Production and export subsidies: A dynamic analysis

We utilize a two-good, two-period intertemporal framework to examine the effects of terms of trade improvement on a small economy. A temporary terms of trade improvement in the current period increases the real GDP in the current period—total welfare and welfare within each period rise by the net wealth effect and the net intertemporal effect. The rise in GDP is more than consumption in the current period, leading to a balance of trade improvement in the current period. ^ We modify this two-period framework to analyze the effects of export and production subsidies on a small open economy. In the absence of investment, a temporary subsidy in the current period leads to a welfare loss as well as a balance of trade deterioration in the current period. A temporary subsidy in the current period, by bringing in production distortions, reduces GDP in the current period. The resulting welfare loss is distributed between two periods. Since GDP falls more than consumption, the balance of trade deteriorates in the current period. A temporary export subsidy, compared to a production subsidy, in the current period leads to a lower welfare level, higher exports, and a smaller balance of trade deterioration in the current period. ^ We utilize a two-good infinite horizon model to compare the effects of export and production subsidies on a small open economy, in presence of investment. A permanent subsidy permanently raises capital stock—the net foreign assets fall in order to finance investment. A permanent subsidy raises net output and welfare through capital formation and the lowering of installation costs of investment, but lowers welfare by creating distortions—the net effect on welfare is ambiguous. A permanent export subsidy, compared to a permanent production subsidy, introduces an additional distortion by raising the domestic installation costs of investment—consequently, the rise in the capital stock and level of the net foreign assets, are lower in case of a permanent export subsidy. A temporary production subsidy always induces initial investment—however, a minimum level or duration of export subsidy is necessary to spur initial investment. This initial investment, resulting from a temporary subsidy, leads to an initial deterioration of the current account.