Questions 2 to 9 refer to an economic model where Country A exports good X and imports good M. Country A does not consume X and does not produce M. International prices are in USD.

Initially, at the original exchange rate of 10 pesos per dollar, A has a balance of trade deficit. A devalues its exchange rate to 11 pesos per dollar. In comparison with the situation before devaluation, examine the effect of devaluation in the very short run, short run, and long run (see definitions below). For simplicity, focus on price change and ignore macroeconomic effects.

1. (6%) Very short run: Only A’s domestic prices adjust; everything else (quantities produced or consumed, international prices) unchanged. How do domestic prices in pesos change (rise, fall, or unchanged)? By how much (less than, equal to, or more than 10%)? Give a short explanation, one sentence each for P_x , P_M.

P_x :

P_M:

3. (6%) Short run: A’s production of X and consumption of M adjust; international prices unchanged. In the short run, how do A’s production of X and consumption of M change (rise, fall, or unchanged)? Give a short explanation, one sentence each for production of X, consumption of M.

X:

M:

4. (8%) Long run (LR): All prices (domestic and international) and quantities adjust till long run equilibrium is reached. Let’s examine the following 3 possible changes in P_x in pesos (in comparison with the pre-devaluation situation): It may fall, stay unchanged, or rise. Let’s consider the first 2 possibilities here, and postpone the last possibility (P_x in pesos rises) to question 5.

a. If P_x in pesos falls, what will happen to

1. The production of X (rise, fall, or unchanged)? ___________
2. P_x in USD (rise, fall, or unchanged)? ____________
3. Consumption of X (rise, fall, or unchanged)? __________
4. Is this a possible LR equilibrium? ___________

b. If P_x in pesos stays unchanged, what will happen to

1. The production of X (rise, fall, or unchanged)? ____________
2. P_x in USD (rise, fall, or unchanged)? ____________
3. Consumption of X (rise, fall, or unchanged)? ___________
4. Is this a possible LR equilibrium? _______________

5. (12%) Long run (LR): Finally, let’s consider the case that P_x in pesos may rise (in comparison with the pre-devaluation situation): It may rise by more than 10%; rise by exactly 10%; or rise by less than 10%. We consider each in turn:

a. If P_x in pesos rises by more than 10%, what will happen to

1. The production of X (rise, fall, or unchanged)? _______________
2. P_x in USD (rise, fall, or unchanged)? ______________
3. Consumption of X (rise, fall, or unchanged)? ______________
4. Is this a possible LR equilibrium? ____________

b. If P_x in pesos rises by exactly 10%, what will happen to

1. The production of X (rise, fall, or unchanged)? _____________
2. P_x in USD (rise, fall, or unchanged)? _____________
3. Consumption of X (rise, fall, or unchanged)? ____________
4. Is this a possible LR equilibrium? _______________

c. If P_x in pesos rises by less than 10%, what will happen to

1. The production of X (rise, fall, or unchanged)? ____________
2. P_x in USD (rise, fall, or unchanged)? ____________
3. Consumption of X (rise, fall, or unchanged)? _______________
4. Is this a possible LR equilibrium? _______________

6. (6%) From the above, what do we know about the change in the price in pesos and in USD of X in LR equilibrium (rise, fall, or unchanged)? By how much (less than, equal to, or more than 10%)?

P_x in pesos:

P_x in USD:

7. (20%) Apply the above reasoning to M. What do we know about the change in the price in pesos and in USD of M in LR equilibrium (rise, fall, or unchanged)? By how much (less than, equal to, or more than 10%)? Give a one sentence explanation.

P_M in pesos:

P_M in USD:

8. (10%) How does A’s USD expenditure on M change (rise, constant, or fall)? Give a one sentence explanation.

9. (16%) Assume international demand for X is unit elastic.

a. How does A’s USD forex earnings from X change (rise, constant, or fall)? Give one sentence explanation.

b. How does A’s balance of trade (in USD) change (rise, constant, or fall)? Give a one sentence explanation.

Answer rating: 100% (QA)

2 Very short run Px Falls by less than 10 PM Rises by less than 10 3 X Falls due to decreased dema... View the full answer