Tariffs and Effects on Terms of Trade

To follow up with a post by Trae Shubat last week, I would like to talk about the China trade war and how it is affecting the American consumers as well as the terms of trade for the United States and China. A recentlypublished article discusses the new round of 15% tariffs that went into effect on $112 billion of Chinese goods will be affecting school supply shopping for years to come. Of the many, the tariffed imports include pencils, crayons, sneakers, overcoats and windbreakers, calendars, and ball-point pens. This effect of the tariff, though the impacts won’t be felt until next year, will be a big dampener on American parents’ already tight back-to-school budget. Economists from the Federal Reserve bank of New York even predict American Families will spend about $831 extra annually due to the tariffs on Chinese imports.

To illustrate how these tariffs have impacted the terms of trade and the two countries welfare, I will use the U.S. import (school supplies) and the U.S. Export (medical instruments). In a perfect world between the U.S. and China, the U.S. would produce medical instruments along its PPF, its consumers would consume medical instruments at a point, above the PPF, along the income line. The right triangle between the utility maximizing point of consumption and the point of production would form a trade triangle showing how much school supplies need to be imported and how much medical instruments are able to be exported. In this scenario, we assume China has the inverse of this, as they are importing medical instruments and exporting school supplies. In a perfect world, where no tariffs exist, China and U.S. are both well off, as we are both able to use the income, we get from our exports, to pay for our imports. The problem is, when relative prices of what the U.S. imports rise, there is a worsening terms of trade effect and a worsening U.S. welfare, because as the income line becomes more horizontal, point of consumption gets closer to the PPF, and the trade triangle gets smaller. Tariffs restrict trade, and when tariffs are put on our imports from China, the prices will rise and the U.S. is not able to reap the benefits from free trade.

Another factor affecting the U.S. terms of trade would be import-biased growth in China. The U.S. China trade war with tariffs has caused China to retaliate against the U.S. and grow in domestic production of what it imports from the U.S. To use our example above, say that China has decided to produce more medical instruments, thus decreasing its production of school supplies. With the increase in relative supply of medical instruments, the world price of medical instruments declines. This will also increase the world price of the school supplies, already being tariffed, as the relative supply has decreased. These factors cause a negative terms of trade effect on the U.S, as the price of its exports goes down and the price of imports goes up. China will be still be realizing some sort of gain from trade, as it is still exporting, but with the high prices of its exports and the tariffs, it is not the most optimal trading situation for them.