(a) Explain the price effect, protective effect, consumption effect, revenue effect and distributive effect of tariff in partial…

(a) Effects of a tariff in partial equilibrium

In partial equilibrium, for a small country facing world price Pw, a specific tariff t raises the domestic price to Pw+t. The price effect is the rise in price paid by consumers. The protective effect follows because domestic producers receive the higher price and expand output from S1 to S2; producer surplus rises. The consumption effect is the fall in quantity demanded from D1 to D2. The revenue effect is tariff receipts equal to t multiplied by post-tariff imports (D2−S2). The distributive effect is seen in welfare areas: consumers lose the area between the old and new prices to the left of demand; producers gain the area between the two prices to the left of supply; the government gains tariff revenue; and two deadweight triangles remain—one from producing more at higher domestic cost and one from consuming less. Thus a tariff transfers part of consumer surplus to producers and the state but creates efficiency loss. If the country is large, the tariff may improve terms of trade; strategic trade policy and optimal tariff theory modify this simple conclusion, though the partial-equilibrium analysis assumes no retaliation.

(b) Trade creation and trade diversion

In a customs union or free trade area, trade creation occurs when imports from a low-cost member replace higher-cost domestic production, moving resources to more efficient use and raising welfare. Trade diversion occurs when imports shift from a low-cost non-member to a higher-cost member because the member’s preferential tariff is lower. The diversion loss is the extra cost of buying from the higher-cost partner, (Pp−Pw)×M0, where Pp is member price, Pw world price and M0 the diverted volume. This loss may be outweighed by trade-creation gains; consumer surplus gains may even exceed the tariff revenue lost on diverted imports. Viner’s analysis therefore makes the net gain from a trade bloc ambiguous: it depends on whether creation exceeds diversion, the size of tariffs removed, and the relative costs of members and outsiders. India’s post-1991 tariff cuts and WTO commitments show that trade liberalisation can raise efficiency, but sectoral exposure and preferential arrangements require careful design.

(c) Fiscal and monetary policy under perfect capital mobility with a fixed exchange rate

Perfect capital mobility does not improve both policies: it makes fiscal policy fully effective and monetary policy wholly ineffective. Under Mundell-Fleming, perfect capital mobility makes the BP curve horizontal at the world interest rate. With a fixed exchange rate, monetary policy is ineffective: an expansionary monetary shift lowers the domestic interest rate, causing capital outflow; the central bank sells foreign reserves to defend the parity, the money supply contracts, and output returns to its initial level. Fiscal policy is highly effective: an expansionary fiscal shift raises output and the interest rate, attracting capital inflows; the central bank buys foreign currency, expanding the money supply and shifting LM right, so there is no crowding out. However, this short-run effectiveness is not necessarily sustainable. Persistent fiscal expansion or external shocks can exhaust reserves, and the impossible trinity implies that a country cannot simultaneously have a fixed exchange rate, free capital mobility and independent monetary policy. India’s RBI-managed float and capital-account management preserve monetary-policy space, illustrating the trade-off.