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Abstract

The first Sino-Japanese war that took place in 1894–1895 was concluded with Japan's victory and the Treaty of Shimonoseki which in effect requires China to pay a war indemnity of 230 million taels of K.P. silver; cede Taiwan to Japan in perpetuity and full sovereignty; open treaty ports for Japanese export and investment, etc. The amount of indemnity was about a quarter of Japan's GDP at the time. In contrary to the effect of Franco-Prussia war indemnity payment on France studied in Devereux and Smith (2007), China's post war terms-of-trade was improved. Using a small open economy (SOE) full DGE model, this paper investigates the impacts of the war indemnity on China's economy for 1895–1900, particularly issues related to the “transfer problem”. Our simulation results predict an improvement of the terms of trade which fits the Chinese history. The assumptions of two-goods setting, import markup, and SOE explain the difference in results between the current paper and Devereux and Smith (2007).