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Q. Use a figure to study the effects of a change in market belief with regard to the fixed exchange rate, in particular assume market participants expect the government to devaluate.
Answer: This figure below demonstrate the asset markets equilibrium at points 1 the money market and 1 the foreign exchange market with the exchange rate fixed at E0 and expected to remain there indefinitely. M1 is the money supply reliable with this initial equilibrium. Fall in the current account to diminish in the future and adopt a new fixed exchange rate E1 i.e. higher than the current rate E0. THE UPPER PART a change in prospect as a rightward shift in the curve that measures the expected domestic currency return on foreign currency deposits. To embrace the exchange rate fixed at E0 subsequent to the market decides it will be diminish to E1 the central bank should use its reserves to finance a private capital outflow that shrinks the money supply and increase the home interest rate. The expectation of a future depression causes a balance of payments crisis marked by a sharp fall in reserves moreover a rise in the home interest rate above the world interest rate. Likewise an expected revaluation causes an abrupt rise in foreign reserves together with a fall in the home interest rate below the world rate.
The reserve loss supplementary a devaluation scare is frequently labeled capital flight because the associated debt in the balance of payments accounts is a private capital outflow. Capital flight may perhaps force the central bank to devalue sooner and by a larger amount than planned because the central bank's reserves are low to begin with.
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