59 D'D' schedule to shift back to the right If the objective is to offset completely the

adverse effect on home goods output, the aggregate demand schedule D'D' must shift back until it reaches point A. In this case, the government insulates the effect of the volume of trade shock by running a budget deficit. At the same time, the trade balance deficit will increase as point A is now becoming further below the zero trade balance schedule T T . The end result is that the level of home goods output can be maintained at the expense of an external imbalance.

The exchange rate policy to stimulate the aggregate demand for home goods can possibly be used but with some conditions. In a single goods model with no imported intermediate input, an exchange rate devaluation is likely to produce a positive switching effect on production and negative effect on consumption of home goods, providing the Marshall-Lemer condition is satisfied. This is a standard textbook result. However, it is also possible that an exchange rate devaluation may instead result in a fall in home goods output when (i) initially there is a large deficit of the trade balance; (ii) devaluation gives windfall profits to export and import-com peting industries which have high marginal propensity to save; or (iii) there are ad valorem taxes on exports or imports that a devaluation effectively redistributes income from private to government sectors which may save rather than spend (Krugman and Taylor, 1978). In the present framework, the indeterminable effect of the exchange rate devaluation on output is further compounded by an additional effect of exchange rate change on the real cost of imported intermediate input. This outcome is similarly analysed by van Wijnbergen (1986).

We know that exchange rate adjustment will affect not only the trade balance and the aggregate demand schedules but also the aggregate supply of home goods. That is, while exchange rate devaluation will lead to an expansion of the net exports of home goods, it will also cause an increase in the real cost of oil. Thus, the net effect of a devaluation on the trade balance depends upon the strength of these two opposing forces. From equation (4.9) the net effect of the exchange rate change on the trade balance is

dQ de . . . jzM , , , — { >h- ( >L + 1)— t - « ö ( l - m i t ) d T=0 r a + (1 - a ) m _jt < - 0 > (4.16)

Thus, in a country where the share of the oil imported in the production of home goods is close to zero, the net effect of a devaluation on the trade balance will depend upon the assumption about the Marshall-Lemer condition. If the Marshall-Lemer condition holds, exchange rate devaluation will cause the trade balance schedule T'T' to shift back to the right while exchange rate revaluation will cause the trade balance schedule T T ' to shift to the left.

60 Further, the net effect o f the exchange rate change on the trade balance will also lead to a second round effect on the aggregate demand for home goods in the same direction. dQ de ,4D = 0 Ä V + 1 ) ^ 1 - a Q ( a - m n ) --- :--- - 0 (1 - a \ \ - a ) + r a + (1 - a ) m x > (4.17)

That is, in the same situation as assumed above, the exchange rate devaluation will also have the effect of stimulating the aggregate demand for home goods, and thus cause the D'D' schedule to shift to the right. Note that the magnitude of the effect of the exchange rate change on aggregate demand will be smaller than that on the trade balance schedule because the denominator in equation (4.17) is larger than the denominator in equation (4.16).

Finally, the exchange rate change will also affect the real cost of oil imports. The extent of a shift in the aggregate supply is dependent upon the partial effect of a rise in the real cost of oil on the supply o f home goods, i. e.

= < 0 (4.18)

.45=0

Thus, exchange rate devaluation will cause the aggregate supply of home goods to fall and the S'S' schedule will shift to the left. The use of exchange rate adjustment to achieve the above objective is therefore conditional upon the net effect of the exchange rate change on the trade balance and also the net effect of the exchange rate change on aggregate supply and demand. There are four possible cases where exchange rate devaluation or revaluation may be required. These can be explained as follows:

1. When the net effect on the trade balance is positive, and the net effect on the aggregate demand is greater than that on aggregate supply. In this case, exchange rate devaluation will cause the trade balance and the aggregate demand schedules to shift to the right. This leads to an improvement in the trade balance as well as an increase in the aggregate demand for home goods. However, it w ill also raise the real cost o f oil imports and thus cause the aggregate supply of home goods to fall. As the net effect of exchange rate devaluation on aggregate demand is greater than that on aggregate supply, there will be a net increase in the output of home goods. Thus, exchange rate devaluation can be used to achieve the ob jective on the target o f output and em ploym ent. Furthermore, the trade balance deficit may be reduced as the trade balance and the aggregate demand schedules shift to the right. With this adjustment, the domestic price of home goods will rise as the real exchange rate appreciates.

ctQ de

61 On the other hand, exchange rate revaluation will cause the trade balance and the aggregate demand schedules to shift to the left. At the same time, the aggregate supply will shift to the right as the real cost of oil imports falls. As the net effect of exchange rate revaluation on aggregate demand is greater than that on aggregate supply, there will be a net fall in the output of home goods. Thus, the policy to revalue the exchange rate will not only fail to achieve the objective above but will also cause the trade deficit to deteriorate further.

2. When the net effect on the trade balance is positive, and the net effect on the aggregate demand is less than that on aggregate supply. In this case, exchange rate devaluation will lead to an improvement in the trade balance as well as an increase in the aggregate demand for home goods as mentioned above. However, as the net effect of exchange rate devaluation on aggregate demand is less than that on aggregate supply, the aggregate supply will shift by much more and the net effect on output of home goods is a contraction. Also, the domestic price of home goods will rise as the real exchange rate appreciates. This price adjustment is similar to the first case above. Thus, exchange rate devaluation cannot be used to achieve the objective on the target level of output and employment although it may help to improve the external balance.

On the other hand, exchange rate revaluation will cause the trade balance and the aggregate demand schedules to shift to the left. But as the aggregate supply will shift to the right and the net effect of the exchange rate revaluation on aggregate demand is less than that on aggregate supply, there will be a net increase in the output of home goods. Thus, the policy to revalue the exchange rate can be used to achieve the objective on the target of output above. However, as the trade balance and the aggregate demand schedules shift to the left, there will be a deterioration in the trade deficit. At the same time, the domestic price of home goods will fall as the real exchange rate depreciates.

3. When the net effect on the trade balance is negative, and the net effect on aggregate demand is greater than that on aggregate supply. In this case, exchange rate devaluation will cause the trade balance and the aggregate demand for home goods to shift to the left. At the same time, it will also raise the real cost of oil imports and thus cause the aggregate supply of home goods to shift to the left. This negative effect will cause a further fall in the output of home goods and a worsening trade deficit. As the real exchange rate may depreciate or appreciate, the domestic price of home goods may also rise or fall. In this case, the exchange rate devaluation will not only fail to achieve the internal balance objective, but it will lead to a deteriorating external balance.

On the other hand, exchange rate revaluation will cause the trade balance and the aggregate demand schedules to shift to the right. At the same time, the aggregate supply will also shift to the right as the real cost of oil imports falls. This positive effect will lead to a net increase in the output of home goods. At the same time, as the trade balance and

62 aggregate demand schedules shift to the right, the trade balance will improve. And similar to the above case, as real exchange rate may depreciate or appreciate, and therefore the domestic price of home goods may rise or fall. Thus, the policy to revalue the exchange rate not only helps to achieve the internal balance objective but also improves the external balance.

4. When the net effect on the trade balance is negative, and the net effect on aggregate demand is less than that on aggregate supply. In this case, the exchange rate devaluation will cause the trade balance and aggregate demand for home goods to shift to the left as mentioned above. At the same time, aggregate supply will also shift to the left. Therefore, there will be a net fall in the output of home goods and a worsening of the trade balance. The domestic price of home goods may rise or fall depending on the adjustment of the real exchange rate. In this case, the result is similar to the third case when we have the exchange rate devaluation.

On the other hand, exchange rate revaluation will cause the trade balance and the aggregate demand schedules to shift to the right. Also, as the aggregate supply will shift to the right when the real cost of oil imports declines, this will further support the increase in the output of home goods. The domestic price of home goods may rise or fall depending on the adjustment of the real exchange rate. Thus, the policy to revalue the exchange rate can be used to achieve the objective on the target level of output above. And since the trade balance and the aggregate demand schedules shift to the right, the same policy also helps to improve the external balance.

3.

The response to restore external balance

In this case, the government may be more concerned with a worsening of the current account balance and decide to restore external balance. Thus, it can respond to the volume of trade shock by having a contractionary fiscal policy to reduce domestic absorption in line with a fall in income. If there is still an excess of private spending over income, the government will have to run a budget surplus. This will cause the aggregate demand schedule to shift upwards until it intersects the T'T' schedule at D. In this case the economy will be able to achieve an external balance but at the cost of a reduction in the level of home goods output. In addition, the domestic price of home goods will fall further as the real exchange rate depreciates.

Alternatively, exchange rate policy can be similarly applied to achieve the external balance. Nevertheless, w hether the governm ent should em ploy exchange rate devaluation or revaluation depends upon the same conditions as discussed earlier. Without a repetition of the same results, the appropriate policy options to achieve this objective as well as the previous objective on the target level of output can summarised in Table 4.1 below. The expression in the parentheses are also given to show the effect of

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