Assume that an open economy Neverland is operating under a fixed exchange rate r
ID: 1196521 • Letter: A
Question
Assume that an open economy Neverland is operating under a fixed exchange rate regime. Currently, Neverland’s economy is suffering a deep economic recession meaning that Neverland’s total output level is much lower than its medium-run output level. Neverland’s government is discussing how to bring the economy back to its medium-run output level. One side argues that the government should devaluate the currency; while the other side argues that the market itself will bring Neverland’s economy to its medium-run equilibrium.
a) Use an appropriate economic model to illustrate and explain the different policies mentioned above.
b) Discuss the main pros and cons of each policy option.
Explanation / Answer
Open economy with fixed exchange rate
The open economy model with fixed exchange rate is same as the Mundell-Fleming model. Under this policy price level is affected the output through the fixed exchage rate system. When an increase the domestic price level by using fixed exchage the foriegn price level is increased. This will result the real appreciation. When appreciation the demand for the domestic goods will be decreased. It also caused the reduction of output of the economy.
We know that the devaluation of currency means that reduce the value of the domestic currency. It will downward movement of the currency. So the devaluation of the currency will increase the output of the country. also the monetory policy have no effect because the exchange rate are fixed. So the powerful policy under fixed exchage rate in open economy is fiscal policy. It will expand the output of the country. .
When devaluation under fixed prices less than full employment the real exchage rate are reduced. It will create an expansion of domestic exchange rate. That will result an increase in the money supply and output of the economy.