Sunday, October 11, 2009: 9:40 AM
This paper studies the real exchange rate dynamics responding to the increase in oil prices for a small oil-importing open economy. The main purpose of this paper is to examine an exogenous increase in the price of imported intermediate good, such as oil, affects capital stock, investment, employment, and current account in a non-oil producing economy using the dynamic version of a two-sector dependent economy model used by Salter (1959) and Swan (1960). This paper considers the role of the relative price of non-tradable goods and the current account in the adjustment of a two-sector small open economy upon higher oil price shocks. The adjustment mechanism of the relative price of nontradable to tradable goods after exogenous shocks is the key to induce sectoral fluctuations and resources reallocation. The imported intermediate good is placed both sectors as a production factor and then we perform the long run effects of the increase in oil price. We calibrate the model with standard functional forms and parameter values to gain a better understanding of the transmission mechanism. In addition, at the numerical level we want to examine the effects of an oil price increase along with the decline in world interest rates, since many researchers pointed out that OPEC’s surpluses have forced the rest of the world to run the current account deficit. Sachs (1981) and Svensson (1984) have explained the low world interest rate as evidence for this line of reasoning throughout most of seventies. We show that the permanent increase in oil price lowers the level of investment and the current account improves by holding more foreign traded bond with constant world interest rates in the long run. On the other hand, a permanent rise in oil price with the decrease in world interest rate increases the level of investment and accumulates capital in the long-run inducing the current account deterioration. Overall, the effects of the increase in oil price are ambiguous for oil-importing countries.