Macroeconomics 5th Edition by Olivier Blanchard

Exercise 4

Devaluation and interest rates Consider an open economy with a fixed exchange rate,
. Throughout the problem, assume that the foreign interest rate, i*, remains constant.
a. Suppose that financial market participants believe that the government is committed to a fixed exchange rate. What is the expected exchange rate According to the interest parity condition, what is the domestic interest rate
b. Suppose that financial market participants do not believe that the government is committed to a fixed exchange rate. Instead, they suspect that the government will either devalue or abandon the fixed exchange rate altogether and adopt a flexible exchange rate. If the government adopts a flexible exchange rate, financial market participants expect the exchange rate to depreciate from its current fixed value,
How does the domestic interest rate compare to i*
c. Suppose that financial market participants feared a devaluation, as in part (b), and a devaluation actually occurs. The government announces that it will maintain a fixed exchange rate regime but changes the level of the fixed exchange rate to
where
. Suppose that financial market participants believe that the government will remain committed to the new exchange rate,
and that
there will be no further devaluations. What happens to the domestic interest rate after the devaluation d. Does a devaluation necessarily lead to higher domestic interest rates Does fear of a devaluation necessarily lead to higher domestic interest rates