In a two-good,one-period model,an increase in the terms of trade when good b is initially imported implies

Question

Quizplus · Accepted Answer

An increase in the terms of trade implies that the price of exported goods increases relative to imported goods. Therefore, if good b is initially imported, an increase in the terms of trade leads to a decrease in the price of good b. This leads to a positive income effect for good b, as the SOE can now purchase more of good b with the same amount of exports. Additionally, as the relative price of good b decreases, the SOE will also substitute consumption towards good b, leading to a positive substitution effect for good b. Therefore, the income and substitution effects for good b move in the same direction, making choice C the correct answer.

In a Two-Good,one-Period Model,an Increase in the Terms of Trade