Question

45. In a two-commodity, two-country trading world (as in the offer curve diagrams), if, at a given terms of trade (price of good X - price of good Y), there is an excess demand for good X, then there must and the price of good X relative to the price of good Y will therefore a. also be an excess demand for good Y; rise b. also be an excess demand for good Y; rise, fall, or not change - cannot be determined without more information c. be an excess supply of good Y; rise d. be an excess supply of good Y; fall 46. Suppose that a country is exporting good X and importing good Y. Suppose also that, in a particular range of the country's offer curve, a rise in the relative price of X causes the country to export less of X and to import more of Y. Then, in this range, a. with respect to good Y, the "income effect" of a rise in the terms of trade outweighs the "substitution effect" and the production effect." b. with respect to good X, the "substitution effect" of a rise in the terms of trade outweighs the "income effect" and the production effect."

Answer 1

1. In a Terms of Trade model, an excess demand for one good means that there has to be an excess supply of the other good. This implies that excess demand for good X will increase its price in world market and the excess supply of good Y will decrease its price down wards. So option c is right here.

2. When a relative price of X rises, it means the country can trade a given amount of X for more units of Y. so the income effect will increase the consumption of both goods whereas the substitution effect will effect will reduce consumption of X and increase that of Y. Therefore, the increase in price of X will increase its production relatively but also decrease its consumption as substitution effect will overpower income effect. hence option b is correct