Question

Discuss the short term and long term effect of a devaluation on balance of payments in a monetary model with fixed exchange rates.

Answer 1

Short run

Devaluation under conditions of fixed exchange rate and less than full employment causes the real exchange rate to fall inducing an expansion of the domestic balance of trade. The expansion of domestic trade balance causes the IS to shift to the right . The shift in IS causes the demand for money to rise . This rising demand for money causes the capacity of domestic consumers to rise and they tend to sell more of domestic good, that is rise in the export levels . To maintain the fixed exhange rate , money supply in the market is increased .

long run

With price flexibility and full employment , the rising price levels will cause the prevention of IS curve shift to the right. To maintain the foreign exhange reserves , the govt will start importing equal levels of goods . The money supply will also be increased equal to the level of money demanded.

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