How do terms of trade shocks affect a small open economy with flexible prices?

• A. Positive terms-of-trade shocks raise real income and can appreciate the currency, while negative shocks reduce income and may lead to depreciation; prices adjust accordingly.
• B. Positive shocks reduce real income and lead to depreciation
• C. Shocks have no effect on a small open economy with flexible prices
• D. Terms of trade shocks only affect fiscal policy

Answer: (A)

Terms of trade shocks affect a small open economy with flexible prices through how the country’s income and its currency respond to changes in export and import prices. A positive shock to terms of trade raises the price of the country’s exports relative to imports. In a small economy with flexible prices and perfect capital mobility, that higher income shows up as greater real purchasing power and bigger spending on both domestic and foreign goods. This stronger income position tends to attract capital and increases demand for the domestic currency, pushing the currency's value up (an appreciation). Domestic prices rise as the economy adjusts to the higher demand, so the real exchange rate moves to reflect the new price environment. Conversely, a negative shock lowers real income and tends to reduce demand for the currency, leading toward depreciation, with prices adjusting accordingly. This combination—income improvement and currency appreciation for positive shocks, and the opposite for negative shocks—captures why the positive terms-of-trade shock is associated with higher real income and appreciation, while the negative shock is associated with lower income and possible depreciation.