Chapter 5
? The Standard Trade Model
Copyright ? 2003 Pearson Education,Inc,Slide 5-2
Chapter Organization
? Introduction
? A Standard Model of a Trading Economy
? International Transfers of Income,Shifting the RD
Curve
? Tariffs and Export Subsidies,Simultaneous Shifts in
RS and RD
? Summary
? Appendix,Representing International Equilibrium
with Offer Curves
Copyright ? 2003 Pearson Education,Inc,Slide 5-3
Introduction
? Previous trade theories have emphasized specific
sources of comparative advantage which give rise to
international trade:
? Differences in labor productivity (Ricardian model)
? Differences in resources (specific factors model and
Heckscher-Ohlin model)
Copyright ? 2003 Pearson Education,Inc,Slide 5-4
? Those models share s number of features:
? The productive capacity of an economy can be
summarized by its production possibility frontier
? Production possibilities determine a country’s relative
supply schedule
? World equilibrium is determined by world relative
demand and a world relative supply schedule that lies
between the national relative supply schedules.
? The standard trade model is a general model of trade
that admits these models as special cases.
Copyright ? 2003 Pearson Education,Inc,Slide 5-5
A Standard Model of a
Trading Economy
? The standard trade model is built on four key
relationships:
? Production possibility frontier and the relative supply
curve
? Relative prices and relative demand
? World relative supply and world relative demand
? Terms of trade and national welfare
Copyright ? 2003 Pearson Education,Inc,Slide 5-6
A Standard Model of a
Trading Economy
? Production Possibilities and Relative Supply
? Assumptions of the model:
– Each country produces two goods,food (F) and cloth (C)
– Each country’s production possibility frontier is a
smooth curve (TT)
? The point on its production possibility frontier at
which an economy actually produces depends on the
price of cloth relative to food,PC/PF.
? Isovalue lines
– Lines along which the market value of output is
constant
Copyright ? 2003 Pearson Education,Inc,Slide 5-7
Figure 5-1,Relative Prices Determine the Economy’s Output
Q
Isovalue lines
TT
A Standard Model of a
Trading Economy
Cloth production,QC
Food production,QF
Copyright ? 2003 Pearson Education,Inc,Slide 5-8
Figure 5-2,How an Increase in the Relative Price of Cloth Affects
Relative Supply
Q1
VV1(PC/PF)1Q2
VV2(PC/PF)2
A Standard Model of a
Trading Economy
TT
Cloth production,QC
Food production,QF
Copyright ? 2003 Pearson Education,Inc,Slide 5-9
? Relative Prices and Demand
? The value of an economy's consumption equals the
value of its production:
PCQC + PFQF = PCDC + PFDF = V
? The economy’s choice of a point on the isovalue line
depends on the tastes of its consumers,which can be
represented graphically by a series of indifference
curves.
A Standard Model of a
Trading Economy
Copyright ? 2003 Pearson Education,Inc,Slide 5-10
? Indifference curves
– Each traces a set of combinations of cloth (C) and food
(F) consumption that leave the individual equally well
off
– They have three properties:
– Downward sloping
– The farther up and to the right each lies,the higher the level of
welfare to which it corresponds
– Each gets flatter as we move to the right
A Standard Model of a
Trading Economy
Copyright ? 2003 Pearson Education,Inc,Slide 5-11
TT
Figure 5-3,Production,Consumption,and Trade in the Standard Model
Cloth production,QC
Food production,QF
Q
D
Indifference curves
Food
imports
Cloth exports
A Standard Model of a
Trading Economy
Copyright ? 2003 Pearson Education,Inc,Slide 5-12
? If the relative price of cloth,PC/PF,increases,the
economy’s consumption choice shifts from D1 to D2.
– The move from D1 to D2 reflects two effects:
– Income effect
– Substitution effect
– It is possible that the income effect will be so strong that
when PC/PF rises,consumption of both goods actually
rises,while the ratio of cloth consumption to food
consumption falls.
A Standard Model of a
Trading Economy
Copyright ? 2003 Pearson Education,Inc,Slide 5-13
TT
Figure 5-4,Effects of a Rise in the Relative Price of Cloth
Q1
VV1(PC/PF)1
Q2
VV2(PC/PF)2
D2
D1
A Standard Model of a
Trading Economy
Cloth production,QC
Food production,QF
Copyright ? 2003 Pearson Education,Inc,Slide 5-14
? The Welfare Effect of Changes in the Terms of Trade
? Terms of trade
– The price of the good a country initially exports divided
by the price of the good it initially imports.
– A rise in the terms of trade increases a country’s welfare,
while a decline in the terms of trade reduces its welfare.
A Standard Model of a
Trading Economy
Copyright ? 2003 Pearson Education,Inc,Slide 5-15
? Determining Relative Prices
? Suppose that the world economy consists of two countries:
– Home (which exports cloth)
– Its terms of trade are measured by PC/PF
– Its quantities of cloth and food produced are QC and QF
– Foreign (which exports food)
– Its terms of trade are measured by PF/PC
– Its quantities of cloth and food produced are Q*C and Q*F
A Standard Model of a
Trading Economy
Copyright ? 2003 Pearson Education,Inc,Slide 5-16
? To determine PC/PF,one must find the intersection of
world relative supply of cloth and world relative
demand.
– The world relative supply curve (RS) is upward sloping
because an increase in PC/PF leads both countries to
produce more cloth and less food.
– The world relative demand curve (RD) is downward
sloping because an increase in PC/PF leads both
countries to shift their consumption mix away from
cloth toward food.
A Standard Model of a
Trading Economy
Copyright ? 2003 Pearson Education,Inc,Slide 5-17
Figure 5-5,World Relative Supply and Demand
RS
RD
Relative price
of cloth,PC/PF
Relative quantity
of cloth,QC + Q*C
QF + Q*F
A Standard Model of a
Trading Economy
(PC/PF)1
1
Copyright ? 2003 Pearson Education,Inc,Slide 5-18
? Economic Growth,A Shift of the RS Curve
? Is economic growth in other countries good or bad for
our nation?
– It may be good for our nation because it means larger
markets for our exports,
– It may mean increased competition for our exporters.
? Is growth in a country more or less valuable when that
nation is part of a closely integrated world economy?
– It should be more valuable when a country can sell
some of its increased production to the world market,
– It is less valuable when the benefits of growth are
passed on to foreigners rather than retained at home.
A Standard Model of a
Trading Economy
Copyright ? 2003 Pearson Education,Inc,Slide 5-19
? Growth and the Production Possibility Frontier
? Economic growth implies an outward shift of a
country’s production possibility frontier (TT).
? Biased growth
– Takes place when TT shifts out more in one direction
than in the other
– Can occur for two reasons:
– Technological progress in one sector of the economy
– Increase in a country’s supply of a factor of production
A Standard Model of a
Trading Economy
Copyright ? 2003 Pearson Education,Inc,Slide 5-20
Figure 5-6,Biased Growth
TT1 TT1TT2 TT2
A Standard Model of a
Trading Economy
Cloth production,QC
Food
production,QF
(a) Growth biased toward cloth
Cloth production,QC
Food
production,QF
(b) Growth biased toward food
Copyright ? 2003 Pearson Education,Inc,Slide 5-21
? Relative Supply and the Terms of Trade
? Export-biased growth
– Disproportionately expands a country’s production
possibilities in the direction of the good it exports
– Worsens a growing country’s terms of trade,to the
benefit of the rest of the world
? Import-biased growth
– Disproportionately expands a country’s production
possibilities in the direction of the good it imports
– Improves a growing country’s terms of trade at the rest
of the word’s expense
A Standard Model of a
Trading Economy
Copyright ? 2003 Pearson Education,Inc,Slide 5-22
Figure 5-7,Growth and Relative Supply
Relative price
of cloth,PC/PF
Relative quantity
of cloth,QC + Q*C
QF + Q*F
RS1
RD
1
(PC/PF)1
RS2
(PC/PF)2
2
Relative price
of cloth,PC/PF
Relative quantity
of cloth,QC + Q*C
QF + Q*F
RS2
RD
2
(PC/PF)2
RS1
(PC/PF)1
1
(a) Cloth-biased growth (b) Food-biased growth
A Standard Model of a
Trading Economy
Copyright ? 2003 Pearson Education,Inc,Slide 5-23
? International Effects of Growth
? Export-biased growth in the rest of the world improves
our terms of trade,while import-biased growth abroad
worsens our terms of trade.
? Export-biased growth in our country worsens our
terms of trade,reducing the direct benefits of growth,
while import-biased growth leads to an improvement
of our terms of trade.
A Standard Model of a
Trading Economy
Copyright ? 2003 Pearson Education,Inc,Slide 5-24
? Immiserizing growth
– A situation where export-biased growth by poor nations
can worsen their terms of trade so much that they would
be worse off than if they had not grown at all
– It can occur under extreme conditions,Strongly export-
biased growth must be combined with very steep RS and
RD curves.
– It is regarded by most economists as more a theoretical
point than a real-world issue.
A Standard Model of a
Trading Economy
Copyright ? 2003 Pearson Education,Inc,Slide 5-25
Table 5-1,Average Annual Percent Changes in Terms of Trade
A Standard Model of a
Trading Economy
Copyright ? 2003 Pearson Education,Inc,Slide 5-26
International Transfers of Income,
Shifting the RD Curve
? International transfers of income,such as war
reparations and foreign aid,may affect a country’s
terms of trade by shifting the world relative demand
curve.
? Relative world demand for goods may shift because
of:
? Changes in tastes
? Changes in technology
? International transfers of income
? The Transfer Problem
? How international transfers affect the terms of trade
Copyright ? 2003 Pearson Education,Inc,Slide 5-27
? Effects of a Transfer on the Terms of Trade
? When both countries allocate their change in spending
in the same proportions (Ohlin’s point):
– The RD curve will not shift,and there will be no terms
of trade effect.
? When the two countries do not allocate their change in
spending in the same proportions (Keynes’s point):
– The RD curve will shift and there will be a terms of
trade effect.
– The direction of the effect on terms of trade will depend on the
difference in Home and Foreign spending patterns.
International Transfers of Income,
Shifting the RD Curve
Copyright ? 2003 Pearson Education,Inc,Slide 5-28
Figure 5-8,Effects of a Transfer on the Terms of Trade
Relative price
of cloth,PC/PF
Relative quantity
of cloth,QC + Q*C
QF + Q*F
RS
RD2
RD1
(PC/PF)2
2
1
(PC/PF)1
International Transfers of Income,
Shifting the RD Curve
Copyright ? 2003 Pearson Education,Inc,Slide 5-29
? Presumptions about the Terms of Trade Effects of
Transfers
? A transfer will worsen the donor’s terms of trade if the
donor has a higher marginal propensity to spend on its
export good than the recipient.
? In practice,most countries spend a much higher share
of their income on domestically produced goods than
foreigners do.
– This is not necessarily due to differences in taste but
rather to barriers to trade,natural and artificial.
International Transfers of Income,
Shifting the RD Curve
Copyright ? 2003 Pearson Education,Inc,Slide 5-30
? Import tariffs and export subsidies affect both
relative supply and relative demand.
? Relative Demand and Supply Effects of a Tariff
? Tariffs drive a wedge between the prices at which
goods are traded internationally (external prices) and
the prices at which they are traded within a country
(internal prices).
? The terms of trade correspond to external,not internal,
prices.
Tariffs and Export Subsidies,
Simultaneous Shifts in RS and RD
Copyright ? 2003 Pearson Education,Inc,Slide 5-31
Tariffs and Export Subsidies,
Simultaneous Shifts in RS and RD
Figure 5-9,Effects of a Tariff on the Terms of Trade
Relative price
of cloth,PC/PF
Relative quantity
of cloth,QC + Q*C
QF + Q*F
RS1
RD1
RD2
RS2
(PC/PF)1
1
(PC/PF)2
2
Copyright ? 2003 Pearson Education,Inc,Slide 5-32
? Effects of an Export Subsidy
? Tariffs and export subsidies are often treated as similar
policies but they have opposite effects on the terms of
trade.
– Example,Suppose that Home offers 20% subsidy on the
value of cloth exported:
– This will raise Home’s internal price of cloth relative to food by
20%.
– This will lead Home producers to produce more cloth and less
food.
– A Home export subsidy worsens Home’s terms of trade
and improves Foreign’s.
Tariffs and Export Subsidies,
Simultaneous Shifts in RS and RD
Copyright ? 2003 Pearson Education,Inc,Slide 5-33
Tariffs and Export Subsidies,
Simultaneous Shifts in RS and RD
Figure 5-10,Effects of a Subsidy on the Terms of Trade
Relative price
of cloth,PC/PF
Relative quantity
of cloth,QC + Q*C
QF + Q*F
RS1
RD1
RD2
RS2
(PC/PF)1
1
(PC/PF)2
2
Copyright ? 2003 Pearson Education,Inc,Slide 5-34
? Implications of Terms of Trade Effects,Who Gains
and Who Loses?
? The International Distribution of Income
– If Home (a large country) imposes a tariff,its welfare
increases as long as the tariff is not too large,while
Foreign’s welfare decreases.
– If Home offers an export subsidy,its welfare
deteriorates,while Foreign’s welfare increases.
? The Distribution of Income Within Countries
– A tariff (subsidy) has the direct effect of raising the
internal relative price of the imported (exported) good.
– Tariffs and export subsidies might have perverse effects
on internal prices (Metzler paradox).
Tariffs and Export Subsidies,
Simultaneous Shifts in RS and RD
Copyright ? 2003 Pearson Education,Inc,Slide 5-35
Summary
? The standard trade model provides a framework that
can be used to address a wide range of international
issues and admits previous trade models as special
cases.
? A country’s terms of trade are determined by the
intersection of the world relative supply and demand
curves.
? Economic growth is usually biased,Growth that is
export-biased (import-biased) worsens (improves) the
terms of trade.
Copyright ? 2003 Pearson Education,Inc,Slide 5-36
? International transfers of income may affect a
country’s terms of trade,depending if they shift the
world relative demand curve.
? Import tariffs and export subsidies affect both relative
supply and demand.
? The terms of trade effects of an export subsidy hurt
the exporting country and benefit the rest of the world,
while those of a tariff do the reverse.
? Both trade instruments have strong income distribution
effects within countries.
Summary
Copyright ? 2003 Pearson Education,Inc,Slide 5-37
Figure 5A-1,Home’s Desired Trade at a Given Relative Price
TDesiredimports
of food
Desired
exports
of cloth
Home’s
imports,DF - QF
Home’s
exports,QC - DC
O
PC/PF
Appendix,Representing International
Equilibrium with Offer Curves
Copyright ? 2003 Pearson Education,Inc,Slide 5-38
Figure 5A-2,Home’s Offer Curve
C
T2
T1
Appendix,Representing International
Equilibrium with Offer Curves
Home’s
imports,DF - QF
Home’s
exports,QC - DC
O
Copyright ? 2003 Pearson Education,Inc,Slide 5-39
Figure 5A-3,Foreign’s Offer Curve
F
Appendix,Representing International
Equilibrium with Offer Curves
Foreign’s
exports,Q*F – D*F
Foreign’s
imports,D*C – Q*C
O
Copyright ? 2003 Pearson Education,Inc,Slide 5-40
Appendix,Representing International
Equilibrium with Offer Curves
Figure 5A-4,Offer Curve Equilibrium
C
F
X
Y
E
Home’s exports of cloth,QC – DC
Foreign’s imports of cloth,D*C – Q*C
O
Home’s imports of food,DF– QF
Foreign’s exports of cloth,Q*F – D*F
? The Standard Trade Model
Copyright ? 2003 Pearson Education,Inc,Slide 5-2
Chapter Organization
? Introduction
? A Standard Model of a Trading Economy
? International Transfers of Income,Shifting the RD
Curve
? Tariffs and Export Subsidies,Simultaneous Shifts in
RS and RD
? Summary
? Appendix,Representing International Equilibrium
with Offer Curves
Copyright ? 2003 Pearson Education,Inc,Slide 5-3
Introduction
? Previous trade theories have emphasized specific
sources of comparative advantage which give rise to
international trade:
? Differences in labor productivity (Ricardian model)
? Differences in resources (specific factors model and
Heckscher-Ohlin model)
Copyright ? 2003 Pearson Education,Inc,Slide 5-4
? Those models share s number of features:
? The productive capacity of an economy can be
summarized by its production possibility frontier
? Production possibilities determine a country’s relative
supply schedule
? World equilibrium is determined by world relative
demand and a world relative supply schedule that lies
between the national relative supply schedules.
? The standard trade model is a general model of trade
that admits these models as special cases.
Copyright ? 2003 Pearson Education,Inc,Slide 5-5
A Standard Model of a
Trading Economy
? The standard trade model is built on four key
relationships:
? Production possibility frontier and the relative supply
curve
? Relative prices and relative demand
? World relative supply and world relative demand
? Terms of trade and national welfare
Copyright ? 2003 Pearson Education,Inc,Slide 5-6
A Standard Model of a
Trading Economy
? Production Possibilities and Relative Supply
? Assumptions of the model:
– Each country produces two goods,food (F) and cloth (C)
– Each country’s production possibility frontier is a
smooth curve (TT)
? The point on its production possibility frontier at
which an economy actually produces depends on the
price of cloth relative to food,PC/PF.
? Isovalue lines
– Lines along which the market value of output is
constant
Copyright ? 2003 Pearson Education,Inc,Slide 5-7
Figure 5-1,Relative Prices Determine the Economy’s Output
Q
Isovalue lines
TT
A Standard Model of a
Trading Economy
Cloth production,QC
Food production,QF
Copyright ? 2003 Pearson Education,Inc,Slide 5-8
Figure 5-2,How an Increase in the Relative Price of Cloth Affects
Relative Supply
Q1
VV1(PC/PF)1Q2
VV2(PC/PF)2
A Standard Model of a
Trading Economy
TT
Cloth production,QC
Food production,QF
Copyright ? 2003 Pearson Education,Inc,Slide 5-9
? Relative Prices and Demand
? The value of an economy's consumption equals the
value of its production:
PCQC + PFQF = PCDC + PFDF = V
? The economy’s choice of a point on the isovalue line
depends on the tastes of its consumers,which can be
represented graphically by a series of indifference
curves.
A Standard Model of a
Trading Economy
Copyright ? 2003 Pearson Education,Inc,Slide 5-10
? Indifference curves
– Each traces a set of combinations of cloth (C) and food
(F) consumption that leave the individual equally well
off
– They have three properties:
– Downward sloping
– The farther up and to the right each lies,the higher the level of
welfare to which it corresponds
– Each gets flatter as we move to the right
A Standard Model of a
Trading Economy
Copyright ? 2003 Pearson Education,Inc,Slide 5-11
TT
Figure 5-3,Production,Consumption,and Trade in the Standard Model
Cloth production,QC
Food production,QF
Q
D
Indifference curves
Food
imports
Cloth exports
A Standard Model of a
Trading Economy
Copyright ? 2003 Pearson Education,Inc,Slide 5-12
? If the relative price of cloth,PC/PF,increases,the
economy’s consumption choice shifts from D1 to D2.
– The move from D1 to D2 reflects two effects:
– Income effect
– Substitution effect
– It is possible that the income effect will be so strong that
when PC/PF rises,consumption of both goods actually
rises,while the ratio of cloth consumption to food
consumption falls.
A Standard Model of a
Trading Economy
Copyright ? 2003 Pearson Education,Inc,Slide 5-13
TT
Figure 5-4,Effects of a Rise in the Relative Price of Cloth
Q1
VV1(PC/PF)1
Q2
VV2(PC/PF)2
D2
D1
A Standard Model of a
Trading Economy
Cloth production,QC
Food production,QF
Copyright ? 2003 Pearson Education,Inc,Slide 5-14
? The Welfare Effect of Changes in the Terms of Trade
? Terms of trade
– The price of the good a country initially exports divided
by the price of the good it initially imports.
– A rise in the terms of trade increases a country’s welfare,
while a decline in the terms of trade reduces its welfare.
A Standard Model of a
Trading Economy
Copyright ? 2003 Pearson Education,Inc,Slide 5-15
? Determining Relative Prices
? Suppose that the world economy consists of two countries:
– Home (which exports cloth)
– Its terms of trade are measured by PC/PF
– Its quantities of cloth and food produced are QC and QF
– Foreign (which exports food)
– Its terms of trade are measured by PF/PC
– Its quantities of cloth and food produced are Q*C and Q*F
A Standard Model of a
Trading Economy
Copyright ? 2003 Pearson Education,Inc,Slide 5-16
? To determine PC/PF,one must find the intersection of
world relative supply of cloth and world relative
demand.
– The world relative supply curve (RS) is upward sloping
because an increase in PC/PF leads both countries to
produce more cloth and less food.
– The world relative demand curve (RD) is downward
sloping because an increase in PC/PF leads both
countries to shift their consumption mix away from
cloth toward food.
A Standard Model of a
Trading Economy
Copyright ? 2003 Pearson Education,Inc,Slide 5-17
Figure 5-5,World Relative Supply and Demand
RS
RD
Relative price
of cloth,PC/PF
Relative quantity
of cloth,QC + Q*C
QF + Q*F
A Standard Model of a
Trading Economy
(PC/PF)1
1
Copyright ? 2003 Pearson Education,Inc,Slide 5-18
? Economic Growth,A Shift of the RS Curve
? Is economic growth in other countries good or bad for
our nation?
– It may be good for our nation because it means larger
markets for our exports,
– It may mean increased competition for our exporters.
? Is growth in a country more or less valuable when that
nation is part of a closely integrated world economy?
– It should be more valuable when a country can sell
some of its increased production to the world market,
– It is less valuable when the benefits of growth are
passed on to foreigners rather than retained at home.
A Standard Model of a
Trading Economy
Copyright ? 2003 Pearson Education,Inc,Slide 5-19
? Growth and the Production Possibility Frontier
? Economic growth implies an outward shift of a
country’s production possibility frontier (TT).
? Biased growth
– Takes place when TT shifts out more in one direction
than in the other
– Can occur for two reasons:
– Technological progress in one sector of the economy
– Increase in a country’s supply of a factor of production
A Standard Model of a
Trading Economy
Copyright ? 2003 Pearson Education,Inc,Slide 5-20
Figure 5-6,Biased Growth
TT1 TT1TT2 TT2
A Standard Model of a
Trading Economy
Cloth production,QC
Food
production,QF
(a) Growth biased toward cloth
Cloth production,QC
Food
production,QF
(b) Growth biased toward food
Copyright ? 2003 Pearson Education,Inc,Slide 5-21
? Relative Supply and the Terms of Trade
? Export-biased growth
– Disproportionately expands a country’s production
possibilities in the direction of the good it exports
– Worsens a growing country’s terms of trade,to the
benefit of the rest of the world
? Import-biased growth
– Disproportionately expands a country’s production
possibilities in the direction of the good it imports
– Improves a growing country’s terms of trade at the rest
of the word’s expense
A Standard Model of a
Trading Economy
Copyright ? 2003 Pearson Education,Inc,Slide 5-22
Figure 5-7,Growth and Relative Supply
Relative price
of cloth,PC/PF
Relative quantity
of cloth,QC + Q*C
QF + Q*F
RS1
RD
1
(PC/PF)1
RS2
(PC/PF)2
2
Relative price
of cloth,PC/PF
Relative quantity
of cloth,QC + Q*C
QF + Q*F
RS2
RD
2
(PC/PF)2
RS1
(PC/PF)1
1
(a) Cloth-biased growth (b) Food-biased growth
A Standard Model of a
Trading Economy
Copyright ? 2003 Pearson Education,Inc,Slide 5-23
? International Effects of Growth
? Export-biased growth in the rest of the world improves
our terms of trade,while import-biased growth abroad
worsens our terms of trade.
? Export-biased growth in our country worsens our
terms of trade,reducing the direct benefits of growth,
while import-biased growth leads to an improvement
of our terms of trade.
A Standard Model of a
Trading Economy
Copyright ? 2003 Pearson Education,Inc,Slide 5-24
? Immiserizing growth
– A situation where export-biased growth by poor nations
can worsen their terms of trade so much that they would
be worse off than if they had not grown at all
– It can occur under extreme conditions,Strongly export-
biased growth must be combined with very steep RS and
RD curves.
– It is regarded by most economists as more a theoretical
point than a real-world issue.
A Standard Model of a
Trading Economy
Copyright ? 2003 Pearson Education,Inc,Slide 5-25
Table 5-1,Average Annual Percent Changes in Terms of Trade
A Standard Model of a
Trading Economy
Copyright ? 2003 Pearson Education,Inc,Slide 5-26
International Transfers of Income,
Shifting the RD Curve
? International transfers of income,such as war
reparations and foreign aid,may affect a country’s
terms of trade by shifting the world relative demand
curve.
? Relative world demand for goods may shift because
of:
? Changes in tastes
? Changes in technology
? International transfers of income
? The Transfer Problem
? How international transfers affect the terms of trade
Copyright ? 2003 Pearson Education,Inc,Slide 5-27
? Effects of a Transfer on the Terms of Trade
? When both countries allocate their change in spending
in the same proportions (Ohlin’s point):
– The RD curve will not shift,and there will be no terms
of trade effect.
? When the two countries do not allocate their change in
spending in the same proportions (Keynes’s point):
– The RD curve will shift and there will be a terms of
trade effect.
– The direction of the effect on terms of trade will depend on the
difference in Home and Foreign spending patterns.
International Transfers of Income,
Shifting the RD Curve
Copyright ? 2003 Pearson Education,Inc,Slide 5-28
Figure 5-8,Effects of a Transfer on the Terms of Trade
Relative price
of cloth,PC/PF
Relative quantity
of cloth,QC + Q*C
QF + Q*F
RS
RD2
RD1
(PC/PF)2
2
1
(PC/PF)1
International Transfers of Income,
Shifting the RD Curve
Copyright ? 2003 Pearson Education,Inc,Slide 5-29
? Presumptions about the Terms of Trade Effects of
Transfers
? A transfer will worsen the donor’s terms of trade if the
donor has a higher marginal propensity to spend on its
export good than the recipient.
? In practice,most countries spend a much higher share
of their income on domestically produced goods than
foreigners do.
– This is not necessarily due to differences in taste but
rather to barriers to trade,natural and artificial.
International Transfers of Income,
Shifting the RD Curve
Copyright ? 2003 Pearson Education,Inc,Slide 5-30
? Import tariffs and export subsidies affect both
relative supply and relative demand.
? Relative Demand and Supply Effects of a Tariff
? Tariffs drive a wedge between the prices at which
goods are traded internationally (external prices) and
the prices at which they are traded within a country
(internal prices).
? The terms of trade correspond to external,not internal,
prices.
Tariffs and Export Subsidies,
Simultaneous Shifts in RS and RD
Copyright ? 2003 Pearson Education,Inc,Slide 5-31
Tariffs and Export Subsidies,
Simultaneous Shifts in RS and RD
Figure 5-9,Effects of a Tariff on the Terms of Trade
Relative price
of cloth,PC/PF
Relative quantity
of cloth,QC + Q*C
QF + Q*F
RS1
RD1
RD2
RS2
(PC/PF)1
1
(PC/PF)2
2
Copyright ? 2003 Pearson Education,Inc,Slide 5-32
? Effects of an Export Subsidy
? Tariffs and export subsidies are often treated as similar
policies but they have opposite effects on the terms of
trade.
– Example,Suppose that Home offers 20% subsidy on the
value of cloth exported:
– This will raise Home’s internal price of cloth relative to food by
20%.
– This will lead Home producers to produce more cloth and less
food.
– A Home export subsidy worsens Home’s terms of trade
and improves Foreign’s.
Tariffs and Export Subsidies,
Simultaneous Shifts in RS and RD
Copyright ? 2003 Pearson Education,Inc,Slide 5-33
Tariffs and Export Subsidies,
Simultaneous Shifts in RS and RD
Figure 5-10,Effects of a Subsidy on the Terms of Trade
Relative price
of cloth,PC/PF
Relative quantity
of cloth,QC + Q*C
QF + Q*F
RS1
RD1
RD2
RS2
(PC/PF)1
1
(PC/PF)2
2
Copyright ? 2003 Pearson Education,Inc,Slide 5-34
? Implications of Terms of Trade Effects,Who Gains
and Who Loses?
? The International Distribution of Income
– If Home (a large country) imposes a tariff,its welfare
increases as long as the tariff is not too large,while
Foreign’s welfare decreases.
– If Home offers an export subsidy,its welfare
deteriorates,while Foreign’s welfare increases.
? The Distribution of Income Within Countries
– A tariff (subsidy) has the direct effect of raising the
internal relative price of the imported (exported) good.
– Tariffs and export subsidies might have perverse effects
on internal prices (Metzler paradox).
Tariffs and Export Subsidies,
Simultaneous Shifts in RS and RD
Copyright ? 2003 Pearson Education,Inc,Slide 5-35
Summary
? The standard trade model provides a framework that
can be used to address a wide range of international
issues and admits previous trade models as special
cases.
? A country’s terms of trade are determined by the
intersection of the world relative supply and demand
curves.
? Economic growth is usually biased,Growth that is
export-biased (import-biased) worsens (improves) the
terms of trade.
Copyright ? 2003 Pearson Education,Inc,Slide 5-36
? International transfers of income may affect a
country’s terms of trade,depending if they shift the
world relative demand curve.
? Import tariffs and export subsidies affect both relative
supply and demand.
? The terms of trade effects of an export subsidy hurt
the exporting country and benefit the rest of the world,
while those of a tariff do the reverse.
? Both trade instruments have strong income distribution
effects within countries.
Summary
Copyright ? 2003 Pearson Education,Inc,Slide 5-37
Figure 5A-1,Home’s Desired Trade at a Given Relative Price
TDesiredimports
of food
Desired
exports
of cloth
Home’s
imports,DF - QF
Home’s
exports,QC - DC
O
PC/PF
Appendix,Representing International
Equilibrium with Offer Curves
Copyright ? 2003 Pearson Education,Inc,Slide 5-38
Figure 5A-2,Home’s Offer Curve
C
T2
T1
Appendix,Representing International
Equilibrium with Offer Curves
Home’s
imports,DF - QF
Home’s
exports,QC - DC
O
Copyright ? 2003 Pearson Education,Inc,Slide 5-39
Figure 5A-3,Foreign’s Offer Curve
F
Appendix,Representing International
Equilibrium with Offer Curves
Foreign’s
exports,Q*F – D*F
Foreign’s
imports,D*C – Q*C
O
Copyright ? 2003 Pearson Education,Inc,Slide 5-40
Appendix,Representing International
Equilibrium with Offer Curves
Figure 5A-4,Offer Curve Equilibrium
C
F
X
Y
E
Home’s exports of cloth,QC – DC
Foreign’s imports of cloth,D*C – Q*C
O
Home’s imports of food,DF– QF
Foreign’s exports of cloth,Q*F – D*F
