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Using IS-LM-BP model, what is the impact graphically of a devaluation on GDP and interest rates...

Using IS-LM-BP model, what is the impact graphically of a devaluation on GDP and interest rates assuming a fixed exchange rate regime and perfect capital mobility

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Answer #1

A devaluation increases net exports and therefore IS shifts outwards. This increases interest rate and domestic income (GDP), lower the value of exchange rate. Note that with higher interest rate there will be capital inflows and this would increase the demand for domestic curreny (upward pressure on the exchange rate).

Now due to its commitment under fixed exchange rate the government will observe trade surplus and a BOP surlus so the central bank releases domestic currency and buy foreign one. This reduces the rate of interest and eliminate the excess upward pressure on the exchange rate. LM shifts out and this will result in restoring the exchange rate to its committed level and BOP is again 0.

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