Small Open Economy with no trade
If there is no trade in the small open economy, equilibrium is determined by the tangency between the PPF and indifference curve for the representative consumer. In equilibrium, the slope of the PFF is equal to minus the price of good a relative to good b (see figure bellow).
The effects of Trade in the Small Open Economy
With trade, the relative price of good a in terms of good b is determined at world markets-call it: TOTab
MRTa,b = TOTa,b
Suppose the consumer is endowed with a1 units of good a and b1 units of good b. Let qa and qb be respectively the quantity consumed of goods a and b. Representative consumer’s budget constraint when there is trade with the rest of the world:
TOTabqa+qb = TOTaba1+b1
The consumer optimize by choosing a bundle where the indifference curve is tangeant to budget constraint -(a2, b2)
When the small open economy trades with the rest of the world at market prices given by the terms of trade, consumption occurs at point E and production occurs at point D, with the slope of DE equal to minus the term of trade (see figure bellow).
The small open economy imports good a (a2 > a1) and exports good b (b2 < b1). Recall current account surplus = net exports + net factors payment from abroad:
CA = b1 − b2 − TOTab (a2 − a1)
From budget constraint, we have CA = 0, Assumed that there is no borrowing and lending.
Two factors determine the patterns of trade are:
1. Comparative advantage: Here comparative advantage in good b-slope of PPF (stteep slope more a to produce b)
2. Consumer preferences
Theoretically free trade improves welfare, but practically some people win while others loose
Welfare must increase for the SOE when trade opens up, no matter which good the SOE initially imports.
When there is no trade, consumption and production occur at point A, but when the Small Open Economy trades with the rest of the world, production occurs at B and consumption at D. In this case, good a is imported and welfare is higher with trade, as the representative consumer attains a higher indifference curve (see figure bellow).
In contrast with the figure above, good b is imported when the small open economy can trade with the rest of the world. Trade improves welfare, as the consumer attains higher indifference curve (see figure bellow).
Next page, effects of change in the Terms of Trade