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Chapter 3 Applications of the Basic Model © 2007 Pearson Addison-Wesley. All rights reserved Review • Any country that moves from autarky to free trade can experience gains in real income. • Suppose now we are already in the position of free trade equilibrium. • Free trade could be measured as the matching-size trade triangle as before. • But, assuming home is the clothing exporter, there exists a rising net export supply curve. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 4-2 Figure 3.1 An Outward Shift in Foreign Demand Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 4-3 An Outward Shift in Foreign Demand • • • • • • • Import demand increases due to taste changes. Import demand curve shifts right. It guarantees an increase in the relative price of exports. Terms of trade better-off Terms of trade=Price of Exports/Price of Imports It raises real income at home The increase of real income depends on (1) improvement of the TOT; (2) Increase of the export volume. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 4-4 Figure 3.1 An Outward Shift in Foreign Demand Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 4-5 An Outward Shift in Foreign Demand • An outward shift in foreign demand for home exports of clothing raises clothing’s price but may or may not increase home exports of clothing. • The backward-bending supply curve. • Home’s real income improves, but some of these gains spill over to greater home demand for clothing. • If such an increase in home demand exceeds the greater quantity produced, a lower quantity is available for export. • It corresponds to the segment BQR in the offer curve. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 4-6 Figure 2.C.1 Offer Curves Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 4-7 Protection in the import-competing goods • At free trade equilibrium, Is it possible that government step in and interfere with resource allocation to protect the importcompeting food sector ? • Possible. • Special interest groups of agricultural industry could lobby for the government. • SIG gains in expenditure of the national loss. • E.g., the move from line 1 to line 2. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 4-8 Figure 3.2 Restriction on Exportables Production Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 4-9 Protection in the import-competing goods • Is it possible that a government’s intervention (tariffs or nontariff-barriers) benefits for its whole country. • No way when such a country is small. • A small country cannot affect the world price (see line 2) • But it is possible for a large country. • When a large country restricts imports then it could cause the world price of food importables lowered (since less demand). • Home’s terms of trade improves. • Budget line rotates from line 1 to line 3. • Representative consumers obtain higher utility. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 4-10 Protection in the import-competing goods • Some caveats though. • The domestic adjustment from A to B distorts the domestic consumption as well. • The food market needs to explore. • Foreign retaliation is possible. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 4-11 Immiserizing Growth • Can an outward shift of the production-possibility schedule in a country with a constant population ever lead to a lowering of real income at home? • Perhaps. • Balanced Growth • An expansion of both domestic exportable and importable could affect the world market. • Dark side: it induces a deterioration on the terms of trade. • So, to some extent, it may erode the gains from trade. • Bright side: it causes real income to rise in trading partners that are importers of the growing country’s exports. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 4-12 The Deterioration of Home’s TOT • pc/pf • Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Qc+Qc*/Qf+Qf* 4-13 Immiserizing Growth • Consider an extreme case. • The growth could lower real incomes by being concentrated in domestic export sector and by significantly worsening the TOT. • Figure 3.3 • Growth biased toward the nation’s export industry (clothing) can reduce real income by so worsening the TOT (from line 1 to line 2) that consumption (at D) ends up on a lower indifference curve than initially (at B). Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 4-14 Figure 3.3 Immiserizing Growth Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 4-15 Assumptions for Immiserizing Growth (1) Grow primarily increases capacity and output in domestic export industries. (2) World’s demand elasticity for the country’s export good is quite low. This guarantees a worse-off of terms of trade. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 4-16 Transfer Problem • • • • • • Historically, more direct forms of transfer is important. Home is obligated to transfer money to foreign. Franco-Prussian War in 1870-1871: France World War I: Germany Marshall Plan: US Gulf War in 1991: Japan, Germany, Kuwait, Saudi Arabia to US • Southern-East Asian Crisis in 1997: IMF • How does such a transfer affect the terms of trade? Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 4-17 Transfer Problem • At any given price ratio, the home, or transferring, country can be expected to cut back its spending on all normal goods such as food. • Foreign could increase all demand for all goods. The demand increase of food happens to some extent. • The world demand curve for food could shift in or out. • Marginal propensities to import (m or m*) • T denotes transfer • The world demand curve for food shifts to the right iff (1-m*)T> mT Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 4-18 It is never better to give than to receive • Secondary blessing is impossible in a 2-country setup. • If the home makes a transfer, its real income is reduced. • But if its terms of trade improve (price of food falls), then loss will not be so severe. • The TOT moves in favor of home if the sum of import propensities satisfy: (1-m*)T < mT • Let OB denote the full compensation for the home country for the transfer. • Can the transfer shift world demand to the left sufficiently to reduce food’s price to 0B or lower? Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 4-19 Figure 3.4 Transfer and the Terms of Trade Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 4-20 It is never better to give than to receive • No. • Since at point B, world demand must exceed world supply. • This is because no real income in both countries will be changed if the price of food at point B. • Also, no income effect at B. • Only substitution effect exists. • Food’s lower relative price must call forth a substitution of food for clothing in both countries. • Therefore, equilibrium must be at somewhere in between AB, say, point G. • It is never better to give than to receive! Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 4-21 Some extensions of simple trade model • Many final goods (intra-industry trade) • Many countries • Trade in intermediate goods and international factor mobility • Non-tradable goods • Trade in assets Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 4-22 Figure 3.5 Intertemporal Trade Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 4-23 Equilibrium Stability • Before we assume a unique equilibrium. • Two necessary assumptions: • Price above equilibrium must have excess supply higher than excess demand, and vice versa. • It is assumed that price is driven up iff the existence of excess world demand. • Consider multiple free-trade equilibrium Panel a: three equilibria • The middle equilibrium point C is unstable but is flanked by a pair of stable equilibria Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 4-24 Figure 3.A.1 Multiple Equilibria Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 4-25 Equilibrium Stability • Say, the price of food is slightly higher, at 2, world demand is higher than world supply. • It will jump up the food’s price, away from point C, but to D. • How about point 1? • Offer curve in panel B is also the case. • Consider price ratio curve 2, dis-equilibrium there. • TV is the excess of the home’s import demand of food over foreign supplies • Remember the green line is home offer curve. • Therefore, food’s relative price will rise, going clockwise way to the stable point I. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 4-26