Raising tariffs on imported goods in order to reduce our trade deficit with othe
ID: 1222055 • Letter: R
Question
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.
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 this reasoning. In order to get credit you must use the small open economy model
Explanation / Answer
Under small open economy model, economy is considered to be price takers and it does not affect prices in international market, interest rates and other global macroeconomic variables.
Under the small open economy model,
GDP = C + I + G + (Export - Import)
Raising income tax will reduce the income available for expenditure. It will reduce the aggregate consumption (C). It will further lead to decreased demand and import will also come down. At the same time, persuading trade partner to reduce income tax will increase consumption in their economies. It will lead to increase the aggregate demand. Thus, export will increase.
Thus, adopting above policies will reduce the aggregate demand, reduce imports and increase export. Thus, the net result will be the reduction in the trade deficit. Though, it will come at a cost as domestic production level of the economy can also come down. But, it can be compensated by the increased demand in overseas economies.
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