The NN schedule represents the excess supply of non-traded goods It has a negative slope with respect to the real exchange rate because the own-price elasticity of
III. The Effects of an Oil Price Shock
It is now possible to analyse the effects of an oil price shock on the real exchange rate and the current account. Suppose there is a rise in the price of oil relative to the price of traded goods (a fall in t ). The effect on the equilibrium real exchange rate will depend on whether the NN schedule shifts up or down. This is dependent upon the outcome of two opposing forces. First, there will be a fall in real income because of the adverse terms of trade effect. Consequently the consumption of traded and non-traded goods will fall (the income effect). Second, the increase in the price of imported oil will lead to a fall in the supply of final tradeable and non-tradeable goods, providing oil is a normal input. The extent of the fall in supply is dependent upon the partial effects of an oil price change on the supplies of traded (Yrxf) and non-traded goods ( YNM -the input substitution effect). At unchanged prices of traded and non-traded goods, if the input substitution effect dominates the income effect in the non-traded goods sector, there will be an excess demand for non-traded goods and its price will rise. The NN schedule will shift downward. To restore equilibrium in the non-traded goods market the real exchange rate must appreciate. This is shown in Figure 5.2 (A) by a fall in the real exchange rate from po to pj. At the same time, the current account will unambiguously worsen by the amount of aQ^dt (assuming that case III holds). This is shown by the distance 'be' at the real exchange rate of pj.
However, if the income effect dominates the input substitution effect, there will be an excess supply of non-traded goods and the NN schedule will shift upward. To restore equilibrium in the non-traded goods market the real exchange rate must depreciate. This is shown in Figure 5.2 (B) by a rise in the real exchange rate from po to pj. At the real exchange rate of pi the current account worsens by the amount of s Q ^ t . Note that in both cases the change in the current account balance depends upon the type of marginal propensity to save of the individual consumer (the sign and magnitude of s) and the initial level of oil imported.
4 The reason is that Figure 5.1 uses the insight of the absorption approach to the balance of payments by plotting separately the excess supply of non-traded goods and the excess of income over expenditure. In the absorption approach the current account surplus is the excess of the national supply of all goods (traded plus non-traded goods) over the national demand of those goods, i.e. CA = XN + XT . A condition for equilibrium is that XN = 0, and so CA - XT . Therefore, when Xv equal to zero at point 'a' the current account is equal to XT (distance 'ab'), and this docs not depend on the real exchange rate whereas XN does. This insight of the absorption approach is used to simplify the analysis.
92 Figure 5.2
Effect o f an oil price shock on the real exchange rate
(A ) ( B)
N
sGlm {
The movement of the real exchange rate following the oil price shock is an adjustment to regain an equilibrium in the economy. W hether it will depreciate or appreciate should not be a problem in itself. However, it does have an implication on the level of current account in the long-run. In the case of the real exchange rate depreciation the traded goods sector will expand and the non-traded goods sector contract. The rising import cost of oil input on the current account can be offset by an increase in production and a decline in consumption of traded goods. Hence, the current account may deteriorate but in the long-run it will ultimately improve by itself. On the other hand, if the real exchange rate appreciates it will lead to a contraction in production and an increase in consumption of traded goods. Consequently, the current account will further deteriorate until the relative prices of traded goods to imported oil is reversed or the import of oil is cut down.
The adjustment of the real exchange rate also has an important implication for the use of fiscal policy. An increase in the price of oil imported also reduces the present level of income and affects employment. This deflationary effect is usually dealt with by an expansionary fiscal policy. If the real exchange rate appreciates following an oil price shock, the use of an expansionary fiscal policy which involves an increase in the government spending on non-traded goods will cause the real exchange rate to appreciate further. The current account will also continue to worsen. In this case, the use of an expansionary fiscal policy to achieve the internal balance also worsens the external balance. On the other hand, if the real exchange rate depreciates following the oil price shock, the use of an expansionary fiscal policy to achieve the internal balance may be possible to some degree without further worsening the external balance.