Question

Suppose there is a large foreign country operating under fixed exchange rate regime. It devaluates its currency by increasing its money supply. How does this affect real exchange rate, net exports, investments, consumption of our small domestic economy in short run and long run?

Answer 1

Answer - Due to the process of Devaluation implemented by the government , the value of the domestic currency declines or the exchange rate increases. Hence the real money supply increases in the domestic country. Our goods become cheaper for the foreigners. As a result of this increased money supply , the consumption , investment in the domestic economy will rise. The imports will fall and exports will rise hence the value of Net exports will rise. All this will take place in the short run

In the long run , due to the above effects taking place , there will be favourable balance of trade and current account. The rise in AD will increase the level of real GDP in the economy.