adjustment in medium run under fixed exchange rates –
- economy reaches same output, exchange rate regardless of whether it’s under fixed or flexible exchange rates
- e = EP/P*
- E cannot change under a fixed exchange rate
- prices change to accommodate changing real exchange rates under fixed exchange rate system
- r = i-p
- E = Ee
- i = i*
- Y = C(Y-T) + I(Y,i*-p)+G+NX(Y,Y*,EP/P*)
- assuming interest can’t change
- Y ~ Y(EP/P*, G, T) >> aggregate demand relation
- prices increase >> real exchange rate decreases (domestic goods more expensive) >> net exports decrease >> output decreases
- P = Pe(1+m)F(1-Y/L,z) >> aggregate supply relation
- price decreases when output lower than natural level
- in medium run, always a return to natural level of output
- price level changes to accommodate move
- to keep fixed nominal exchange rate, real exchange rate adjusts by price level changes
using devaluation - can reach natural rate of output faster
- devaluation >> decrease in nominal exchange rate >> depreciation
- increases output
- shifts aggregate demand relation (unlike naturally, where aggregate supply shifts)
response to exchange rate change –
- assume expected devaluation of exchange rate in fixed exchange rate system
- due to domestic currency being overvalued (in countries where inflation higher than that of country being pegged)
- requires domestic interest rate increase
- just the expectation of devaluation can devastate demand/output (by increasing interest)
- gov’t may be forced to devalue if financial markets believe they will devalue (even if the gov’t originally wasn’t planning to devalue)
- try to maintain parity >> long period of high interest >> recession
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