Question

Please read the following short case carefully and provide your answer after analyzing question based on the appropriate open market models/diagrams.

Case: Currency Devaluation and Capital Flight

You work for Dr.Zhang, the autocratic dictator of the Republic of Zhouland. After taking an economics course, you decide that devaluing your currency (Zhoullars) is the way to increase GDP. Following your advice, DR.Zhang orders massive increases in the supply of Zhoullars, which reduces the value of Zhoullars in world markets.

1. Use the AD-AS model to determine the effects of real GDP, unemployment, and the price level in Zhouland in both the short run and the long run. Assume the economy was in long-run equilibrium before this change and consider only this stated change.
2. Analyze the effects on the market for loanable funds and the market for foreign exchange markets. Discuss the effects on investment, national saving, NCO, interest rate, exchange rate, and net export.
3. Assume that the Republic of Zhouland faces political instability and experiences a huge capital flight from its country. Repeat the same exercise you have done on the question (b).

Please do not plagiarize or copy-paste from other sources.

Answer 1

a) Due to devaluation, export becomes cheaper in foreign market and hence, demand for export goods increases. Export industries expand both in terms of employment and output. Therefore, domestic income and aggregare demand both increase.

In AD-AS model, AD curve shifts towards right, price level rises. As the economy was in long run, devaluation of currency again raises price with the increase in aggregate demand and output. Figure 1 shows the short run ipact.

In the long run, aggregate supply increases as well, Y rises further. Hence, AS curve also shifts rightward. Price level drops in domestic market. Real GDP rises and unemployment falls in the long run.

b) Effects on loanable funds

effects on foreign markets

Effects on investment, interest arte, NOC and national savings exchange rate and net export into the domestic market.

Due to devaluation, capital inflows into the market as export rises. Net export rises which improves the balance of payment of the domestic country. Eventually export oriented sector expands. Income rises and hence savings rises in aggregate, which is in turn a source of supply of loable funds.

Demand for wage hike increses keepting pressure on export sectors. Inflation rises in the domestic economy as the price of import goods increases.

In order to deal with higher inflation, central bank rise interest rate which further discourages invetsment. Therefore, initial boosts from devaluation are depleted in the long run. Demand for loanable funds drops later.

c) Republic of Zhouland faces political instability and and experienced a huge capital outflow. Therefore as decribed in (b), capital flow reduces supply of domestic currency and thus domestic curreny of Republic of Zhouland appreciates. Currency appreciation discourages export and increases demand for imports. Real GDP falls and GDP growth falls. Drop in price lowers inflation. Thus interest arte falls and invetsmnet rises further. Demand for loanable funds rises although there is a shrink in supply of loanle funds initially.