Question

If there is an upward pressure on domestic currency (i.e. an increase in E due to higher foreign interest rates, higher Ee, or higher risk premium under imperfect asset substitution) under a fixed exchange rate, show the effects on domestic firms and financial sector of the policy choices available to the central bank.

Answer 1

Devaluation is a deliberate downward adjustment to the value of a country's currency relative to another currency. It is a monetary policy tool used y countries that have fixed exchange rate . It is conducted by the government, the decision to devalue a currency is made by the government issuing the currency.

One reason a country may devalue its currency is to combat a trade imbalance. Devaluation reduces the cost of a country's exports rendering them more competitive in the global market . This , in turn increases the cost of imports so that domestic consumers are less likely to purchase them, strengthening domestic businessses.

Negative effect of devalauation : It increases the price of imports , domestic industries are protected but they may become less efficient without the pressure of competition. Higher exports relative to imports can also increase aggregate demand which can lead to higher GDP and inflation.Inflation can occur because imports are more expensive , aggregate demand causes demand pulll inflation and manufacturers may less incentive to cut costs because exports are cheaper , increasing the costs of goods and services over time.