Depreciation, the J-Curve, and a Steel Tariff
A country's currency depreciates 18% against major trading partners. In the first two quarters, export volumes rise 3% and import volumes fall 2%, while import prices rise 20% and export prices rise 5%. Economists estimate the sum of export and import demand elasticities is 0.7 in the short run and 1.6 in the long run. The government proposes a 25% tariff on imported steel. Steel is an input for about 40% of domestic manufacturing, and the country is a small open economy in steel trade. The tariff would raise $400 million in revenue, but domestic steel producers would gain and steel-using manufacturers would lose. The country's trade balance is currently -3% of GDP. Retaliation from trading partners is considered likely.
1. Use the Marshall-Lerner condition and the price and volume data to explain the J-curve. What should policymakers expect for the trade balance in the short run and long run?
Read the worked answer
The Marshall-Lerner condition says a depreciation improves the trade balance only if the sum of export and import demand elasticities exceeds 1. Here the short-run sum is 0.7, so price effects dominate volume effects. Import prices rise 20% while import volume falls only 2%, so the import bill rises by roughly 1.20 × 0.98 − 1 = +17.6%. Export prices rise 5% while export volume rises 3%, so export revenue rises by about 1.05 × 1.03 − 1 = +8.2%. With imports rising faster than exports, the trade balance at -3% of GDP worsens in the short run-the J-curve. As elasticities rise to 1.6 in the long run, volume responses dominate and the trade balance should improve, provided the depreciation is not offset by domestic inflation.
2. Evaluate the steel tariff using welfare analysis for a small open economy. Identify the winners, losers, and deadweight losses, and explain why the tariff may be worse than it looks.
Read the worked answer
For a small open economy, the country cannot change the world price of steel, so the 25% tariff is passed through to domestic steel users. Domestic steel producers gain producer surplus; the government gains about $400 million in revenue; steel-using manufacturers and final consumers lose consumer surplus. The welfare loss is the standard production distortion, as domestic high-cost steel replaces imports, plus the consumption distortion, as less steel is used. The tariff looks worse because steel is an input for 40% of manufacturing: the tariff raises costs for downstream firms, reducing their output and export competitiveness. That can destroy more jobs in steel-using industries than it protects in steel. Retaliation and compliance costs add further losses.
3. How should the government weigh the tariff against alternatives such as adjustment assistance or infrastructure investment? Discuss development implications.
Read the worked answer
The government should compare the tariff with alternatives that address the same adjustment problem at lower cost. If the goal is to protect steel workers, direct adjustment assistance or wage insurance is more targeted and does not tax downstream manufacturers. If the goal is development, infrastructure or education spending may raise productivity in tradables without raising input costs. Tariffs may fit an import-substitution strategy, but they risk retaliation and lock resources into a sector where the country may lack comparative advantage. Export-led growth would emphasize the exchange-rate depreciation and removal of supply bottlenecks instead. The decision should weigh the present value of downstream losses and retaliation against the temporary protection of steel.