Briefly explain the impact of an increase in the price of U.S. oil imports on the country's balance of payments and domestic product and income, assuming floating exchange rates.

Question

What will be an ideal response?

Answer 1

POSSIBLE RESPONSE: International trade shocks such as an increase in the price of oil imports cause the value of the country's current account balance to change. An adverse international trade shock reduces both the current account and the country's domestic product and income. As the current account worsens, the overall payments balance tends to go into deficit and the country's currency depreciates. The improvement in price competitiveness leads to an increase in the country's exports and a decline in imports. The current account improves and domestic product and income rise. If all of this happens with no change in international capital flows, then the currency must depreciate enough to completely reverse the deterioration in the current account, putting the overall payments balance back to zero. With floating exchange rates, the effects of international trade shocks on internal balance are mitigated by the effects of the resulting change in the exchange rate. An adverse trade shock tends to depreciate the country's currency, and this reverses some of the effects of the shock.