Chapter 2

How is TOT established Mill’s Reciprocal Demand Principle

Graph Autarky Trade equilibrium

Offer Curve Conception How to derive offer curve Trade equilibrium

Chapter 2

Autarky

OX0 X

Y

Y0

I0

I1

I2

Price Line

A

B

K

Chapter 2

Trade Equilibrium

Chapter 2

Offer Curves are all combinations of a country’s

desired exports and imports at different terms of trade

also known as reciprocal demand curves (J.S. Mills)

measures of willingness to trade

Chapter 2Y

XY

X

(PX/PY)1

X2

Y2

X1

Y1

C P

X5

Y5

(PX/PY)1

Chapter 2Y

XY

X

(PX/PY)1

X5

Y5

(PX/PY)1

(PX/PY)2

X4X3

Y3

Y4

(PX/PY)2

X6

Y6

Chapter 2Y

XY

X

(PX/PY)1

X5

Y5

(PX/PY)1

(PX/PY)2

X4X3

Y3

Y4

(PX/PY)2

X6

Y6

OCA

Chapter 2

Offer Curves Offer curves represent willingness

to trade at every possible terms of trade

As the relative price of good X rises, Country A becomes willing to export more and import more

Offer curves “bow” towards the import good axis

Chapter 2

Deriving Country B’s Offer Curve This will reflect Country B’s

willingness to trade at different terms of trade

B’s offer curve bows towards the axis with B’s import good on it

Chapter 2Y

XY

X

(PX/PY)1

p

X7

Y7

c

X8

Y8

(PX/PY)1

X9

Y9

Chapter 2Y

XY

X

(PX/PY)1

(PX/PY)1

X9

Y9

(PX/PY)2

Y10

X10

Y11

X11

X12

Y12

(PX/PY)2

OCB

Chapter 2

Terms of Trade Equilibrium The international terms of trade

(that is, PX/PY) will be the slope of a line passing through the point where the offer curves cross.

This equilibrium point takes into account demand and supply conditions in both countries

Chapter 2

Terms of Trade EquilibriumY

X

(PX/PY)E

X1

Y1

OCA

OCB

If these are the terms of trade,country A will desire to exportX1 units, and country B will want to import X1 units;

country A will desire to importY1 units, and country B will want to export Y1 units

Chapter 2

How Do We Know It’s Equilibrium? Any terms of trade other than

(PX/PY)E will result in excess demand for one good excess supply for the other

Therefore relative prices will adjust until (PX/PY)E is reached

Chapter 2

Disequilibrium

Y

X

(PX/PY)1OCA

OCBY1

Y2

At (PX/PY)1, country A wishesto import Y1 units, but country B is only interested in exporting Y2

units. That is, there is an excess demand for good Y.

Chapter 2

Disequilibrium

Y

X

(PX/PY)1OCA

OCB

X1X2

At (PX/PY)1, country A wishesto export X1 units, but country B is only interested in importing X2

units. That is, there is an excess supply of good X.

Chapter 2

Disequilibrium Excess demand for Y causes PY to rise Excess supply of X causes PX to fall Thus, (PX/PY) falls In other words, the terms of trade line

gets flatter, moving the countries in the direction of equilibrium

Chapter 2

Moving Towards Equilibrium

Y

X

(PX/PY)1 OCA

OCB

Chapter 2

Disequilibrium Terms of trade lines that are flatter

than (PX/PY)E, such as

Y

X

(PX/PY)2OCA

OCB

Chapter 2

Disequilibrium Terms of trade lines that are flatter

than (PX/PY)E will results in an excess demand for good X an excess supply of good Y, and so

(PX/PY) will rise That is, the terms of trade line will

get steeper until (PX/PY)E is reached

Chapter 2

Moving Towards Equilibrium

OCA

Y

X

(PX/PY)2

OCB