Exam 16: The Price Adjustment Mechanism With Flexible and Fixed Exchange Rates

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(a)A depreciation of the nation's currency stimulated the nation's exports and its production of import substitutes.Unless real output can somehow be expanded and/or domestic absorption reduced,however,this will lead to excess aggregate demand.The resulting inflation will then wipe out the price advantage of the devaluation and the deficit will remain uncorrected.
(b)Even if the nation is already at full employment,a depreciation of the nation's currency could lead to higher real national output through the better utilization and the more economic allocation of existing resources.Though possible,this is by no means certain or sufficient.Thus,for a depreciation to be effective,domestic absorption must fall.
(c)Domestic absorption can fall automatically as the nation's currency depreciates because of a real cash balance effect,money illusion,and redistributive effect.The real cash balance effect operates as follows: When a nation's currency depreciates,domestic prices rise; if the money supply remains constant,real cash balances fall and can be replenished only by reducing consumption or absorption.The money illusion cuts absorption if consumers spend less when prices rise,even though their income has also risen.Finally,absorption falls if the depreciation redistributes income to consumers with higher marginal propensities to save.These effects,however,may be inoperative or insufficient.
(d)The government can help reduce domestic absorption (and allow the depreciation to be effective)by adopting expenditure-switching or demand policies.