In the monetary small open-economy model with a fixed exchange rate, a devaluation of the domestic currency in the absence of any other shocks

Question

Quizplus · Accepted Answer

In a fixed exchange rate regime, the central bank is committed to maintaining a fixed exchange rate by buying or selling domestic currency in the foreign exchange market. When the domestic currency is devalued, the central bank sells a certain amount of foreign reserves in exchange for domestic currency. This lowers foreign reserves and decreases the domestic money supply, as the central bank buys up domestic currency.

A devaluation of the domestic currency also makes exports cheaper and imports more expensive, which reduces the current account surplus. Therefore, choice (C) is the correct answer as it correctly describes the effect of a devaluation in a fixed exchange rate system.

In the Monetary Small Open-Economy Model with a Fixed Exchange