devaluation – real depreciation

• not allowed to happen often under fixed exchange rate
• increases nominal/real exchange rates >> shifts aggregate demand curve to the right
  • output higher, price level higher
  • may help skip the wait of medium run as price levels readjust
  • price increase offsets devaluation >> real exchange rate unchanged
• devaluation must wait for import/export quantities to adjust before taking full affect

overvaluation – makes domestic goods too expensive >> trade deficit

• overvaluation w/ recession >> output less than natural rate >> economy will adjust itself
  • move along AD curve as AS shifts down and P falls
  • real depreciation >> net exports increase >> output increases to natural rate
  • can be sped up by devaluation
• overvaluation w/o recession >> devaluation can’t permanently change real exchange rate when already at natural rate of output
  • gov’t must increase public/private saving (T>G) or reduce investment to increase net exports
  • can combine reduction in gov’t spending w/ devaluation to prevent recession

selecting regimes (fixed vs flexible) –

• fixed exchange rate >> gives up ability to change interest rate, nominal exchange rate
  • exchange rate crises >> forces devaluation
  • preferred where group of countries so tightly integrated that common currency is ideal
  • optimal currency area – countries experience similar shocks (similar monetary policy) or high factor mobility (workers willing to move back and forth to countries doing well)
  • preferred where central bank can’t follow responsible monetary policy
• hard peg – making it technically harder to change parity (ie. replacing domestic currency w/ foreign currency)
  • currency board – central bank ready to exchange foreign for domestic currency, cannot buy/sell gov’t bonds (no open-market operations)
• flexible exchange rate >> exchange rate significantly more volatile