Macroeconomics 5th Edition by Olivier Blanchard

Exercise 7

Devaluation and credibility
Consider an open economy with a fixed exchange rate,
.
Suppose that, initially, financial market participants believe that the government is committed to maintaining the fixed exchange rate. Let UIP stand for the uncovered interest parity condition.
Now suppose the central bank announces a devaluation. The exchange rate will remain fixed, but at a new level,
, such that
. Suppose that financial market participants believe that there will be no further devaluations and that the government will remain committed to maintaining the exchange rate at
.
a. What is the domestic interest rate before the devaluation If the devaluation is credible, what is the domestic interest rate after the devaluation (See your answers to Problem 4.)
b. Draw an IS-LM-UIP diagram for this economy. If the devaluation is credible, how does the expected exchange rate change How does the change in the expected exchange rate affect the UIP curve
c. How does the devaluation affect the IS curve Given your answer to part (b) and the shift of the IS curve, what would happen to the domestic interest rate if there is no change in the domestic money supply
d. Given your answer to part (c), what must happen to the domestic money supply so that the domestic interest rate achieves the value you identified in part (a) How does the LM curve shift e. How is domestic output affected by the devaluation
f. Suppose that devaluation is not credible in the sense that the devaluation leads financial market participants to expect another devaluation in the future. How does the fear of further devaluation affect the expected exchange rate How will the expected exchange rate in this case, where devaluation is not credible, compare to your answer to part (b) Explain in words. Given this effect on the expected exchange rate, what must happen to the domestic interest rate, as compared to your answer to part (a), to maintain the new fixed exchange rate