Question

If you were in charge of macroeconomic policies in a small open economy, what qualitative effect would each of the following events have on your target for external balance? a. Large deposits of uranium are discovered in the interior of your country. b. The world price of your main export good, copper, rises permanently. c. The world price of copper rises temporarily. d. There is a temporary rise in the world price of oil.

Short answer

a. Positive effect, b. Positive effect, c. Temporary positive effect, d. Negative effect for oil importers, temporary positive effect for oil exporters.

Step-by-step solution

Analyzing Impact of Uranium Deposits

Discovering large uranium deposits would likely increase the export potential of the country, as uranium is a valuable commodity. If this resource is exploited, it could improve the trade balance, thereby positively affecting the target for external balance. More exports would translate into a surplus or reduced deficit in the current account.

Understanding Permanent Rise in Copper Prices

If the world price of the main export good, copper, rises permanently, the country's income from exports would increase, leading to an improvement in the trade balance. With higher revenues from exports, the target for external balance would be positively impacted, likely leading to a surplus.

Assessing Temporary Rise in Copper Prices

A temporary rise in the world price of copper would boost export revenues in the short term, but as the price increase is temporary, the effect on the external balance would also be temporary. Policymakers should account for the fleeting nature of this change when setting targets for external balance.

Considering Temporary Rise in Oil Prices

A temporary rise in the world price of oil, if the country is an oil importer, would increase the import bill, worsening the current account deficit. For an oil exporter, it could lead to a temporary improvement in the trade balance. Either way, macroeconomic policies should be adjusted to address such temporary fluctuations to maintain the target for external balance.

Key concepts

Current Account Surplus and Deficit

When considering the health of a nation's economy, the current account, which is a component of the balance of payments, plays a crucial role. It includes transactions related to imports and exports of goods and services, income from abroad, and current transfers. A current account surplus indicates that a country is a net lender to the rest of the world, while a current account deficit shows that it is a net borrower.

A surplus is often seen as a positive economic indicator, suggesting that a country's investment income and export of goods and services exceed its spending on foreign imports and investment income payments. Conversely, a deficit might suggest greater economic activity in terms of domestic consumption but could also imply excessive spending relative to the country's production capabilities, potentially leading to long-term sustainability issues.

Understanding the dynamics behind surpluses and deficits helps policymakers to create strategies for maintaining a desired level of external balance, ensuring that the economy interacts with global markets in a sustainable manner.

Export Revenue and Commodity Prices

The discovery of a resource, such as uranium, can substantially influence a nation's exports and through this, its current account balance. If the international commodity prices are favorable, as would likely be the case with a newly discovered valuable resource, export revenues can soar.

However, the dependency on a single commodity can also leave the economy vulnerable. For instance, if copper is the main export good of a country and its price rises permanently on the world market, the country experiences an inflow of foreign capital, enhancing its export revenue. But such a reliance can be risky; if commodity prices fluctuate, so too will the export revenues, potentially leading to economic instability.

Policymakers must monitor these factors closely, understanding that high commodity prices and subsequent high export revenues can lead to a more favorable current account balance, but they must also prepare for the volatility of the global commodity market.

Macroeconomic Policy Adjustments

Macroeconomic policies need to be flexible to respond to both transient and enduring changes in the external environment. A temporary or permanent rise in commodity prices, such as copper or oil, necessitates different policy responses.

In the case of a permanent increase in the price of a principal export, such as copper, the increased revenue could lead to a long-term improvement in the country's current account balance. Policymakers might then explore ways to invest the surplus into other areas of the economy to foster diversification and mitigate the risks associated with commodity dependency.

On the other hand, a temporary price rise does not promise long-term stability and therefore requires a more cautious approach. Policies geared towards saving the windfall or using it for short-term economic stabilization measures may be more appropriate to avoid potential future deficits when prices fall.

Temporary Versus Permanent Price Changes

Differentiating between temporary and permanent changes in commodity prices is vital for making sound macroeconomic policies. A permanent increase in prices can suggest a long-term trend, providing a sustained boost to export revenues and potentially allowing for increased public spending or investment in other sectors to solidify growth.

In contrast, temporary price spikes, while beneficial in the short term, should be treated with caution. For example, a brief rise in oil prices might temporarily improve a country's trade balance if it’s an exporter, yet economic planning should not rely on these transient increases. Instead, reserve accumulation or bolstering fiscal buffers could be prudent to prepare for the eventual reversal of prices.

Policymakers must analyze the causes behind price changes to determine their likely duration and implement policies that will help smooth out the economic cycles associated with commodity price volatility, thereby maintaining a stable external balance.