Macroeconomics 5th Edition by Olivier Blanchard

Exercise 6

Self-fulfilling exchange rate crises
Consider an open economy with a fixed exchange rate,
Suppose that, initially, financial market participants believe that the government is committed to the fixed exchange rate. Suddenly, however, financial market participants become fearful that the government will devalue or allow the exchange rate to float (a decision that everyone believes will cause the currency to depreciate).
a. What will happen to the expected exchange rate,
(See your answer to Problem 4(b)). Suppose that, despite the change in the expected exchange rate, the government keeps the exchange rate fixed today. Let UIP stand for the uncovered interest parity condition.
b. Draw an IS-LM-UIP diagram. How does the change in the expected exchange rate affect the UIP curve As a result, how must the domestic interest rate change to maintain an exchange rate of
c. Given your answer to part (b), what happens to the domestic money supply if the central bank defends the fixed exchange rate How does the LM curve shift
d. What happens to domestic output and the domestic interest rate Is it possible that a government that was previously committed to a fixed exchange rate might abandon it when faced with a fear of depreciation (either through devaluation or abandonment of the fixed exchange rate regime) Is it possible that unfounded fears about a depreciation can create a crisis Explain your answers.