International Borrowing and Lending
Up to this point, all of the trading relationships we have described were not referenced by
a time dimension: One good, say cloth, is exchanged for a different good, say food. In this
section, we show how the standard model of trade we have developed can also be used to
analyze another very important kind of trade between countries that occurs over time:
international borrowing and lending. Any international transaction that occurs over time
has a financial aspect, and this aspect is one of the main topics we address in the second
half of this book. However, we can also abstract from those financial aspects and think of
borrowing and lending as just another kind of trade: Instead of trading one good for
another at a point in time, we exchange goods today in return for some goods in the future.
This kind of trade is known as intertemporal trade; we will have much more to say about
it later in this text, but for now we will analyze it using a variant of our standard trade
model with a time dimension.11
11See the appendix for additional details and derivations.
128 PART ONE International Trade Theory
Intertemporal Production Possibilities and Trade
Even in the absence of international capital movements, any economy faces a trade-off
between consumption now and consumption in the future. Economies usually do not consume
all of their current output; some of their output takes the form of investment in
machines, buildings, and other forms of productive capital. The more investment an economy
undertakes now, the more it will be able to produce and consume in the future. To
invest more, however, an economy must release resources by consuming less (unless there
are unemployed resources, a possibility we temporarily disregard). Thus there is a tradeoff
between current and future consumption.
Let’s imagine an economy that consumes only one good and will exist for only two periods,
which we will call present and future. Then there will be a trade-off between present
and future production of the consumption good, which we can summarize by drawing an
intertemporal production possibility frontier. Such a frontier is illustrated in Figure 6-10.
It looks just like the production possibility frontiers between two goods at a point in time that
we have been drawing.
The shape of the intertemporal production possibility frontier will differ among countries.
Some countries will have production possibilities that are biased toward present
output, while others are biased toward future output. We will ask in a moment what real
differences these biases correspond to, but first let’s simply suppose that there are two
countries, Home and Foreign, with different intertemporal production possibilities.
Home’s possibilities are biased toward current consumption, while Foreign’s are biased
toward future consumption.
Reasoning by analogy, we already know what to expect. In the absence of international
borrowing and lending, we would expect the relative price of future consumption to be
higher in Home than in Foreign, and thus if we open the possibility of trade over time, we
would expect Home to export present consumption and import future consumption.
This may, however, seem a little puzzling. What is the relative price of future consumption,
and how does one trade over time?
The Real Interest Rate
How does a country trade over time? Like an individual, a country can trade over time by
borrowing or lending. Consider what happens when an individual borrows: She is initially
Future
consumption
Present
consumption
Figure 6-10
The Intertemporal Production
Possibility Frontier
A country can trade current consumption
for future consumption
in the same way that it can
produce more of one good by
producing less of another.
CHAPTER 6 The Standard Trade Model 129
able to spend more than her income or, in other words, to consume more than her production.
Later, however, she must repay the loan with interest, and therefore in the future she
consumes less than she produces. By borrowing, then, she has in effect traded future consumption
for current consumption. The same is true of a borrowing country.
Clearly the price of future consumption in terms of present consumption has something
to do with the interest rate. As we will see in the second half of this book, in the real world
the interpretation of interest rates is complicated by the possibility of changes in the overall
price level. For now, we bypass that problem by supposing that loan contracts are specified
in “real” terms: When a country borrows, it gets the right to purchase some quantity
of consumption at present in return for repayment of some larger quantity in the future.
Specifically, the quantity of repayment in the future will be times the quantity borrowed
in the present, where r is the real interest rate on borrowing. Since the trade-off is
one unit of consumption in the present for units in the future, the relative price of
future consumption is
When this relative price of future consumption rises (that is, the real interest rate r falls), a
country responds by investing more; this increases the supply of future consumption relative
to present consumption (a leftward movement along the intertemporal production possibility
frontier in Figure 6-10) and implies an upward-sloping relative supply curve for future consumption.
We previously saw how a consumer’s preferences for cloth and food could be represented
by a relative demand curve relating relative consumption to the relative prices of
those goods. Similarly, a consumer will also have preferences over time that capture the extent
to which she is willing to substitute between current and future consumption. Those substitution
effects are also captured by an intertemporal relative demand curve that relates the relative
demand for future consumption (the ratio of future consumption to present consumption)
to its relative price
The parallel with our standard trade model is now complete. If borrowing and lending
are allowed, the relative price of future consumption, and thus the world real interest rate,
will be determined by the world relative supply and demand for future consumption. The
determination of the equilibrium relative price is shown in Figure 6-11 (notice
the parallel with trade in goods and panel (a) of Figure 6-5). The intertemporal relative
supply curves for Home and Foreign reflect how Home’s production possibilities are biased
1/(1 + r 1)
1/(1 + r).
1/(1 + r).
(1+ r)
(1+ r)
Relative price
of future consumption,
1/(1 + r )
1/(1 + r1)
RD
RS HOME
RS WORLD
RS FOREIGN
Future consumption
Present consumption
Figure 6-11
Equilibrium Interest Rate with
Borrowing and Lending
Home, Foreign, and world supply
of future consumption relative to
present consumption. Home and
Foreign have the same relative
demand for future consumption,
which is also the relative demand
for the world. The equilibrium
interest rate is
determined by the intersection
of world relative supply and
demand.
1/(1 + r1)
130 PART ONE International Trade Theory
toward present consumption whereas Foreign’s production possibilities are biased toward
future consumption. In other words, Foreign’s relative supply for future consumption is
shifted out relative to Home’s relative supply. At the equilibrium real interest rate, Home
will export present consumption in return for imports of future consumption. That is, Home
will lend to Foreign in the present and receive repayment in the future.
Intertemporal Comparative Advantage
We have assumed that Home’s intertemporal production possibilities are biased toward
present production. But what does this mean? The sources of intertemporal comparative
advantage are somewhat different from those that give rise to ordinary trade.
A country that has a comparative advantage in future production of consumption goods
is one that in the absence of international borrowing and lending would have a low relative
price of future consumption, that is, a high real interest rate. This high real interest rate
corresponds to a high return on investment, that is, a high return to diverting resources
from current production of consumption goods to production of capital goods, construction,
and other activities that enhance the economy’s future ability to produce. So
countries that borrow in the international market will be those where highly productive
investment opportunities are available relative to current productive capacity, while countries
that lend will be those where such opportunities are not available domestically.
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 of 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 turn leads to a change in the growing country’s terms of trade, which can go in
either direction. If the growing country’s terms of trade improve, this improvement reinforces
the initial growth at home but hurts the growth in the rest of the world. If the
growing country’s terms of trade worsen, this decline offsets some of the favorable
effects of growth at home but benefits the rest of the world.
3. The direction of the terms of trade effects depends on the nature of the growth. Growth that
is export-biased (growth that expands the ability of an economy to produce the goods it was
initially exporting more than it expands the economy’s ability to produce goods that compete
with imports) worsens the terms of trade. Conversely, growth that is import-biased,
disproportionately increasing the ability to produce import-competing goods, improves a
country’s terms of trade. It is possible for import-biased growth abroad to hurt a country.
4. Import tariffs and export subsidies affect both relative supply and relative demand.
A tariff raises relative supply of a country’s import good while lowering relative
demand. A tariff unambiguously improves the country’s terms of trade at the rest of the
world’s expense. An export subsidy has the reverse effect, increasing the relative supply
and reducing the relative demand for the country’s export good, and thus worsening the
terms of trade. The terms of trade effects of an export subsidy hurt the subsidizing
CHAPTER 6 The Standard Trade Model 131
biased growth, p. 119
export-biased growth, p. 121
export subsidy, p. 124
external price, p. 125
immiserizing growth, p. 122
import-biased growth, p. 121
import tariff, p. 124
indifference curves, p. 114
internal price, p. 125
intertemporal production
possibility frontier, p. 128
intertemporal trade, p. 127
isovalue lines, p. 113
real interest rate, p. 129
standard trade
model, p. 112
terms of trade, p. 112
country and benefit the rest of the world, while those of a tariff do the reverse. This
suggests that export subsidies do not make sense from a national point of view and that
foreign export subsidies should be welcomed rather than countered. Both tariffs and
subsidies, however, have strong effects on the distribution of income within countries,
and these effects often weigh more heavily on policy than the terms of trade concerns.
5. International borrowing and lending can be viewed as a kind of international trade, but
one that involves trade of present consumption for future consumption rather than
trade of one good for another. The relative price at which this intertemporal trade takes
place is 1 plus the real rate of interest.
KEY TERMS
PROBLEMS
1. Assume that Norway and Sweden trade with each other, with Norway exporting fish
to Sweden, and Sweden exporting Volvos (automobiles) to Norway. Illustrate the
gains from trade between the two countries using the standard trade model, assuming
first that tastes for the goods are the same in both countries, but that the production
possibility frontiers differ: Norway has a long coast that borders on the north Atlantic,
making it relatively more productive in fishing. Sweden has a greater endowment of
capital, making it relatively more productive in automobiles.
2. In the trade scenario in problem 1, due to overfishing, Norway becomes unable to
catch the quantity of fish that it could in previous years. This change causes both a
reduction in the potential quantity of fish that can be produced in Norway and an
increase in the relative world price for fish,
a. Show how the overfishing problem can result in a decline in welfare for Norway.
b. Also show how it is possible that the overfishing problem could result in an
increase in welfare for Norway.
3. In some economies relative supply may be unresponsive to changes in prices. For
example, if factors of production were completely immobile between sectors, the production
possibility frontier would be right-angled, and output of the two goods would
not depend on their relative prices. Is it still true in this case that a rise in the terms of
trade increases welfare? Analyze graphically.
4. The counterpart to immobile factors on the supply side would be lack of substitution
on the demand side. Imagine an economy where consumers always buy goods in rigid
proportions—for example, one yard of cloth for every pound of food—regardless of
the prices of the two goods. Show that an improvement in the terms of trade benefits
this economy as well.
5. Japan primarily exports manufactured goods, while importing raw materials such as
food and oil. Analyze the impact on Japan’s terms of trade of the following events:
a. A war in the Middle East disrupts oil supply.
b. Korea develops the ability to produce automobiles that it can sell in Canada and
the United States.
Pf /Pa.
132 PART ONE International Trade Theory
c. U.S. engineers develop a fusion reactor that replaces fossil fuel electricity plants.
d. A harvest failure in Russia.
e. A reduction in Japan’s tariffs on imported beef and citrus fruit.
6. The Internet has allowed for increased trade in services such as programming and
technical support, a development that has lowered the prices of such services relative
to those of manufactured goods. India in particular has been recently viewed as an
“exporter” of technology-based services, an area in which the United States had been
a major exporter. Using manufacturing and services as tradable goods, create a standard
trade model for the U.S. and Indian economies that shows how relative price
declines in exportable services that lead to the “outsourcing” of services can reduce
welfare in the United States and increase welfare in India.
7. Countries A and B have two factors of production, capital and labor, with which they
produce two goods, X and Y. Technology is the same in the two countries. X is capitalintensive;
A is capital-abundant.
Analyze the effects on the terms of trade and on the two countries’ welfare of the
following:
a. An increase in A’s capital stock.
b. An increase in A’s labor supply.
c. An increase in B’s capital stock.
d. An increase in B’s labor supply.
8. Economic growth is just as likely to worsen a country’s terms of trade as it is to
improve them. Why, then, do most economists regard immiserizing growth, where
growth actually hurts the growing country, as unlikely in practice?
9. From an economic point of view, India and China are somewhat similar: Both are
huge, low-wage countries, probably with similar patterns of comparative advantage,
which until recently were relatively closed to international trade. China was the first
to open up. Now that India is also opening up to world trade, how would you expect
this to affect the welfare of China? Of the United States? (Hint: Think of adding a new
economy identical to that of China to the world economy.)
10. Suppose that Country X subsidizes its exports and Country Y imposes a “countervailing”
tariff that offsets the subsidy’s effect, so that in the end, relative prices in Country Y
are unchanged. What happens to the terms of trade? What about welfare in the two
countries? Suppose, on the other hand, that Country Y retaliates with an export subsidy
of its own. Contrast the result.
11. Explain the analogy between international borrowing and lending and ordinary international
trade.
12. Which of the following countries would you expect to have intertemporal production
possibilities biased toward current consumption goods, and which biased toward
future consumption goods?
a. A country like Argentina or Canada in the last century that has only recently been
opened for large-scale settlement and is receiving large inflows of immigrants.
b. A country like the United Kingdom in the late 19th century or the United States
today that leads the world technologically but is seeing that lead eroded as other
countries catch up.
CHAPTER 6 The Standard Trade Model 133
c. A country like Saudi Arabia that has discovered large oil reserves that can be
exploited with little new investment.
d. A country that has discovered large oil reserves that can be exploited only with
massive investment, such as Norway, whose oil lies under the North Sea.
e. A country like South Korea that has discovered the knack of producing industrial
goods and is rapidly gaining on advanced countries.
FURTHER READINGS
Rudiger Dornbusch, Stanley Fischer, and Paul Samuelson. “Comparative Advantage, Trade, and
Payments in a Ricardian Model with a Continuum of Goods.” American Economic Review 67
(1977). This paper, cited in Chapter 3, also gives a clear exposition of the role of nontraded goods
in establishing the presumption that a transfer improves the recipient’s terms of trade.
Irving Fisher. The Theory of Interest. New York: Macmillan, 1930. The “intertemporal” approach
described in this chapter owes its origin to Fisher.
J. R. Hicks. “The Long Run Dollar Problem.” Oxford Economic Papers 2 (1953), pp. 117–135. The
modern analysis of growth and trade has its origins in the fears of Europeans, in the early years
after World War II, that the United States had an economic lead that could not be overtaken. (This
sounds dated today, but many of the same arguments have now resurfaced about Japan.) The
paper by Hicks is the most famous exposition.
Harry G. Johnson. “Economic Expansion and International Trade.” Manchester School of Social and
Economic Studies 23 (1955), pp. 95–112. The paper that laid out the crucial distinction between
export- and import-biased growth.
Paul Krugman. “Does Third World Growth Hurt First World Prosperity?” Harvard Business Review
72 (July–August 1994), pp. 113–121. An analysis that attempts to explain why growth in developing
countries need not hurt advanced countries in principle and probably does not do so in practice.
Jeffrey Sachs. “The Current Account and Macroeconomic Adjustment in the 1970s.” Brookings
Papers on Economic Activity, 1981. A study of international capital flows that views such flows
as intertemporal trade.
John Whalley. Trade Liberalization Among Major World Trading Areas. Cambridge: MIT Press,
1985. The impact of tariffs on the international economy has been the subject of extensive study.
Most impressive are the huge “computable general equilibrium” models, numerical models
based on actual data that allow computation of the effects of changes in tariffs and other trade
policies. Whalley’s book presents one of the most carefully constructed of these.
Up to this point, all of the trading relationships we have described were not referenced by
a time dimension: One good, say cloth, is exchanged for a different good, say food. In this
section, we show how the standard model of trade we have developed can also be used to
analyze another very important kind of trade between countries that occurs over time:
international borrowing and lending. Any international transaction that occurs over time
has a financial aspect, and this aspect is one of the main topics we address in the second
half of this book. However, we can also abstract from those financial aspects and think of
borrowing and lending as just another kind of trade: Instead of trading one good for
another at a point in time, we exchange goods today in return for some goods in the future.
This kind of trade is known as intertemporal trade; we will have much more to say about
it later in this text, but for now we will analyze it using a variant of our standard trade
model with a time dimension.11
11See the appendix for additional details and derivations.
128 PART ONE International Trade Theory
Intertemporal Production Possibilities and Trade
Even in the absence of international capital movements, any economy faces a trade-off
between consumption now and consumption in the future. Economies usually do not consume
all of their current output; some of their output takes the form of investment in
machines, buildings, and other forms of productive capital. The more investment an economy
undertakes now, the more it will be able to produce and consume in the future. To
invest more, however, an economy must release resources by consuming less (unless there
are unemployed resources, a possibility we temporarily disregard). Thus there is a tradeoff
between current and future consumption.
Let’s imagine an economy that consumes only one good and will exist for only two periods,
which we will call present and future. Then there will be a trade-off between present
and future production of the consumption good, which we can summarize by drawing an
intertemporal production possibility frontier. Such a frontier is illustrated in Figure 6-10.
It looks just like the production possibility frontiers between two goods at a point in time that
we have been drawing.
The shape of the intertemporal production possibility frontier will differ among countries.
Some countries will have production possibilities that are biased toward present
output, while others are biased toward future output. We will ask in a moment what real
differences these biases correspond to, but first let’s simply suppose that there are two
countries, Home and Foreign, with different intertemporal production possibilities.
Home’s possibilities are biased toward current consumption, while Foreign’s are biased
toward future consumption.
Reasoning by analogy, we already know what to expect. In the absence of international
borrowing and lending, we would expect the relative price of future consumption to be
higher in Home than in Foreign, and thus if we open the possibility of trade over time, we
would expect Home to export present consumption and import future consumption.
This may, however, seem a little puzzling. What is the relative price of future consumption,
and how does one trade over time?
The Real Interest Rate
How does a country trade over time? Like an individual, a country can trade over time by
borrowing or lending. Consider what happens when an individual borrows: She is initially
Future
consumption
Present
consumption
Figure 6-10
The Intertemporal Production
Possibility Frontier
A country can trade current consumption
for future consumption
in the same way that it can
produce more of one good by
producing less of another.
CHAPTER 6 The Standard Trade Model 129
able to spend more than her income or, in other words, to consume more than her production.
Later, however, she must repay the loan with interest, and therefore in the future she
consumes less than she produces. By borrowing, then, she has in effect traded future consumption
for current consumption. The same is true of a borrowing country.
Clearly the price of future consumption in terms of present consumption has something
to do with the interest rate. As we will see in the second half of this book, in the real world
the interpretation of interest rates is complicated by the possibility of changes in the overall
price level. For now, we bypass that problem by supposing that loan contracts are specified
in “real” terms: When a country borrows, it gets the right to purchase some quantity
of consumption at present in return for repayment of some larger quantity in the future.
Specifically, the quantity of repayment in the future will be times the quantity borrowed
in the present, where r is the real interest rate on borrowing. Since the trade-off is
one unit of consumption in the present for units in the future, the relative price of
future consumption is
When this relative price of future consumption rises (that is, the real interest rate r falls), a
country responds by investing more; this increases the supply of future consumption relative
to present consumption (a leftward movement along the intertemporal production possibility
frontier in Figure 6-10) and implies an upward-sloping relative supply curve for future consumption.
We previously saw how a consumer’s preferences for cloth and food could be represented
by a relative demand curve relating relative consumption to the relative prices of
those goods. Similarly, a consumer will also have preferences over time that capture the extent
to which she is willing to substitute between current and future consumption. Those substitution
effects are also captured by an intertemporal relative demand curve that relates the relative
demand for future consumption (the ratio of future consumption to present consumption)
to its relative price
The parallel with our standard trade model is now complete. If borrowing and lending
are allowed, the relative price of future consumption, and thus the world real interest rate,
will be determined by the world relative supply and demand for future consumption. The
determination of the equilibrium relative price is shown in Figure 6-11 (notice
the parallel with trade in goods and panel (a) of Figure 6-5). The intertemporal relative
supply curves for Home and Foreign reflect how Home’s production possibilities are biased
1/(1 + r 1)
1/(1 + r).
1/(1 + r).
(1+ r)
(1+ r)
Relative price
of future consumption,
1/(1 + r )
1/(1 + r1)
RD
RS HOME
RS WORLD
RS FOREIGN
Future consumption
Present consumption
Figure 6-11
Equilibrium Interest Rate with
Borrowing and Lending
Home, Foreign, and world supply
of future consumption relative to
present consumption. Home and
Foreign have the same relative
demand for future consumption,
which is also the relative demand
for the world. The equilibrium
interest rate is
determined by the intersection
of world relative supply and
demand.
1/(1 + r1)
130 PART ONE International Trade Theory
toward present consumption whereas Foreign’s production possibilities are biased toward
future consumption. In other words, Foreign’s relative supply for future consumption is
shifted out relative to Home’s relative supply. At the equilibrium real interest rate, Home
will export present consumption in return for imports of future consumption. That is, Home
will lend to Foreign in the present and receive repayment in the future.
Intertemporal Comparative Advantage
We have assumed that Home’s intertemporal production possibilities are biased toward
present production. But what does this mean? The sources of intertemporal comparative
advantage are somewhat different from those that give rise to ordinary trade.
A country that has a comparative advantage in future production of consumption goods
is one that in the absence of international borrowing and lending would have a low relative
price of future consumption, that is, a high real interest rate. This high real interest rate
corresponds to a high return on investment, that is, a high return to diverting resources
from current production of consumption goods to production of capital goods, construction,
and other activities that enhance the economy’s future ability to produce. So
countries that borrow in the international market will be those where highly productive
investment opportunities are available relative to current productive capacity, while countries
that lend will be those where such opportunities are not available domestically.
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 of 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 turn leads to a change in the growing country’s terms of trade, which can go in
either direction. If the growing country’s terms of trade improve, this improvement reinforces
the initial growth at home but hurts the growth in the rest of the world. If the
growing country’s terms of trade worsen, this decline offsets some of the favorable
effects of growth at home but benefits the rest of the world.
3. The direction of the terms of trade effects depends on the nature of the growth. Growth that
is export-biased (growth that expands the ability of an economy to produce the goods it was
initially exporting more than it expands the economy’s ability to produce goods that compete
with imports) worsens the terms of trade. Conversely, growth that is import-biased,
disproportionately increasing the ability to produce import-competing goods, improves a
country’s terms of trade. It is possible for import-biased growth abroad to hurt a country.
4. Import tariffs and export subsidies affect both relative supply and relative demand.
A tariff raises relative supply of a country’s import good while lowering relative
demand. A tariff unambiguously improves the country’s terms of trade at the rest of the
world’s expense. An export subsidy has the reverse effect, increasing the relative supply
and reducing the relative demand for the country’s export good, and thus worsening the
terms of trade. The terms of trade effects of an export subsidy hurt the subsidizing
CHAPTER 6 The Standard Trade Model 131
biased growth, p. 119
export-biased growth, p. 121
export subsidy, p. 124
external price, p. 125
immiserizing growth, p. 122
import-biased growth, p. 121
import tariff, p. 124
indifference curves, p. 114
internal price, p. 125
intertemporal production
possibility frontier, p. 128
intertemporal trade, p. 127
isovalue lines, p. 113
real interest rate, p. 129
standard trade
model, p. 112
terms of trade, p. 112
country and benefit the rest of the world, while those of a tariff do the reverse. This
suggests that export subsidies do not make sense from a national point of view and that
foreign export subsidies should be welcomed rather than countered. Both tariffs and
subsidies, however, have strong effects on the distribution of income within countries,
and these effects often weigh more heavily on policy than the terms of trade concerns.
5. International borrowing and lending can be viewed as a kind of international trade, but
one that involves trade of present consumption for future consumption rather than
trade of one good for another. The relative price at which this intertemporal trade takes
place is 1 plus the real rate of interest.
KEY TERMS
PROBLEMS
1. Assume that Norway and Sweden trade with each other, with Norway exporting fish
to Sweden, and Sweden exporting Volvos (automobiles) to Norway. Illustrate the
gains from trade between the two countries using the standard trade model, assuming
first that tastes for the goods are the same in both countries, but that the production
possibility frontiers differ: Norway has a long coast that borders on the north Atlantic,
making it relatively more productive in fishing. Sweden has a greater endowment of
capital, making it relatively more productive in automobiles.
2. In the trade scenario in problem 1, due to overfishing, Norway becomes unable to
catch the quantity of fish that it could in previous years. This change causes both a
reduction in the potential quantity of fish that can be produced in Norway and an
increase in the relative world price for fish,
a. Show how the overfishing problem can result in a decline in welfare for Norway.
b. Also show how it is possible that the overfishing problem could result in an
increase in welfare for Norway.
3. In some economies relative supply may be unresponsive to changes in prices. For
example, if factors of production were completely immobile between sectors, the production
possibility frontier would be right-angled, and output of the two goods would
not depend on their relative prices. Is it still true in this case that a rise in the terms of
trade increases welfare? Analyze graphically.
4. The counterpart to immobile factors on the supply side would be lack of substitution
on the demand side. Imagine an economy where consumers always buy goods in rigid
proportions—for example, one yard of cloth for every pound of food—regardless of
the prices of the two goods. Show that an improvement in the terms of trade benefits
this economy as well.
5. Japan primarily exports manufactured goods, while importing raw materials such as
food and oil. Analyze the impact on Japan’s terms of trade of the following events:
a. A war in the Middle East disrupts oil supply.
b. Korea develops the ability to produce automobiles that it can sell in Canada and
the United States.
Pf /Pa.
132 PART ONE International Trade Theory
c. U.S. engineers develop a fusion reactor that replaces fossil fuel electricity plants.
d. A harvest failure in Russia.
e. A reduction in Japan’s tariffs on imported beef and citrus fruit.
6. The Internet has allowed for increased trade in services such as programming and
technical support, a development that has lowered the prices of such services relative
to those of manufactured goods. India in particular has been recently viewed as an
“exporter” of technology-based services, an area in which the United States had been
a major exporter. Using manufacturing and services as tradable goods, create a standard
trade model for the U.S. and Indian economies that shows how relative price
declines in exportable services that lead to the “outsourcing” of services can reduce
welfare in the United States and increase welfare in India.
7. Countries A and B have two factors of production, capital and labor, with which they
produce two goods, X and Y. Technology is the same in the two countries. X is capitalintensive;
A is capital-abundant.
Analyze the effects on the terms of trade and on the two countries’ welfare of the
following:
a. An increase in A’s capital stock.
b. An increase in A’s labor supply.
c. An increase in B’s capital stock.
d. An increase in B’s labor supply.
8. Economic growth is just as likely to worsen a country’s terms of trade as it is to
improve them. Why, then, do most economists regard immiserizing growth, where
growth actually hurts the growing country, as unlikely in practice?
9. From an economic point of view, India and China are somewhat similar: Both are
huge, low-wage countries, probably with similar patterns of comparative advantage,
which until recently were relatively closed to international trade. China was the first
to open up. Now that India is also opening up to world trade, how would you expect
this to affect the welfare of China? Of the United States? (Hint: Think of adding a new
economy identical to that of China to the world economy.)
10. Suppose that Country X subsidizes its exports and Country Y imposes a “countervailing”
tariff that offsets the subsidy’s effect, so that in the end, relative prices in Country Y
are unchanged. What happens to the terms of trade? What about welfare in the two
countries? Suppose, on the other hand, that Country Y retaliates with an export subsidy
of its own. Contrast the result.
11. Explain the analogy between international borrowing and lending and ordinary international
trade.
12. Which of the following countries would you expect to have intertemporal production
possibilities biased toward current consumption goods, and which biased toward
future consumption goods?
a. A country like Argentina or Canada in the last century that has only recently been
opened for large-scale settlement and is receiving large inflows of immigrants.
b. A country like the United Kingdom in the late 19th century or the United States
today that leads the world technologically but is seeing that lead eroded as other
countries catch up.
CHAPTER 6 The Standard Trade Model 133
c. A country like Saudi Arabia that has discovered large oil reserves that can be
exploited with little new investment.
d. A country that has discovered large oil reserves that can be exploited only with
massive investment, such as Norway, whose oil lies under the North Sea.
e. A country like South Korea that has discovered the knack of producing industrial
goods and is rapidly gaining on advanced countries.
FURTHER READINGS
Rudiger Dornbusch, Stanley Fischer, and Paul Samuelson. “Comparative Advantage, Trade, and
Payments in a Ricardian Model with a Continuum of Goods.” American Economic Review 67
(1977). This paper, cited in Chapter 3, also gives a clear exposition of the role of nontraded goods
in establishing the presumption that a transfer improves the recipient’s terms of trade.
Irving Fisher. The Theory of Interest. New York: Macmillan, 1930. The “intertemporal” approach
described in this chapter owes its origin to Fisher.
J. R. Hicks. “The Long Run Dollar Problem.” Oxford Economic Papers 2 (1953), pp. 117–135. The
modern analysis of growth and trade has its origins in the fears of Europeans, in the early years
after World War II, that the United States had an economic lead that could not be overtaken. (This
sounds dated today, but many of the same arguments have now resurfaced about Japan.) The
paper by Hicks is the most famous exposition.
Harry G. Johnson. “Economic Expansion and International Trade.” Manchester School of Social and
Economic Studies 23 (1955), pp. 95–112. The paper that laid out the crucial distinction between
export- and import-biased growth.
Paul Krugman. “Does Third World Growth Hurt First World Prosperity?” Harvard Business Review
72 (July–August 1994), pp. 113–121. An analysis that attempts to explain why growth in developing
countries need not hurt advanced countries in principle and probably does not do so in practice.
Jeffrey Sachs. “The Current Account and Macroeconomic Adjustment in the 1970s.” Brookings
Papers on Economic Activity, 1981. A study of international capital flows that views such flows
as intertemporal trade.
John Whalley. Trade Liberalization Among Major World Trading Areas. Cambridge: MIT Press,
1985. The impact of tariffs on the international economy has been the subject of extensive study.
Most impressive are the huge “computable general equilibrium” models, numerical models
based on actual data that allow computation of the effects of changes in tariffs and other trade
policies. Whalley’s book presents one of the most carefully constructed of these.
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