Module 44: Exchange Rates and Macroeconomic Policy
In 1999, most of Europe adopted the euro, but Britain did not. Why?
There are economic arguments for and against adoption of a common currency.
Those in favor of adopting the euro argued that using the same currency as their neighbors would
help expand their productivity thru greater exports. Those against adopting the euro said it would
take away Britain’s ability to independently set their own monetary policy and could cause
macroeconomic problems down the road.
In our global economy, there are conflicts between increased open trade and stronger domestic
policies.
Devaluation and Revaluation of Fixed Exchange Rates:
If we remember back in Mod 43, Donville wanted to keep a fixed exchange rate of $2/ Cid.
Suppose the central bank of Donville decides to revise the rate so that 1 Cid = $1.50.
This depreciation of the Cid would called devaluation.
Why would a nation want to devalue it’s currency? Maybe Donville has a recessionary gap.
 It now takes fewer dollars to buy 1 Cid, so goods produced in Donville would be less
expensive for Americans to purchase.
 This devaluation would also make American goods more expensive to consumers in Donville,
thus reducing imports from America.
 Donville would experience more net exports to America; AD would shift to the right, boosting
GDP.
What would happen if the nation revalued the Cid so that it took $3 to buy 1 Cid?
Not surprisingly, just the opposite.
 It now takes more US dollars to buy the Cid, so goods produced in Donville are now more
expensive for American consumers.
 This revaluation would also make American goods less expensive to consumers in Donville,
thus increasing imports from America.
 Donville would experience a derease in net exports to America; AD would fall, shifting to 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
exchange market too.
Suppose the market for the Cid is competitive and the exchange rate with the dollar is floating.
What would happen if the central bank of Donville increased the money supply?
 Interest rates would fall with the expansionary monetary policy, investment would increase,
and AD would increase.
 Foreign investors would seek alternative nations in which to invest in financial assets, so the
demand for the Cid would decrease.
 Citizens of Donville would also seek nations with higher returns on financial investments so
the supply of Cids would increase.


With both an increased supply and a decreased demand, the value of the Cid will depreciate
against the dollar.
A depreciated currency will make products made in Donville less expensive to American
consumers, thus there would be an increase in net exports and another increase in AD.
International Business cycles
A recession in Canada, the biggest trading partner with the US, will likely cause a decrease in real
GDP in the US.
Why?
Canadians buy many goods in America, so recession in Canada means American firms will shift
fewer products to Canadian customers. Exports will fall and AD will fall with it. But this
straightforward chain of events is also affected by the exchange rate regime in the US.
A recession hits the Canadian economy.
 Canadians decrease demand for goods made in America.
 This amounts to a decrease in the demand for the US dollar, and the US dollar depreciates.
 A depreciating US dollar means that goods made in America become more affordable to
Canadian customers.
 Thus the depreciating US dollar puts the brakes on the 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 in other nations.