Question

External shocks We return to the case of Arcania, a small open economy that imports oil, but for this question you do not need to worry about the tariffs or quotas discussed above. a) Consider the effect of an increase in the world price of oil. First suppose that Arcania has a floating exchange rate. What will be the effect of that increase in oil prices on output, employment, and the exchange rate? Explain carefully. b) Now suppose Arcania has a fixed exchange rate, but faces the same increase in oil prices. What will be the effect of that increase in oil prices on output, employment, the balance of payments, the money supply and prices? Explain carefully. c) In the real world, the price of oil is subject to very large fluctuations. Oil imports make up a large fraction of Arcania’s imports. If you were making policy recommendations to Arcania, how would these facts affect your recommendation as to whether the country should adopt fixed or floating exchange rates? Explain carefully, referring to your answers in (a) and (b). d) Suppose Arcania adopts a floating exchange rate but then develops a persistent trade deficit. Policymakers suggest adopting a tariff on oil to reduce the trade deficit. As a policy advisor, discuss the pluses and minuses of such a policy. Be specific and explain.

Answer 1

a) Arcania, importing country for oil at floating exchange rate, will have significant impact on output, employment and exchange rate as oil is directly linked to the production process.

Increase in production cost will lead to increase in price of the product and which in turn decreases the demand for that product. Therefore negatively impacting the return on investment and reduce the consumption of the product, which will have negative impact on employment and output.

Exchange rate of the country will also have direct impact because of change in oil price as oil is priced in dollar internationally accepted currency. Increase in Oil price leads exchange rate to depreciate in oil importing countries.

b) Impact of increase in oil price on output, employment, the balance of payments, the money supply and price in an economy with fixed exchange are as follow:

Output: Increase in production cost, will lead to decrease in consumption therefore decrease in output

Employment : Increase oil price, will increase in production cost, will lead to decrease in investment therefore decrease in employment.

Balance of Payment: Since the increase in oil price, will lead to increase in US dollar. Therefor the country with fixed exchange rate will need to increase the reserve therefore implies deficit in BOP.

Money Supply: Money supply will decrease in the system because of more reserves in BOP and letting the currency to devalue.

price: price will increase as explained above

c) Taking into consideration the above points, Arcania should go for floating exchange rate as deficit in BOP would lead to currency depreciation in case of fixed exchange rate where as BOP will be stable in floating exchange rate. There will be no need to keep large foreign currency reserves. Also country with floating exchange rate does not face imported inflation.