Tariffs, Exchange Rates, and the Trade Balance
Nation A imposes a 25% tariff on imported steel. Before the tariff, it imported 10 million tons at a world price of $500/ton. After the tariff, imports fall to 6 million tons and the domestic price rises to $600/ton. Nation A's currency appreciates 10% against its trading partners in the same period. Nation A has a large trade deficit and a low national savings rate. Domestic steel producers expand output, but steel-using manufacturers report rising costs.
1. Calculate the change in consumer surplus for steel users and the change in producer surplus for domestic steel producers, using the standard tariff diagram logic (assume a linear domestic supply and demand schedule is not given - reason qualitatively with the numbers provided).
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We cannot compute exact surplus changes without the domestic supply and demand curves, but we can bound the direction and rough magnitude.
Consumer loss: price rises $100/ton on all steel consumed. Domestic consumption is at least 6M tons (imports) plus domestic production; if domestic consumption is roughly 10M+ tons, the loss is at least $100 × quantity consumed, plus the deadweight loss triangle from reduced consumption.
Producer gain: domestic producers sell more (imports fell 4M tons, replaced partly by domestic output) at a price $100 higher. Gain ≈ $100 × domestic output + triangle from expanded output.
Government revenue: tariff = $100/ton × 6M tons = $600M.
Net welfare: consumer loss > producer gain + revenue because of two deadweight-loss triangles (consumption distortion and production distortion). The judgment: the tariff redistributes from steel users to steel producers and the government, with a net efficiency loss.
2. The currency appreciation occurs simultaneously. Explain how appreciation interacts with the tariff's effect on the trade balance, and determine whether the tariff is likely to reduce the overall trade deficit.
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Appreciation makes Nation A's exports more expensive abroad and imports cheaper, which works against the tariff's goal: it reduces export competitiveness and encourages imports of other goods. The tariff cuts steel imports, but appreciation raises imports of everything else and lowers exports, so the net effect on the trade balance is ambiguous and likely small.
More fundamentally, the trade deficit reflects the savings-investment gap: a low national savings rate with unchanged investment means a capital inflow and a trade deficit regardless of tariffs. Tariffs do not change national savings, so they cannot close the overall deficit - they only reshuffle which goods are imported. The judgment: the tariff likely reduces steel imports but does not reduce the aggregate trade deficit, and appreciation reinforces this.
3. Steel-using manufacturers report rising costs. Trace the effect through the aggregate supply and aggregate demand model and predict the short-run effect on the price level and real output.
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Higher steel prices raise input costs for manufacturers, shifting short-run aggregate supply leftward (a negative supply shock). SRAS shifts left → price level rises and real output falls (stagflation pressure).
Aggregate demand may also shift: higher prices reduce real wealth (wealth effect) and the appreciation reduces net exports (AD shifts left). The combination of leftward SRAS and leftward AD gives an unambiguous fall in real output, but the price-level effect is ambiguous - SRAS pushes prices up, AD pushes them down. The net price effect depends on which shift dominates. The judgment call: the supply-side cost shock is the dominant near-term effect, so expect upward pressure on the price level with lower output - a stagflationary outcome.