Self-fulfilling exchange rate crises
Consider an open economy with a fixed exchange rate, E. Suppose that, initially, financial market participants believe that the government is committed to the fixed exchange rate. Suddenly, however, financial market participants become fear- ful that the government will devalue or allow the exchange rate
a. What is the domestic interest rate before the devaluation? If the devaluation is credible, what is the domestic interest rate after the devaluation?
b. Draw an IS-LM-UIP diagram for this economy. If the devaluation is credible, how does the expected exchange rate change? How does the change in the expected exchange rate affect the UIP curve?
c. How does the devaluation affect the IS curve? Given your answer to part (b) and the shift of the IS curve, what would happen to the domestic interest rate if there is no change in the domestic money supply?
d. Given your answer to part (c), what must happen to the domestic money supply so that the domestic interest rate achieves the value you identified in part (a)? How does the LM curve shift?
e. How is domestic output affected by the devaluation?
f. Suppose that devaluation is not credible in the sense that the devaluation leads financial market participants to ex- pect another devaluation in the future. How does the fear of further devaluation affect the expected exchange rate? How will the expected exchange rate in this case, where devaluation is not credible, compare to your answer to part (b)? Explain in words. Given this effect on the ex- pected exchange rate, what must happen to the domestic interest rate, as compared to your answer to part (a), to maintain the new fixed exchange rate?