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Supply-side effects of exchange rates, exchange rate expectations and induced currency depreciation

  • Ali, Syed Zahid
  • Anwar, Sajid

Within the context of a small open economy model, this paper examines the repercussions of induced currency depreciation. The results presented in this paper are based on a model with firm microeconomic foundations and which takes into account both the supply and demand-side effects of exchange rate variations. The distinguishing feature of the model is the role of exchange rate expectations. We consider three kinds of expectations; adaptive, extrapolative, and regressive expectations. We also perform several sensitivity tests based on these expectations. Our simulation exercise shows that the effect of induced currency depreciation depends largely on supply-side effects. In most cases, we find that currency depreciation results in (i) a fall in output, (ii) an increase in prices and (iii) an improvement in the balance of trade. In the absence of weak supply-side effects of exchange rates, we find that, if the Marshall-Lerner conditions hold, then depreciation of the home currency has a favorable effect on output but its effect on the balance of trade is negative.

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Article provided by Elsevier in its journal Economic Modelling.

Volume (Year): 28 (2011)
Issue (Month): 4 (July)
Pages: 1650-1672

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Handle: RePEc:eee:ecmode:v:28:y:2011:i:4:p:1650-1672
Contact details of provider: Web page: http://www.elsevier.com/locate/inca/30411

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