Question

1) In a two good and two country framework, suppose home is exporting Cloth and importing food. Home country imposes levies on import. What is the effect of such tariff on the terms of trade of Home? Explain it using a graph.

2) In a two good and two country framework, suppose home is exporting Cloth and importing food. Home country provides export subsidies. What is the effect of such subsidy on the terms of trade of Home? Explain it using a graph.

Answer 1

Q1)

Let A represent the home country and B represent the Foreign country.

OA0 is the offer curve of home country without tariff and OA1 is the offer curve post tariff for Home country. OB0 is the offer curve for the foreign country.

At the original equilibrium, when there is no tariff, the home country is ‘exporting OQ0 amount of cloth’ and imports P0Q0 amount of food. The terms of trade are represented by the TOT line T0. This is the straight line assing through origin and the point of intersection of the two ‘countries offer curve representing an equilibrium in trade such that imports and exports demand for each country are in equilibrium simultaneously.

Terms of trade = slope of line T0, defined at P0 = Quantity of import(Qm)/Quantity of exports(Qx) = P0Q0/OQ0

When the tariff is imposed by the home country on imports, the import of food becomes expensive and the demand for imports fall. The offer curve for the country A shifts inwards from OA0to OA1. The new terms of trade is defined by OT1 line passing through the intersection of Home country offer curve (OA1) and foreign country offer curve (OB0).

Terms of trade at P1 (represented by OT1) = Qm/Qx = P1Q1/OQ1.

Clearly the slope of the line OT1 is greater than OT0 since OT1 is steeper than OT0, which means P1Q1/OQ1 > P0Q0/OQ0. Thus the terms of trade has improved.

Hi, Please post each question separately.