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Terms of Trade Shocks (Introduction (Structure (Fixed vs flexible (Prices,…

- - - - Not flexible due to it requiring income to fall so that real demand falls
    - - Allow for smooth adjustment to shocks
  - - - Prices
      - Real Output
      - Real Exchange & Nominal Exchange responses
- - - - Flexible Example: Using MP to eliminate FEX fluctuations, rendering a de jure float a de facto peg as seen in India (1993-96)
  - - - Demise of Fixed Exchange regimes is a myth - based on evidence to FEX volatility and foreign reserves
        
        Claims many supposed flexible exchanges are intervening in FEX to prevent their nominal rate from moving freely
        
        No substantial difference between the two
- - - - LIE subject to alot due to reliance on primary comodities
        
        Compared to developed countries with manufactured goods and services
        
        Price takers of commodities
        
        Lack of ability to increase supply - max capacity
  - - - Negative TOT shock - Price drop exports
        
        Prices
        
        Fixed Exchange Regime
        
        Rely on slow changes in domestic prices - stuck with negative effect of TOT shock
        
        Downward pressure on FEX corrected by CB by buying up DC
        
        Inherently Contractionary - further increases unemplyoment
        
        1 more item...
        
        Flexible Exchange Regime
        
        Keynesian Stick prices, slow to react to TOT shock
        
        Fall in TOT depreciates the nominal FEX
        
        Fall in output and demand for goods, reduces demand for money
        
        1 more item...
        
        Nominal Exchange Rate
        
        Fixed
        
        Calvo-Reinhart Effect - Fear of inflation in dollarized economies with heavy foreign debt burdens
        
        Proven not to be the case for long, emphirical evidence suggests FEX recovers within 2 years by 8% in Flexible Exchange Rates
        
        Real Exchange Rate
        
        Fixed
        
        real depreciation occurs in the following two years, thus resulting in deflationary effect on economy furthering recession
        
        Due to burden of relying on sticky domestic prices being slow to adjust
        
        Floating
        
        Real depreciation is immediate, due to currency depreciation thus having an inflationary effect
        
        Real Output
        
        Fixed
        
        Real output decreases significantly in initial years due to fall in prices and contraction policy
        
        Flexible
        
        Relatively small shock due to nominal exchange rate buffer due to currency depreciation
- - - - Many LIE's lack access to global capital markets, thus get direct loans from Gov denominated in foreign currency and poor domestic funding
        
        Depreciating FEX increases real repayment costs
        
        Could encourage more domestic lending but could crowd out private investment due to greater security of lending to governments
  - - - TOT effect can still be positive if domestic substitutes available (Marshall Learner Condition)
        
        Substitutes not always available in LIE's such as manufactured goods - poor industrial bases