with time trend variable. Unit root tests for growth variables do not include time trend variable. For the Vector Autoregressive model, the results are given for each country in Tables 2A, 2B and 2C. Tables 3A, 3B, and 3C gives the cointegration analyses. Discussion of these tables will be given later. Table 1A: Augmented Dickey-Fuller (ADF) tests with constant and trend - Jamaica Model used: y = α + µ t + βy + γ y + u t t 1 i t i t i= 1 Variable Optimum lag τ ADF Log X i Log X a Log p g i g a g p n β α AIC P-value (B) 13

14 Table 2A: Test of residuals of each equation in VAR model - Jamaica Equation for Durbin Normality P-value ARCH Pr>F the variable Watson (Chi-Square) P>Chi-Sq F-Value g i g a g p Table 3A: Co-integration tests, 1960/61 to 2001/ Jamaica Eigenvalue Rank(r) Trace Test P-Value (5% critical value) Table 4A: Restricted reduced form system with first differences and co-integrating vector - Jamaica Variable g i (-1) Constant Coint(-1) Adjustment Coefficients ARCH F-Value AR-2 F-Value g i g a g p Normality Chi-Square Table 1B: Augmented Dickey-Fuller (ADF) tests with constant and trend Barbados Model used: y = α + µ t + βy + γ y + u t t 1 i t i t i= 1 Variable Optimum lag τ ADF Log X i Log X a Log p g i g a g p n β α AIC P-Value 14

15 Table 2B: Test of residuals of each equation in VAR model - Barbados Equation for Durbin Normality P-value ARCH Pr>F the variable Watson (Chi-Square) P>Chi-Sq F-Value g i g a g p Table 3B: Co-integration tests, 1960/61 to 2001/ Barbados Eigenvalue Rank(r) Trace Test P-Value (5% critical value) Table 4B: Restricted reduced form system with first differences and co-integrating vector - Barbados Variable g i (-1) Constant Coint(-1) Adjustment Coefficients ARCH F-Value AR-2 F-Value g i g a g p Normality Chi-Square 15

16 Table 1C: Augmented Dickey-Fuller (ADF) tests with constant and trend Trinidad and Tobago Model used: y = α + µ t + βy + γ y + u t t 1 i t i t i= 1 Variable Optimum lag τ ADF Log X i Log X a Log p g i g a g p n β α AIC P-Value Table 2C: Test of residuals of each equation in VAR model Trinidad and Tobago Equation for (Durbin Normality P-value ARCH Pr>F the variable Watson) (Chi-Square) P>Chi-Sq. F-Value g i < g a g p Table 3C: Co-integration tests, 1960/61 to 2001/2002 Trinidad and Tobago Eigenvalue Rank(r) Trace Test P-Value (5% critical value) Table 4C: Restricted reduced form system with first differences and co-integrating vector Trinidad and Tobago Variable g i (-1) Constant Coint(-1) Adjustment Coefficients ARCH F-Value AR-2 F-Value g i g a g p Normality Chi-Square 16

17 5. CONCLUSIONS In this limited empirical analysis of the two- sector model, we did not consider the effect of foreign trade, the role of the service sector or the role of government with agricultural price subsidies. For the dual economy, the role of the terms of trade was examined, using the Lewis supply side and the Kaldor demand drive models. We showed that statistically that neither the terms of trade nor the agricultural growth rates are autonomous for Jamaica, Barbados and Trinidad and Tobago. The growth of industrial output seems to be determined by agriculture s demand rather than supply driven. More results will be presented on other countries in the Caribbean and Latin America. References Bhaduri, A, Parikh, A, A, Skarstein, R,.` The Dual Role of the Terms of Trade: The Indian Experience of Agriculture-Industry Interaction, , Presented at a conference on The Lewis Model after 50 years: Assessing Sir Arthur Lewis Contribution to Development Economics and Policy, University of Manchester, July 6-7, Downes A S (2004). Arthur Lewis and Industrial Development in the Caribbean: An Assessment, Presented at a conference on The Lewis Model after 50 years: Assessing Sir Arthur Lewis Contribution to Development Economics and Policy, University of Manchester, July 6-7, Figueroa, Mark, W. Arthur Lewis VS the Lewis Model: Agricultural or Industrial Development? Presented at a conference on The Lewis Model after 50 years: Assessing Sir Arthur Lewis Contribution to Development Economics and Policy, University of Manchester, July 6-7, Kaldor, N. (1967), Strategic Factors in Economic Development, Cornell University Press, Ithaca. Kaldor, N. (1978), What is wrong with economic theory, in same author: Further Essays on Economic Theory, Duckworth, London, pp Kaldor, N. (1989), Equilibrium theory and growth theory, in: F. Targetti and A.P. Thirlwall (eds.): The Essential Kaldor, Duckworth, London, pp (Originally published in Cuadernos de economia, May-August 1974.) Lewis W A (1954). Economic Development with Unlimited Supplies of Labour, Manchester School, vol 22, no 2, pp Meek, R.L. (1962), The Economics of Physiocracy (Essays and translations by R.L. Meek), Allen and Unwin, London. 17

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