Question

4)

a)In the Real Balance Effect of a (nominal) devaluation on Direct Absorption, what is the relationship between Prices, the Money Supply, and Direct Absorption? Will this effect tend to strengthen or weaken the current account, all else equal?

b)Refer to last question. What effect will this have on the real exchange rate? May this alter your prior answer?

Answer 1

Ans a)Real cash balance impact of ‘devaluation’-If a nation devalues its currency, its home prices increase. Suppose the supply of money stays unvarying, the real worth of cash balances held by the public declines. In order to restock their cash balances, the public begins to save more. This is likely only by lessening their expenses /absorption.

Asset impact of real cash balance impact of ‘devaluation’-

Suppose the public own assets & if devaluation lessens their real cash balances, then they want to sell them. This lessens the prices of these assets & raises the ROI . This, in turn, lessens investment & expenditure on consumption ( given the unchanging supply of money). As an outcome, the absorption will be lessened.

The impact of ‘devaluation’ on national income is via its impacts on the TOT. The circumstances under which devaluation deteriorates the terms of trade, NI will be unfavourably impacted , & vice versa.

Usually , devaluation deteriorates the TOT as the devaluing nation has to export greater amount of products in order to be able to import the same amount as before. Subsequently, the trade balance worsens & the NI falls

Ans b) In the non-existence of supporting strategies that restrict rises in prices & in factor costs, devaluation will apply only a temporary   impact on the real exchange rate. The extent of the alteration in the real exchange rate is dependent not only on the scale of the devaluation & the magnitude of fiscal adjustment, but also on the method by which the fiscal deficit is lessened.