Question

Please Help with C - G!!!

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 net exports? Increasing output?

(f) If you’re a corn producer and your sales depend on foreign sales and on domestic sales (a function of how much households have to spend (Y-T), which regime do you prefer?

(g) Under which regime does the money supply increase by more or less, why?

Answer 1

A. With the tariffs, the IS curve will shift to the right, as shown in the graph below.

B. Due to imposition of tariffs, the price of foreign corn will rise by the amount of tariffs. This will lead to an increase in demand for domestic corn and the sales will rise.

if the foreign country also imposes tariffs, the demand for export goods will decline. Otherwise they will remain same.

C. Since the exchange rate is fixed, it means the central bank will have to take measures in case there are any changes in exchange rate. Let us illustrate with a graph.

As the country imposes tariffs, its imports decrease. This means its Net exports increase and the IS curve shifts to the right. This is shown as IS₂. But as the IS curve shifts to the right, the exchange rate increases to E2. To bring the exchange rate back to E1, the central bank must increase the money supply. This will shift the LM curve to the right, as shown, and exchange rate will move back to E1.

d. The sale of domestic corn will increase. Other export goods will sell the same if there are no tariffs.

e. Fixed exchange rate is regime is more effective as far as tariffs are concerned since the currency exchange rate can't adjust and hence cant bring back the net exports in balance. It is also more effective in increasing output.

F. Assuming the other country does not impose tariffs, Fixed exchange rate will be preferred since it will lead to higher increase in Y for domestic consumers and hence will lead to higher sales post tariffs.

G. As explained in part C, money supply increases more in fixed rate regime.