Question

A number of developing countries have accumulated a considerable volume of external debt. In this question, we examine the impact on the terms of trade of the developing countries that would result from repaying part of this debt. For the purposes of this question, suppose that developing countries will pay $300 billion to the industrial countries over the next decade. In addition, assume that this is a transfer. Suppose that the developing countries export raw materials and basic manufactures (“basic goods”) and that the industrial countries export advanced manufactures (“advanced goods”). Spending patterns differ in these two groups of countries. In the developing countries 70 cents of each dollar of spending is allocated to basic goods and 30 cents out of each dollar is allocated to advanced goods. In the industrial countries, the spending pattern is reversed (70% on advanced goods and 30% on basic goods).

a) What is the effect of a $300 billion transfer on world demand for advanced goods?

b) What is the effect of a $300 billion transfer on world demand for basic goods?

c) Using your answers to the first two parts of this question, please determine whether the relative demand curve shifts left or right. Please let the developing countries be the “home country”. Will the terms of trade of trade of the developing countries improve or worsen? Some have argued that, if the developing countries are to generate the surpluses that will facilitate the transfer, the relative price of their exports must fall—their terms of trade must worsen. If so, that would place a “secondary burden” on the developing countries over and above the burden of repaying their debt. Is the concern a valid one in this instance?

d) How would your answers differ if the spending patterns were reversed for the two countries? Repeat the questions with industrial countries spending 30% on advanced goods and 70% on basic goods and developing countries spending 70% on advanced goods and 30% on basic goods.

Answer 1

a) When $300 billion is transfered to developed nations it means they will have more money in hand and developing nations' per capital income falls, Hence their demand for imports of advanced manufactures fall.

b) When $300 billion is transferred, the people of developed nations will have more money in hand and therefore their demand for basic manufactures would go up. In this case they import from the developing economies.

c)

The relative price reflects price of basic manufactures with respect to advanced manufactures. When aggregate demand rises for this category of products, the relative prices will also rise. Moreover with less money in hand, the developing countries might not be able to increase their supplies accordingly. In the graph below advanced manufactures’ demand shifts left as the quantity demanded fall and its relative prices fall as well.

Terms of trade for developing nations improve and therefore price of their exports increases. But if they generate surpluses it means a shift of supply to the right, then relative prices could fall but this is unlikely the case as the developing economies would also plan for their sustainability before making the transfer payments. Also their debt burden will come down and this will imrpove their GDP values.

If the spending patterns were different, then the second graph would be for basic manufactures and first one for advance manufactures. Terms of trade for advanced goods would improve and that for basic manufactures would fall. If developing economies generate surpluses the terms would fall further as supply curve will shift rightward.