Assume that policy makers are pursuing a fixed exchange rate regime and the economy is initially operating at the natural level of output. Which of the following will occur as a result of a revaluation?
A) The real exchange rate will be permanently lower in the medium run.
B) The real exchange rate will be unchanged in the medium run.
C) The nominal exchange rate will initially fall in the short run and then increase in the medium run.
D) The effects of this revaluation on the real exchange rate will be ambiguous in the medium run.
E) The real exchange rate will be permanently higher in the medium run.

Question

Quizplus · Accepted Answer

A revaluation means that the domestic currency becomes stronger relative to the foreign currency. In a fixed exchange rate regime, this means that the central bank must intervene in the foreign exchange market to buy up the excess supply of domestic currency and sell foreign currency, thereby decreasing the supply of domestic currency and increasing the supply of foreign currency. This will lead to a decrease in the nominal exchange rate, making the domestic goods more expensive relative to foreign goods. However, since the economy is initially at the natural level of output, there is no excess demand or supply in the goods market. Therefore, the increase in the price of domestic goods relative to foreign goods will lead to a decrease in net exports, and hence a decrease in aggregate demand. This decrease in aggregate demand will lead to a decrease in the price level and output in the short run, but in the medium run, output will return to the natural level and the real exchange rate will be unchanged because there is no change in the relative prices of domestic and foreign goods. Thus, the answer is B - the real exchange rate will be unchanged in the medium run.

Assume That Policy Makers Are Pursuing a Fixed Exchange Rate