Answer to Question #292203 in Macroeconomics for nick

Question

Consider an open economy with a fixed exchange rate at time t. Suppose that initially financial market participants believe that the government is committed to maintaining the fixed exchange rate. Suppose at time t+1 the central bank announces a devaluation. The exchange rate will remain fixed, but at a new level, where the new fixed exchange rate is below the initial fixed exchange rate. At the new level of fixed exchange rate, assume that financial market participants believe that there will be no further devaluation and that the government will remain committed to maintaining the exchange rate.

a) Draw an IS-LM-UIP diagram for this economy. Consider the change in the expected exchange rate.

Answer 1

IS-LM-UIP Diagram

When the domestic currency is devalued in any economy, the domestic goods become cheaper in the world market. Production and employment therefore increase, increasing the current account balances of the nation. The increase in current account balances increases aggregate demand. An increase in aggregate demand shifts the IS curve to the right. With fixed exchange rates, the domestic interest rate is determined by the global market situation. Economy is at equilibrium therefore where RR intersects the IS curve. As output and employment increased with the devaluation, money demand in the economy rises. Due to flexibility of price levels and assumed full employment, IS curve is checked on shifting to the right by the $LM^1$ . This enables the federal government to acquire enough foreign exchange through an increased money supply by selling of assets and the increased production abroad. Acquired foreign exchange reserve enables the country get to its initial state of domestic interest rates and foreign exchange rates, a through c. b is the point where, domestic currency remains in the devalued state. (Ghosh & Ghosh, 2019)

Reference.

Ghosh, C., & Ghosh, A. N. (2019). Interaction Between the Real Sector and the Financial Sector: An Alternative to the IS-LM Model. In Keynesian Macroeconomics Beyond the IS-LM Model (pp. 21-58). Springer, Singapore.