1Topic 7-4 Exchange Rates and Macro PolicyNominal Exchange Rate- P that is determined by supply and demand in a marketDevaluation and Revaluation of Fixed Exchange RatesIn the hypothetical nation of Sarasha, the previous topic described a fixed exchange rate regimewhere the rash was valued at $2.Suppose the central bank of Sarasha decided to revise the fixed exchange rate such that :1 rash = $1.50.This depreciation of the rash would be called a devaluation Why would a nation want to devalue its own currency? Maybe Sarasha is experiencing a recessionary gap It now takes fewer U.S. dollars to buy 1 rash, so goods produced in Sarasha would be lessexpensive for American consumers.This devaluation would also make American goods more expensive to consumers in Sarashathus reducing imports from America.Sarasha would experience an increase in net exports to America; aggregate demand wouldshift to the right, boosting GDP.What would happen if the nation revalued the rash so that it took $3 to buy one rash?Why would a nation want to revalue its own currency? Maybe Sarasha is experiencing an inflationary gap It now takes more U.S. dollars to buy 1 rash, so goods produced in Sarasha would be moreexpensive for American consumers.This revaluation would also make American goods less expensive to consumers in Sarasha,In 1999, while most of Europe adopted the euro, Britain did not. Why?There are economic arguments for and against adoption of a common currency.British economists who favored adoption of the euro argued that if Britain used the same currency as its neighbors, the country’s international trade would expand and its economy would become more productive. But other economists pointed out that adopting the euro would take away Britain’s ability to have an independent monetary policy and might lead to macroeconomic problems.In a global economy, there are conflicts between more open trade and stronger domestic concerns.2thus increasing imports from America.Sarasha would experience a decrease in net exports to America; aggregate demand would shiftto the left, reducing inflation.Monetary Policy under a floating exchange rate regime- Monetary policy is used to stabilize the economy, but it can also have an impact on the foreign market Suppose the market for the rash is competitive and the exchange rate with the dollar is floating.What would happen if the central bank of Sarasha increased the money supply?-Interest rates fall with expansionary monetary policy  domestic investment would increase and AD would increase -Foreign investors would seek alternative nations in which to invest in financial assets so the D for rash would decrease -Citizens of Sarasha would also seek nations with higher returns on financial investments, so the supply of rashas will increase -Value of the rasha will depreciate against the dollar -A depreciated currency will make products made in Sarasha less expensive to American consumers  increase in net exports and another increase in AD International Business CyclesA recession in Canada, the biggest trading partner with the U.S., will likely cause a decrease in real GDPin the U.S. Why?Canadians buy many goods made in America, so a recession in Canada means American firms will shiftfewer products to Canadian customers. Exports will fall and aggregate demand will fall with it.But this straightforward chain of events is also affected by the exchange rate regime in the U.S.A recession hits the Canadian economy. Canadians decrease D for goods made in the US  Leads to a decrease in D for US dollar and the US dollar depreciates Depreciating US dollar means that goods made in the US become more affordable to Canadian consumers  Puts the brakes on diminished exports to Canada and the negative impact on the US economy is lessened So in theory a free-floating exchange rate allows a nation some insulation from recessions that begin inother nations.3PS 7-41. Devaluation of currency occurs when which of the following happens?I. The supply of a currency with a floating exchange rate increases II. The demand for a currency with a gloating exchange rate decreases III. The government decreases the fixed exchange ratea. I onlyb. II onlyc. III onlyd. I and II onlye. I, II, and III2. Devaluation of a currency will lead to which of the following?a. Appreciation of the currencyb. An increase in exportsc. An increase in importsd. A decrease in exportse. Floating exchange rates 3. Devaluation of a currency is used to achieve which of the following?a. An elimination of a surplus in the foreign exchange marketb. An elimination of a shortage in the foreign exchange marketc. A reduction in aggregate demandd. A lower inflation ratee. A floating exchange rate4. Monetary policy that reduces the interest rate will do which of the following?a. Appreciate the domestic currencyb. Decrease exportsc. Increase importsd. Depreciate the domestic currencye. Prevent inflation5. Which of the following will happen in a country if a trading partner’s economy experiences a recession?a. It will experience an expansionb. Exports will decreasec. The demand for the country’s currency will increased. The country’s currency will appreciatee. All of the above will occur4Problem 7DSuppose the US and Australia were the only two countries in the world and that both pursued a floating exchange rate regime. Note that all currency in Australia is the Australian dollar. a. Draw a correctly labeled graph showing equilibrium in the foreign exchange market for US dollars. b. If the Fed pursues expansionary monetary policy, what will happen to the US interest rate and international capital flows. Explainc. On your graph of the foreign exchange market, illustrate the effect of the Fed’s policy on the supply of US dollars, the demand for US dollars, and the equilibrium exchange rate. d. How does the Fed’s monetary policy affect US aggregate demand?