In a recent speech, Fed Vice Chair Stan Fischer, made two points: (1) Raising ta

Question

In a recent speech, Fed Vice Chair Stan Fischer, made two points:

(1) Raising tariffs on imported goods in order to reduce our trade deficit with other countries, (i.e. NXUSA <0) while it sounds good, is unlikely to actually impact the trade deficit at all, and will most likely harm the U.S. export sector.

(2) Perhaps the most direct way to reduce our trade deficit is to increase U.S. income taxes, TUSA, while persuading our trading partners to reduce their income taxes, Tpartners . Use the small open economy model, equations or graphs, to explain Vice Chair Fischer’s reasoning. In order to get credit you must use the small open economy model.

Explanation / Answer

1. As a result of rasising the tariff on imported goods, a disincentive of export is created by directily altering the price of imported goods relative to expotred goods. As Lerner (1936) argued that the effect of export tax and import tariff are symetric or equivalence.

An import tariff raises the price of imported good. consumers want to consume more of home good rather than expensive imported good. As a result the price of home good increases. The price of exports decreases compared to nontarded home good. This affects real exchange rate and the production shifts from export to non traded home goods. This harms U.S. export sector.

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