Foreign Price Disturbances and the Internal and External Adjustment of a Small Open Economy under Fixed and Flexible Exchange Rates

In the contemporary world, a national economy is closely integrated with the rest of the world through international trade and investment, to such an extent that it is continually exposed to changing conditions in foreign markets. It could be affected in many ways by disturbances in both the level and the structure of foreign prices. For instance, a decline in the foreign price level is likely to bring about a fall in the domestic price level, causing a reduction in the domestic employment and a deficit on the current account of the balance of payments at least in the short run. Furthermore, if this also involves a change in the foreign price structure, the national economy is forced to undergo structural adjustment processes, both in the short and the medium term. These will impose additional social costs unless resources can be smoothly reallocated from contracting to expanding sectors.