Consider a small open economy in the short run where the government imposes trad
ID: 1199488 • Letter: C
Question
Consider a small open economy in the short run where the government imposes trade tariffs on corn.
(a) Given a floating exchange rate sketch a graph of the impact of the tariffs on IS-LM.
(b) With a floating exchange rate how does the trade tariffs impact the sale of domestic corn? Other export goods?
(c) Given a fixed exchange rate sketch a graph of the impact of the tariffs on IS-LM.
(d) With a fixed exchange rate how does the trade tariffs impact the sale of domestic corn? Other export goods?
(e) Under which regime (floating or fixed exchange), are the tariffs more effective in increasing output? (f) Under which regime does the money supply increase by more or less, why?
Explanation / Answer
(a)
As an import tariff is imposed on corn, the import of corn falls. This leads to a rise in net exports, whereby the IS curve shifts outwards. The income stays constant and the exchange rate rises.
b) Due to the tariff, the domestic price of corn rises and the quantity supplied of domestic corn rises, and thus the sale of domestic corn rises.
The difference between q1 and q4 shows the import before tariff. And the difference between q2 and q3 is the import after tariff. The above figure shows that earlier the domestic quantity demanded was q4, and the domestic quantity supplies was q1. But after the increase in price, the domestic quantity demanded became q3, and the domestic quantity suplied became q2. So the sale of domestic corn rose.
Since the exchange rate has risen, the country's goods have become expensive for foreigners and thus the country's exports have fallen.