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Basics:
start with bowed out PPF
this drives RS curve:
production point maximizes GDP (highest iso-GDP line)
equation of iso-GDP line:
PC QC + PF QF = GNP
or
QF = GNP/ PF - [PC/PF] QC
Fig. 5-1
Fig. 5-2
Consumers
Draw indiff. curves – choose highest one that is tangent to budget constraint.
Fig. 5-3
Note: Since QC > DC country exports cloth, QF < DF country imports food.
1) PC/PF = 1
2) Production function is QC2 + QF2 = 1
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3) Indifference curves: U(QC, QF) = k = QC *QF
Now suppose that the relative price of cloth rises (Fig. 5-4), so that now PC/PF = 2. What
happens? Both the production and consumption choices change.
If PC/PF then QC QF
So even though cloth is relatively more expensive, is possible (although not usual) that
both DF and DC
Note that although people may consume more of each good (income effect), will
consume relatively more food than cloth (substitution effect)
Welfare
Note that a change in world relative prices doesn’t always make you better off.
If Pc/PF fell, then value of exports falls. Then income would also fall and country would
be worse off.
Define “terms of trade”: the price of the good a country initially exports divided by the
price of the good it initially imports. (p.97)
Finding equilibrium
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Assume Home exports cloth and Foreign exports food
(then Home’s terms of trade is PC/PF and Foreign’s terms of trade is PF/PC)
Figure 5-5
Comparative Statics
(A) Biased growth – shifts out PPF more along one axis than another:
This shifts out RS curve of cloth for country and so for whole world:
Fig. 5-7 a
If Home exports cloth then this cloth-biased growth worsens Home’s terms of trade.
improves Foreign’s terms of trade.
Define
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Result: Export-biased growth tends to worsen a growing country’s terms of trade, to the
benefits of the rest of the world; import-biased growth tends to improve a growing
country’s terms of trade at the rest of the world’s expense. (p.100)
Does this improvement in Foreign’s terms of trade make Foreign better off?
Yes:
Food*
PC/PF|old
PC/PF|new
U*new
U*old
Cloth*
Food
PC/PF|new
biased
growth
PC/PF|old
Cloth
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Depends on where you were originally consuming:
PC/PF|new
if originally consumed
along yellow segment,
then will be better
off despite worsening
terms of trade
PC/PF|old
Cloth
If Home originally consuming in pink region, then are worse off from own growth:
example of immiserizing growth.
(Need terms of trade effect to be very strong – i.e. need steep RD curve.)
European community argued that economic slump in late 80’s, early 90’s was due to
growth in NIEs.
This explanation can only work if terms of trade of developed countries deteriorated
considerably.
Fig. 5-8
IMF data (Advanced countries): see severe drops during oil crises, but not otherwise.
Can calculate (we won’t) that declining terms of trade over this period responsible for
1.1% drop in real income loss due to NIE growth.
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Offer Curves
Relative Supply (RS) curves not very satisfying -- glosses over issues of aggregation
across countries.
Instead use different tool (offer curves) to solve graphically for international trade
equilibrium.
Fig. 5A-1 graphs imports and exports for a given relative price. Point T corresponds to
the situation in Fig. 5-3. Since (DF – QF) = (QC – DC) * (PC/PF), the slope of the line
equals the price ratio. We can do this for different price ratios and trace out the Home
offer curve (Fig. 5A-2). Note that the slope of this curve is always positive.
We can do the same for the Foreign offer curve (Fig. 5A-3). Putting these two together,
we get the international equilibrium shown in Fig. 5A-4. World equilibrium is where the
offer curves intersect.
Examples of transfers:
war reparations
foreign aid
(OPEC)
Mechanics of a transfer:
If Foreign has lower marginal propensity to consume (mpc) cloth than Home (and so a
higher mpc food), then transfer lowers world RD for cloth.
Fig. 5-9
see PC/PF
worsens Home’s terms of trade (assume Home is cloth exporter)
improves Foreign’s
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But if Home has lower marginal propensity to consume cloth than Foreign, then the
transfer raises RD for cloth:
see PC/PF
improves Home’s terms of trade
hurts Foreign’s
Food*
Equation of Budget Constraint with transfer:
DF* = [GDP* + Transfer]/PF – [PC/PF]DC*
PC/PF|old
PC/PF|new
Transfer Cloth*
PC
Food*
PC/PF|old
if originally consumed
along yellow line,
transfer makes
recipient worse off
PC/PF|new
Transfer Cloth*
PC
In general:
A transfer worsens the donor’s terms of trade if the donor has a higher marginal
propensity to spend on its export good than the recipient. (p.106)
The result that recipient can be made worse off is also viewed as a theoretical curiosity.
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Home Bias in Consumption
This alone suggests that the marginal propensity to consume own export goods in US is
higher than in country’s receiving US aid
US aid likely to hurt US terms of trade.
Even without Home bias in consumption, even if mpc=mpc*, if there are non-traded
goods then the transfer should still worsen donor's terms of trade.
Definitions:
Example:
Suppose Foreign imports cloth.
Applies a 10% ad valorem tariff on cloth imports.
This reduces Foreign’s demand for cloth for any given relative prices
shifts in RD curve for cloth (both for Foreign and for World)
At same time, higher cloth prices in Foreign induce more Foreign production of cloth
shifts out RS curve for cloth (both for Foreign and for World)
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Fig. 5-10
Outcome:
lower world relative price of cloth
worsening of Home’s terms of trade
improvement in Foreign’s terms of trade!
It is possible that Foreign consumers end up facing lower domestic price for cloth than
without the import tariff.
This can’t happen if Foreign is a “small country”, since the terms of trade effect would be
quite small.
Effect of a subsidy
Example:
Home applies subsidy to cloth exports.
Raises Home supply of cloth.
See world RS of cloth shift out.
Home consumers face higher price (= PC + subsidy)
then Home consumers face higher relative price for cloth
Home and World RD curve for cloth shifts in
Fig. 5-11
Since tariffs on US imports improve US terms of trade, why not impose tariffs all the
time?
If other countries do same (EU), hurts US – no one has better terms of trade, but
everyone loses by distorting prices.
But if other countries can’t retaliate, then US better off to impose small tariffs (optimal
tariff) – will come back to this later in the course.
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Subsidies
Suggests US should love it when trade partners subsidize goods imported by US.
Paul Krugman proponent of unpopular argument that US should encourage, not penalize,
other countries who “dump” (sell at below cost) goods on US market.
Summary
Transfers improve the terms of trade of the donor so long as the donor has lower mpc its
exporting good than the recipient does.
General results:
import tariffs benefit import competing industry, hurt exporting sector, and benefit
country’s own terms of trade
export subsidies benefit exporting sector, hurt import competing sector, and hurt
country’s own terms of trade
Paradoxical results
Growth can make you worse off (immiserizing growth)
Aid can make you worse off (transfer problem)
Import tariffs can lower domestic prices of imported goods.
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