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Unformatted text preview: Department of Economics University of California, Berkeley Fall 2006 Economics 182 Suggested Solutions to Problem Set 9 Problem 1 Many developing countries that adopted fixed exchange rate regimes, usually pegging to the U.S. dollar, had most of their liabilities denominated in dollars and assets in domestic currency. A devaluation under this currency mismatch severely decreases output as firms, households, and the government now have to pay debts that in terms of the currency of their income has increased in value. So, in terms of domestic currency, payments have increased and receipts remained the same. This drives many agents to default and bankruptcy. Hence, aggregate demand is reduced as consumption and investment go down. This effect usually dominates the boost in economic activity due to increased exports. So we see that the IS shifts in lowering output and the real interest rate. In the IEB-RIP diagram this translates into a real depreciation of the domestic currency that shifts the IS slightly out ameliorating (but not completely offsetting) the effects of the drop in economic activity due to the collapse of the financial markets. In addition, you may realize that developing countries sometimes have histories of high inflation and hence a devaluation may cause prices to rise eliminating the expansionary effect of the devaluation on output....
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