In a small open economy, if the government adopts a policy that lowers imports, then that policy raises the real exchange rate and does not change net exports.
I don't get the above statement. From my understanding, lower imports means higher net exports from NX = Exports - Imports. They are inversely related. Since NX is higher, that means e is lower and E must be lower as well (they are positively related). Please explain why the statement above is true and mine is not.
In the long run, in an open economy, imports=exports.
If a country limits imports but continues to export, then goods are flowing out and foreign currency flows in. What good is that foreign currency if the holders cant buy anything with it? (Think about it, if imports are completely restricted, then the foreign currency would be worthless). Anyway, since it is harder to import, foreign currency is worth less. So, either the exchange rate drops or exports drops. With a drop in the exchange rate, imports become more expensive, and exports drops because, foreigners, the cost of the goods from our small country went up. Equilibrium is achieved when, at the new exchange rate, imports=exports.
I hope this helps.
The statement "In a small open economy, if the government adopts a policy that lowers imports, then that policy raises the real exchange rate and does not change net exports" is indeed counterintuitive, and it can be a bit confusing to understand why this is the case. Let's break it down step by step to understand the reasoning behind it.
First, let's clarify the relationship between imports and net exports. In a small open economy, as you correctly mentioned, net exports (NX) is calculated as the difference between exports (X) and imports (M): NX = X - M. This means that when imports are higher than exports, net exports will be negative, indicating a trade deficit. On the other hand, when exports exceed imports, net exports will be positive, indicating a trade surplus.
Now, let's consider the impact of a policy that lowers imports. When the government adopts a policy that restricts imports, it reduces the amount of foreign goods and services entering the domestic economy. As a result, domestic consumption and investment will likely shift towards domestically produced goods and services, which increases exports.
However, the statement suggests that this increase in exports due to lower imports does not result in a change in net exports. How is this possible?
To understand this, we need to examine the relationship between the real exchange rate (e) and net exports (NX) in a small open economy. The real exchange rate represents the price of domestic goods and services relative to foreign goods and services. A decrease in the real exchange rate makes domestic goods relatively cheaper than foreign goods, which can stimulate exports and discourage imports.
In our case, when the government lowers imports, the reduced demand for foreign goods means that fewer domestic currency units will leave the economy to pay for those imports. This reduced demand for foreign currency leads to an increase in the value of the domestic currency relative to foreign currencies — in other words, it raises the real exchange rate (e).
Now, you might be wondering why this increase in the real exchange rate does not lead to changes in net exports. The key to understanding this lies in the elasticity of demand for exports and imports.
When the real exchange rate rises, it makes the domestic currency stronger and, therefore, domestic goods relatively more expensive for foreign buyers. This can reduce the demand for exports. Simultaneously, with lower imports, domestic consumers have limited choices and might turn to domestically produced goods instead, boosting domestic sales and exports.
If the elasticity of demand for both exports and imports is relatively low, meaning that changes in prices have a limited impact on demand, the increase in exports due to lower imports may not be significant enough to offset the reduction in demand for exports caused by the higher real exchange rate.
As a result, net exports remain relatively unchanged despite the increase in exports, and the rise in the real exchange rate becomes the main adjustment mechanism to balance imports and exports.
To summarize, although it might seem counterintuitive at first, in a small open economy, a policy that lowers imports can raise the real exchange rate. However, the impact on net exports may be limited due to the elasticity of demand for exports and imports, resulting in a relatively unchanged level of net exports.