Answer to Question #292207 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.

b) Based on your answer in (a), what would happen to the domestic interest rate if there is no change in the domestic money supply? Explain in suitable diagram and equation.

Answer 1

a) If exchange rate (e) decreases, then we’ll be able to buy more foreign currency with less of our own currency. On the other hand, foreigners we’ll need to pay more of their currency to buy our own. Therefore, when e decreases (revaluation), domestic residents have more purchasing power, thus being able to buy the same amount of goods using less domestic currency. So, a decrease in e causes net export to decrease (IS curve shifts to the left).

b) The domestic interest rate will decrease if there is no change in the domestic money supply.