adjustment in medium run under fixed exchange rates –

• economy reaches same output, exchange rate regardless of whether it’s under fixed or flexible exchange rates
• e = EP/P*
  • E cannot change under a fixed exchange rate
  • prices change to accommodate changing real exchange rates under fixed exchange rate system
• r = i-p
• E = Ee
• i = i*
• Y = C(Y-T) + I(Y,i*-p)+G+NX(Y,Y*,EP/P*)
  • assuming interest can’t change
  • Y ~ Y(EP/P*, G, T) >> aggregate demand relation
  • prices increase >> real exchange rate decreases (domestic goods more expensive) >> net exports decrease >> output decreases
• P = Pe(1+m)F(1-Y/L,z) >> aggregate supply relation
  • price decreases when output lower than natural level
• in medium run, always a return to natural level of output
• price level changes to accommodate move
• to keep fixed nominal exchange rate, real exchange rate adjusts by price level changes

using devaluation - can reach natural rate of output faster  

• devaluation >> decrease in nominal exchange rate >> depreciation
• increases output
• shifts aggregate demand relation (unlike naturally, where aggregate supply shifts)

response to exchange rate change –

• assume expected devaluation of exchange rate in fixed exchange rate system
  • due to domestic currency being overvalued (in countries where inflation higher than that of country being pegged)
  • requires domestic interest rate increase
• just the expectation of devaluation can devastate demand/output (by increasing interest)
  • gov’t may be forced to devalue if financial markets believe they will devalue (even if the gov’t originally wasn’t planning to devalue)
  • try to maintain parity >> long period of high interest >> recession