Question

What happens graphically when there is devaluation on GDP and interest rates assuming a fixed exchange rate regime and

perfect capital mobility?

Answer 1

Hello!

Devaluation oocurs when the central bank of any country raises the domestic currency price of foreign currency i.e. exchange rate (E) of the foreign currency in terms of domestic currency increases. The method for the central bank to devalue is to just show its willingness to trade domestic currency against the foreign currency, in unlimited amounts, at the new exchange rate.



The above figure shows the effect of devaluation on the economy. A rise in the level of fixed exchange rates (under perfect capital mobility), from E₀ to E_1, makes the domestic goods and services cheaper relative to the foreign goods and services (given here at the P (domestic) and P^*(foreign) are fixed in short run). Since domestic goods are comparatively cheaper now, therefore their demand increases and the firms react by increasing their output from Y₁ to Y₂ as shown by the point 2 on the DD schedule in the diagram. This point is not on the asset market equilibrium schedule i.e. AA₁. Initially at point 2, there is excess demand for money as the transactions in the economy increases due to increase in the overall output. This increase demand for money puts pressure on the domestic interest rates and they increase above the world interest rate. Now, the central bank interferes to maintain the exchange rate as we are talking about fixed exchange rate case here. The central bank therefore buys the foreign assets and expand the money supply until the asset market curve reaches AA². The new equilibrium is therefore reached at point 2.

Hence, devaulation causes a rise in output, a rise in official reserves, and an expansion of the money supply in a fixed exchange rate regime and perfect capital mobility.

Hope you understood!:)