Chapter 5 Notes

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Economics for Management Studies
Garth Frazer

Chapter 5 The Standard Trade Model Notes A Standard Model of a Trading Economy • the standard trade model is built on 4 key relationships—(1) the relationship between the production possibility frontier and the relative supply curve; (2) the relationship between relative prices and relative demand; (3) the determination of world equilibrium by world relative supply and world relative demand; and (4) the effect of the terms of trade—the price of a country’s exports divided by the price of its imports—on a nation’s welfare International Transfers of Income: Shifting the RD Curve • the most important and controversial issue is the shift in world relative demand that can result from international transfers of income • international loans are not strictly transfers of income, since current transfer of spending power comes with obligation to repay later • in the short run, the economic effects of a sum of money given outright to a nation and the same sum let to that nation are similar Tariffs and Export Subsidies: Simultaneous Shifts in RS and RD • import tariffs (taxes levied on imports) and export subsidies (payments given to domestic producers who sell a good abroad) are not usually put in place to affect a country’s terms of trade—these government interventions in trade usually take place for income distribution, for the promotion of industries thought to be crucial to the economy, or for balance of payments • distinctive feature is they create difference between prices at which goods are traded on world market and their prices within country • the direct effect of a tariff is to make imported goods more expensive inside a country than they are outside • an export subsidy gives producers an incentive to export; therefore, it will be more profitable to sell abroad than at home unless the price at home is higher, so such a subsidy raises the price of exported goods inside a country • the price changes caused by tariffs and subsidies change both relative supply and relative demand • the result is a shift in the terms of trade of the country imposing the policy change and in the terms of the rest of the world Summary 1. The standard trade model derives a world relative supply curve from production possibilities and a world relative demand curve from preferences. The price of exports relative to imports, a country’s terms of trade, is determined by the intersection o the world relative supply and demand curves. Other things equal, a rise in a country’s terms of trade increases its welfare. Conversely, a decline in a country’s terms of trade will leave the country worse off. 2. Economic growth means an outward shift in a country’s production possibility frontier. Such growth is usually biased; that is, the production possibility frontier shifts out more in the direction of some goods than in the direction of others. The immediate effect of biased growth is to lead, other things equal, to an increase in the world relative supply of the goods toward which the growth is biased. This shift in the world relative supply curve in t
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