A flexible exchange rate ________ the impact of terms of trade shocks on output and employment because of the effect of a change in the exchange rate on ________.

Question

Quizplus · Accepted Answer

A flexible exchange rate dampens the impact of terms of trade shocks on output and employment because a change in the exchange rate affects net exports. When a country's terms of trade worsen (i.e. the prices of its exports relative to its imports fall), its currency tends to depreciate, making its exports relatively cheaper and imports relatively more expensive. This leads to an increase in net exports, which helps to offset the negative impact on output and employment. Conversely, if the terms of trade improve, the currency tends to appreciate, making exports relatively more expensive and imports relatively cheaper, which reduces net exports and helps to offset the positive impact on output and employment. Therefore, a flexible exchange rate dampens the impact of terms of trade shocks by adjusting net exports.

A Flexible Exchange Rate ________ the Impact of Terms of Trade