Answer to Question #292205 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) Assume that the financial market participants to expect another devaluation at time t+2. How does the expectation affect the nominal exchange rate, real exchange rate, domestic interest rate and domestic output? Explain in suitable diagram and equation.

Answer 1

a) If the financial market participants expect another devaluation at time t+2, then the nominal exchange rate will not change, the real exchange rate will decrease, domestic interest rate will not change and domestic output will decrease.