In this chapter our objective is to examine tariff policy in the presence of capital markets. In particular, we address the following issues: (1) how does the degree of integration of financial markets affect the optimal tariff rate; (2) what is the magnitude of the welfare gains arising from the change in tariff rates on the opening of financial markets, and how do these gains compare with the direct gains from risk sharing; and (3) can financial markets play a role in coordinating international policy.

The model that is used to analyze these issues is an extended version of the basic framework described in Chapter 3. The major difference is that now commodity markets are segmented because of an explicit tariff instead of a shipping cost – that is, one needs to interpret the exogenous shipping cost as an endogenously determined tariff rate, as done in Lee (1998) and Devereux and Lee (1998).

The choice of optimal tariff policy has been studied at length. Johnson (1954) framed the choice of optimal tariff in terms of the terms-of-trade argument. Kennan and Riezman (1988) extended the results in Johnson by relaxing the assumption of constant-elasticity offer curves. Other models of strategic tariff interactions between governments include McMillan (1986) and Dixit (1987). These models, however, do not consider stochastic endowments or the role of financial markets.

Helpman and Razin (1978b) are among the first to study the effect of financial markets on tariffs.