Question

In: Economics

Suppose the country has the production structure (including the production structure in the export sector) that...

Suppose the country has the production structure (including the production structure in the export sector) that depends on imported energy.
i) How energy price (increase) shocks can pass through domestic prices and how nominal exchange rate changes in the flexible exchange rate system after the shock?
ii) How the Central Bank aiming to decrease shock's negative impact on the competitiveness of the firms in the export sector might intervene in the foreign exchange market if the relevant elasticities do not allow the nominal exchange rate to completely absorb the oil price shock?

Solutions

Expert Solution

When the energy prices increased create a shock in the domestic market, will lower the rate of import. Thus the supply of energy products in home country will fall down. There is scarcity of this products formed in domestic market. The import becomes more expensive with increasing nominal interest rate. So the increasing price of energy products in international market lower the investment and output rate in domestic country.
With flexible exchange rate the shock can be maintained. Flexible exchange rate act as shock absorbers. It can be changed according to the then market situation. Flexible exchange rates having the ability to accommodate better real external shocks. The shattered investment rate and lower rate can be maintained through this flexible exchange rate.
(ii) Central bank’s monetary policy committee can maintain the inflationary pressure occurred due to the shock. More financial integration will dampen the effect due to increase in oil price. Thus the central bank intervenes in the foreign exchange market to reduce the negative impacts. Central bank will increase the value of currency and attract the foreign market to retain their international relations. Monetary authority imposes several policies which tried to reduce the price of subsidies of oil products. The oil prices affect the transportation, manufacturing and heating. The oil price hike induce the cost in the whole economy.


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