CHAPTER 20: International Adjustment and Interdependence Complete Study Guide

CHAPTER 20
International Adjustment &
Interdependence
Complete Interactive Study Guide

Newcomer Explanations • Exam-Ready Answers • All Formulas with Numericals

Original Textbook Figures Included

Topics Covered:

Fixed Exchange Rate Adjustment • Automatic Mechanisms • Devaluation

J-Curve Effect • Hysteresis • Wage-Price Spiral • Crawling Peg
Monetary Approach • Sterilisation • IMF Approach
Flexible Exchange Rates • Exchange Rate Overshooting

■ FORMULA QUICK REFERENCE

Formula Meaning Key Point

R = ePf/P Real Exchange Rate Competitiveness measure

NX = Y-(C+I+G) Trade Balance Identity Deficit = spending > income

NX = S-I+T-G Twin Deficit Link Budget deficit → trade deficit

NX = X-(ePf/P)Q J-Curve Formula Import value vs volume

∆NFA = ∆H - ∆DC IMF Monetary Formula Credit ceiling controls deficit

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TABLE OF CONTENTS
PAGE 599 Introduction — Countries Are Interconnected

PAGE 600 Section 20-1: Fixed Exchange Rates + Real Exchange Rate Formula

PAGE 601 Figure 20-1: Open Economy Equilibrium + Financing the Deficit

PAGE 602 Automatic Adjustment — The Classical Process

PAGE 603 Policies: Expenditure Switching & Reducing + Formulas 2 & 2a

PAGE 604 Devaluation — Figure 20-2 + Types of Exchange Rate Systems

PAGE 605 Real vs Nominal Devaluation — The Critical Distinction

PAGE 606 Figure 20-3: Competitiveness & Adjustment

PAGE 607 Figure 20-4: Mexico Price History + Crawling Peg

PAGE 608-609 Box 20-1: Mexico Case Study + Table 1

PAGE 610 Wage-Price Spiral — Why Devaluation Can Fail

PAGE 611 The J-Curve — Formula 3 + Why Trade Balance Worsens First

PAGE 612 Hysteresis Effects of Overvaluation

PAGE 613 Section 20-3: Monetary Approach + Sterilisation

PAGE 614 Formula 4: ∆NFA = ∆H − ∆DC + IMF Balance Sheet

PAGE 615 How the IMF Monetary Approach Works in Practice

PAGE 616 Monetary Approach & Depreciation + Section 20-4 Begins

PAGE 617 Figure 20-5: The Four Zones of Adjustment

PAGE 618 Figure 20-6: Monetary Expansion — Short & Long Run

PAGE 619-620 Figure 20-7: Exchange Rate Overshooting

MASTER SUMMARY All Formulas + 5 Key Concepts for Exam

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599 Introduction — Countries Are Interconnected

■ NEWCOMER EXPLANATION — Understand Like a Story

Think of countries like neighbours sharing a wall. If your neighbour blasts loud music, YOU are
disturbed — even though you did not choose the music. Countries work exactly the same way
through trade and money flows.

The textbook opens with a real example: Germany 1991–1993. Germany spent huge amounts
reunifying East and West Germany. This caused a boom and inflation. The Bundesbank raised
interest rates sharply. Now Britain and France were in trouble — foreign investors moved money TO
Germany for better returns. Britain and France were forced to either raise their own interest rates
(even though their economies were not booming) or let their currencies weaken. Britain and Italy
refused both choices. Result: European Currency Crisis, September 1992.

This single example captures the WHOLE POINT of the chapter: what one major country does
financially affects every other country.

✍■ EXAM-READY ANSWER — Write This in Your Paper

International economic interdependence means that booms, recessions, and interest rate
changes in one country spill over to others through trade flows and financial linkages.

The textbook example: Germany's reunification (1991–93) caused the Bundesbank to raise interest
rates sharply to fight inflation. Countries like Britain and France were forced to match Germany's
higher rates or accept currency depreciation. Britain and Italy refused both, triggering the European
Currency Crisis of September 1992.

The chapter covers: (1) How fixed-exchange-rate countries adjust to balance of payments problems
through automatic mechanisms and policy. (2) How flexible exchange rate systems behave,
including exchange rate overshooting.

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Section 20-1: Adjustment Under Fixed Exchange Rates +

600 Real Exchange Rate
■ NEWCOMER EXPLANATION — Understand Like a Story

A "balance of payments problem" simply means a country is paying out more money
internationally than it is receiving — like your bank account going into the red every month.

There are two ways to fix this. Automatic — the economy corrects itself without deliberate action
(slow, painful). Policy — the government takes deliberate action (faster, but requires decisions).

Now the chapter introduces a critical formula. Before this, the textbook assumed prices never
change. Now it says: prices DO change, and that completely changes how we think about
international trade and competitiveness.

The Real Exchange Rate (R) answers the question: "How expensive are OUR goods compared to
FOREIGN goods in the same currency?" This measures TRUE competitiveness — not just the
exchange rate number on paper.

R = ePf / P

R = Real Exchange Rate (competitiveness) | e = Nominal exchange rate (e.g. ■80/$) | Pf = Foreign prices | P =
Domestic prices

■ Numerical Example — Real Exchange Rate

Setup: Indian steel costs ■8,000/tonne (P=8000). American steel costs $100/tonne (Pf=100). Exchange
rate e=80 (■80 per $1).

R = ePf/P = (80 × 100) / 8000 = 8000 / 8000 = 1.0 → Both equally competitive.

Now Indian prices rise: Indian steel now ■10,000 (P=10,000). Exchange rate unchanged (e=80).

R = (80 × 100) / 10,000 = 8000/10,000 = 0.8 → India LESS competitive. Indian steel costs $10 vs
American $10... wait — Indian steel in dollars = 10,000/80 = $125! Much more expensive.

Key Rule: R falls → less competitive. R rises → more competitive. For real devaluation: e must rise
MORE than P.

✍■ EXAM-READY ANSWER — Write This in Your Paper

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Adjustment to a balance of payments problem can occur through automatic adjustment

mechanisms (payments imbalances affect money supply and hence spending; unemployment
affects wages/prices and thereby competitiveness) or through deliberate policy (monetary, fiscal,
tariffs, exchange rate changes).

The analysis brings prices explicitly into the open economy model. With fixed prices, the real
exchange rate was also fixed. Now prices can change. The real exchange rate is defined as R =
ePf/P, where e is the nominal exchange rate, Pf the foreign price level, and P the domestic price
level.

In an open economy, a higher price level reduces aggregate demand for TWO reasons: (1) higher
prices reduce real money balances, raise interest rates, reduce spending (as in closed economy); (2)
higher domestic prices make goods more expensive than foreign goods, reducing exports and
increasing imports — an additional competitive effect absent in a closed economy.

The AD schedule (AD = A + NX) slopes downward for both reasons. The NX=0 schedule is also
downward-sloping (higher income → more imports → need lower prices to restore trade balance)
and is steeper than the AD curve.

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Figure 20-1: Open Economy Equilibrium + Financing the

601 Deficit
■ ORIGINAL TEXTBOOK FIGURE

Figure 20-1: Open Economy Equilibrium With Price Adjustment. AD slopes down for two reasons. NX=0 line also slopes
down. Equilibrium at E has unemployment and trade deficit. Full employment with trade balance is achieved only at E'.

■ NEWCOMER EXPLANATION — Understand Like a Story

Figure 20-1 has three curves. AD (Aggregate Demand) — total demand for the country's goods,
slopes down. AS (Aggregate Supply) — what businesses produce, slopes up. NX=0 line — every
point where exports exactly equal imports (trade perfectly balanced), slopes down and is steeper
than AD.

Point E is where AD meets AS — the current equilibrium. But E is to the LEFT of Y* (full employment
output), meaning there is unemployment. And E is to the RIGHT of the NX=0 line, meaning there is
a trade deficit. The economy is suffering from BOTH problems simultaneously.

Point E' is where we WANT to be — full employment AND balanced trade. The whole chapter is
about how to get from E to E'.

Financing the deficit: In the short term, the central bank can use its foreign exchange reserves (like
using your savings to cover monthly overspending), or the country can borrow foreign currency from
abroad. But these are temporary only — you cannot borrow or use savings forever. Eventually the
underlying problem must be fixed.

✍■ EXAM-READY ANSWER — Write This in Your Paper

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Figure 20-1 shows three schedules. The downward-sloping AD schedule represents aggregate
demand. The AS schedule is upward-sloping. The NX=0 schedule is also downward-sloping (and
steeper than AD), showing combinations of price level and output where trade is balanced.

Point E (AD meets AS) is the macroeconomic equilibrium, but represents simultaneous
unemployment (output below Y*) and trade deficit (right of NX=0). Point E' is the desired long-run
equilibrium of full employment with external balance.

Financing vs Adjusting: Under a fixed exchange rate, the central bank can temporarily use foreign
exchange reserves to finance the deficit — meeting excess demand for foreign currency at the
existing rate. Alternatively, the country may borrow abroad. However, both are unsustainable
indefinitely. Borrowing to finance consumption is especially risky. The economy must ultimately
adjust the deficit, not merely finance it.

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602 Automatic Adjustment — The Classical Process

■ NEWCOMER EXPLANATION — Understand Like a Story

This is what happens if the country does NOTHING and lets the market fix the deficit on its
own. Think of it like your body's immune system fighting a fever — it works, but slowly and painfully.

Demand side: The deficit means more people want to buy dollars than sell them. The central bank
sells its dollar reserves to maintain the fixed rate. This removes rupees from circulation → money
supply shrinks → people spend less (including on imports) → deficit shrinks.

Supply side: Output is below full capacity, so workers are unemployed. Unemployed workers accept
lower wages to keep their jobs. Companies pay less in wages → lower production costs →
companies lower their prices → Indian goods become cheaper → foreigners buy more → exports
rise.

Both effects together push the economy from E toward E'. BUT: this takes 5-10 years of painful
unemployment, wage cuts, and deflation. That is why governments prefer to use policy tools instead
of just waiting.

✍■ EXAM-READY ANSWER — Write This in Your Paper

The Classical Automatic Adjustment Process operates through two simultaneous channels:

Demand Side: A balance of payments deficit means demand for foreign exchange exceeds private
supply. The central bank sells foreign exchange to maintain the fixed rate, reducing domestic
high-powered money and hence the money stock (assuming no sterilisation). Lower money supply
→ lower spending → lower imports → deficit narrows. The AD schedule shifts downward and
leftward over time.

Supply Side: Point E is also a point of unemployment. Unemployment causes wages to fall as
workers compete for scarce jobs. Falling wages reduce production costs, reflected in a
downward-shifting AS schedule. Falling prices increase competitiveness — exports rise, imports fall.

Both channels operate simultaneously, moving the short-run equilibrium E progressively toward E'.
At E', trade is balanced, exchange rate pressure disappears, central bank stops intervening, money
supply stabilises, and wages/costs stabilise. Full employment with external balance is achieved
automatically.

Critical limitation: The classical adjustment process works but may take a very long time and
require a prolonged, painful recession — exactly the kind France took almost a decade to complete
after 1983 (Blanchard & Muet, 1993).

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Policies: Expenditure Switching & Reducing + Formulas

603 2 & 2a
■ NEWCOMER EXPLANATION — Understand Like a Story

The cruel irony of policy: There are TWO things wrong at Point E — trade deficit AND
unemployment. Fixing one tends to worsen the other! If you stimulate economy to reduce
unemployment → people spend more → buy more imports → deficit worsens. If you cut spending to
fix deficit → economy slows → more unemployment. So you need TWO types of policies together.

Expenditure Switching = make people switch from foreign goods to domestic goods (devaluation,
tariffs). Expenditure Reducing = cut total spending in the economy (raise interest rates, cut
government spending).

Tariffs (taxes on imports) could help but GATT and IMF discourage them. World moved toward free
trade since WW2.

The formulas below show WHY a trade deficit exists in accounting terms, and how it connects to the
government budget.

NX ≡ Y − (C + I + G)

Formula (2): Trade surplus = National Income minus Total Spending. If spending exceeds income → deficit.

■ Numerical Example — Formula (2)

Given: Y=■500cr, C=■200cr, I=■100cr, G=■150cr.

NX = 500 - (200+100+150) = 500 - 450 = +■50cr surplus ■

If G rises to ■250cr: NX = 500 - (200+100+250) = 500 - 550 = -■50cr deficit ■

→ Government overspending directly causes a trade deficit.

NX ≡ S − I + T − G

Formula (2a): Trade balance = Private saving − Investment + Government budget surplus (T−G). This is the
TWIN DEFICIT formula.

■ Numerical Example — Formula (2a) — Twin Deficits

Given: S=■150cr, I=■100cr, T=■80cr, G=■100cr.

NX = (150-100) + (80-100) = 50 + (-20) = +■30cr surplus

Government cuts spending to G=■80cr: NX = 50 + (80-80) = 50 + 0 = +■50cr surplus improved ■

Key insight: Cutting budget deficit → improves trade balance. This is the "twin deficit" relationship.

✍■ EXAM-READY ANSWER — Write This in Your Paper

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Because automatic adjustment requires a prolonged recession, explicit policy is preferred. Since
there are TWO targets (internal and external balance), two types of policy must be combined.

Expenditure Switching Policies shift demand between domestic and imported goods without
changing total spending. Examples: devaluation, tariffs. Tariffs are restricted by GATT and the IMF.

Expenditure Reducing Policies decrease total aggregate demand: tight monetary or fiscal policy.

Formula (2): NX ≡ Y − (C+I+G) — Trade deficit reflects excess expenditure over income. Reducing
(C+I+G) relative to Y through tight policy reduces the deficit.

Formula (2a): NX ≡ S − I + T − G — A government budget deficit (G>T) directly worsens the trade
balance if saving and investment are held constant. This is the theoretical basis of the twin deficit
hypothesis. In practice, saving and investment also change, so budget cuts have a complex effect
on trade balance.

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604 Devaluation — Figure 20-2 + Exchange Rate Systems

■ ORIGINAL TEXTBOOK FIGURE

Figure 20-2: A Loss of Export Revenue. Economy starts at full equilibrium E. Export loss shifts NX=0 and AD leftward.
New equilibrium E' has unemployment and deficit. Devaluation can restore both full employment and trade balance
simultaneously.

■ NEWCOMER EXPLANATION — Understand Like a Story

Devaluation = the government officially lowers the value of its currency. Example: changes $1 =
■80 to $1 = ■100.

Effect on exports: Your shoe costs ■900 to make. Before devaluation ($1=■80): American pays
■900÷80 = $11.25. After devaluation ($1=■100): American pays ■900÷100 = $9.00. Your shoe got
cheaper — Americans buy MORE. Exports rise ■

Effect on imports: American phone costs $500. Before ($1=■80): You pay 500×80=■40,000. After
($1=■100): You pay 500×100=■50,000. Phone is more expensive — Indians buy LESS. Imports fall
■

Figure 20-2 story: Economy at E (perfect: full employment + trade balance). Export demand
suddenly falls (e.g., world recession). NX=0 line shifts LEFT (to NX'=0). AD shifts LEFT. New
equilibrium E' = unemployment + deficit. Devaluation shifts NX line back → solves BOTH problems at
once.

Important rule: This works perfectly because BOTH problems (unemployment AND deficit) had the
same cause (export fall). Usually problems have different causes, so one instrument alone cannot
solve both.

✍■ EXAM-READY ANSWER — Write This in Your Paper

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Devaluation is an increase in the domestic currency price of foreign exchange. It is primarily an

expenditure switching policy, raising the domestic price of imports and lowering the foreign price
of exports.

Numerical Example: Indian shoe costs ■900. At $1=■80, American pays ■900÷80 = $11.25. After
devaluation to $1=■100, American pays ■900÷100 = $9.00. Exports become cheaper for foreigners
→ export volumes rise. Simultaneously, a $500 American phone costs Indians ■50,000 instead of
■40,000 → imports fall.

Figure 20-2: economy at E (full employment, trade balance) faces an exogenous export loss. NX=0
and AD shift left. E' has unemployment AND deficit. Devaluation restores the NX schedule, solving
both problems with one instrument — valid here because both problems had a single common
cause.

Tinbergen Principle: You need as many independent policy instruments as independent policy
targets. When internal and external problems have different causes, one instrument is insufficient.

Exchange Rate System Description

Fixed rate system Exchange rate is a policy instrument; central bank sets and maintains a
specific rate; can devalue deliberately when deficit becomes prolonged.

Clean floating Exchange rate moves freely to equilibrate the balance of payments; no
government intervention.

Dirty floating (managed float) Central bank intervenes to influence the rate but does not commit to a specific
level; intermediate between fixed and clean floating; most real-world systems.

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605 Real vs Nominal Devaluation — The Critical Distinction

■ NEWCOMER EXPLANATION — Understand Like a Story

Nominal devaluation = just changing the exchange rate number. Easy — government announces it.

Real devaluation = your goods actually becoming cheaper for foreigners in real terms. Much harder
to achieve.

Why harder? When the rupee weakens, imported goods (petrol, raw materials) cost more in rupees.
This causes domestic inflation. If Indian prices rise by as much as the exchange rate weakened, a
foreign buyer sees NO change in the price of your goods. Example: shoe still looks like $9 to
American? Only if Indian prices didn't change. If shoe price rose to ■1,000 because of inflation after
devaluation: ■1,000 ÷ 100 = $10 — SAME as before. No real gain.

The formula: For real devaluation: the exchange rate e must rise MORE than domestic prices P rise.
If both rise equally, the real exchange rate R = ePf/P is unchanged.

Real devaluation requires: e rises MORE than P rises

If P rises proportionally with e → R unchanged → no competitiveness gain → nominal devaluation only

■ Numerical Example — Real vs Nominal Devaluation

Initial: e=80, Pf=10, P=100. R = (80×10)/100 = 800/100 = 8.0

After nominal devaluation (e=100), P unchanged: R = (100×10)/100 = 10.0 ■ Real devaluation

achieved!

But if inflation pushes P to 125: R = (100×10)/125 = 1000/125 = 8.0 ■ Back to original. No real
devaluation.

Lesson: Devaluation fails if domestic prices rise proportionally. Must control inflation alongside
devaluation.

✍■ EXAM-READY ANSWER — Write This in Your Paper

A devaluation succeeds in improving the trade balance only if it achieves a real devaluation —
actually reducing the relative price of domestic goods. Using R = ePf/P, a real devaluation occurs
when e/P rises — i.e., the exchange rate increases by more than the domestic price level.

This is not guaranteed because devaluation raises import prices, which feeds into domestic costs
and wages (the wage-price spiral, explained on page 610), potentially causing P to rise as fast as e.
If P rises proportionally with e, R remains unchanged and no competitive gain results.

Essential condition for real devaluation: the central bank must NOT accommodate price
increases by expanding the money supply. Tight money prevents the full wage-price spiral but
accepts some unemployment as a cost. This is the fundamental trade-off in devaluation policy.

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606 Figure 20-3: Competitiveness and Adjustment

■ ORIGINAL TEXTBOOK FIGURE

Figure 20-3: Competitiveness and Adjustment. Vertical axis shows P/e (domestic price in foreign currency terms). An
adverse external shock shifts NX left. To restore balance, economy must reach E'' (lower P/e). Devaluation raises e,
reducing P/e directly — but only if domestic prices don't rise equally.

■ NEWCOMER EXPLANATION — Understand Like a Story

Figure 20-3 shows competitiveness differently. The vertical axis shows P/e — the domestic price
level MEASURED IN FOREIGN CURRENCY (dollars). Think of it as: "How expensive are your
goods when priced in dollars?"

If P/e is HIGH → your goods are expensive in dollar terms → foreigners won't buy → deficit. If P/e is
LOW → your goods cheap → foreigners buy lots → surplus.

External shock example: Oil prices fall. Mexico earns less from oil exports. NX schedule shifts
LEFT (to NX'=0). Mexico now at E with a deficit. To restore full employment AND balanced trade,
must reach E'' — which requires LOWER P/e.

Two ways to get P/e lower: (1) Automatic — wait for domestic prices to deflate slowly (painful,
takes years). (2) Devaluation — raise e immediately, which mechanically reduces P/e since P/e = P
÷ e. But ONLY if domestic prices P don't also rise after devaluation.

✍■ EXAM-READY ANSWER — Write This in Your Paper

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Figure 20-3 uses P/e on the vertical axis — the domestic price level measured in foreign currency,
representing how expensive domestic goods appear to foreigners. A rise in P/e worsens net exports;
points to the right of NX=0 are deficit positions.

An oil price fall reduces Mexico's export earnings, shifting NX to NX'=0. Mexico must reach point E''
(lower P/e, at full-employment income Y*) to restore both internal and external balance.

Devaluation route: Raising e reduces P/e = P/e immediately. If P=1000 and e rises from 80 to 100:
P/e falls from 12.5 to 10 — Mexican goods cheaper in dollars.

Frustration of devaluation: If domestic prices rise from 1000 to 1250 as e rises to 100: P/e =
1250/100 = 12.5 — identical to before. No competitiveness gain. This is why devaluation must be
accompanied by tight monetary and fiscal policy.

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607 Figure 20-4: Mexico Dollar Price History + Crawling Peg

■ ORIGINAL TEXTBOOK FIGURE

Figure 20-4: Dollar Price Levels — USA and Mexico, 1970–1992 (Index 1985=100). P_US rises gradually. Mexican dollar
prices (P_Mex/e) are erratic — devaluations in 1982 and 1985-86 caused sharp drops, but inflation quickly erased the
competitiveness gains. By 1992 Mexico was less competitive than in 1987.

■ NEWCOMER EXPLANATION — Understand Like a Story

Figure 20-4 is real history. Two lines: the smooth, slowly-rising line is the US price level. The wild,
erratic line is Mexico's price level measured IN DOLLARS (P_Mex/e).

What the drops mean: Every time Mexico devalued (1982 and 1985-86), you see a sharp DROP in
P_Mex/e. Mexican goods became very cheap in dollars — competitiveness improved momentarily.
But then Mexican inflation kicked in, P_Mex rose, and since the peso wasn't depreciating fast
enough, P_Mex/e rose again. By 1992 Mexico was LESS competitive than 1987 despite multiple
devaluations. This set up the 1994 crisis.

Crawling Peg is a smarter system: instead of waiting for crisis and then doing a big devaluation, the
exchange rate is adjusted gradually and continuously — at roughly the same rate as the inflation
differential between home and trading partners. If Mexico has 10% inflation and USA has 2%,
Mexico should depreciate the peso by approximately 8% per year. This keeps the real exchange rate
stable.

The temptation countries face: Hold exchange rate fixed → import prices stay low → inflation
slows temporarily. Sounds good! But secretly, competitiveness is eroding every day. Eventually:
massive currency crisis. "Buying time by destroying competitiveness."

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Crawling Peg Goal: Keep R = Pf/(P/e) constant

Depreciate e at the same rate as the inflation differential (home inflation minus foreign inflation)

■ Numerical Example — Crawling Peg

Mexico inflation = 10%/yr, US inflation = 2%/yr. Inflation differential = 8%.

Year 0: e=80, P=100, Pf=10. R = (80×10)/100 = 8.0

Year 1 WITHOUT crawling peg (e fixed at 80): P rises to 110 (10% inflation), Pf to 10.2 (2%). R =
(80×10.2)/110 = 816/110 = 7.42 — competitiveness fell!

Year 1 WITH crawling peg (e rises 8% to 86.4): R = (86.4×10.2)/110 = 881.3/110 = 8.01 —

approximately unchanged ■

Crawling peg preserves competitiveness by keeping e in line with the inflation differential.

✍■ EXAM-READY ANSWER — Write This in Your Paper

Figure 20-4 shows that Mexico's 1982 and 1985–86 devaluations temporarily reduced the dollar
price of Mexican goods, but domestic inflation quickly erased these competitive gains. By 1992 the
real exchange rate had deteriorated below its 1987 level — leading to the 1994 peso crisis.

Crawling Peg: When a country has persistently higher inflation than trading partners, a fixed
exchange rate implies steady competitiveness loss. The crawling peg depreciates the currency
continuously at a rate equal to the inflation differential, maintaining the real exchange rate R =
Pf/(P/e) approximately constant.

The temptation: Countries use a fixed exchange rate to slow inflation (stable import prices moderate
the CPI). This works short-term but erodes competitiveness and typically leads to a larger crisis.
Exchange rate policy is at best a supplementary tool in disinflation — monetary and fiscal policy
must do the primary work.

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608-6 Box 20-1: Mexico Case Study + Table 1

09
■ NEWCOMER EXPLANATION — Understand Like a Story

Mexico's Full Story in Simple Terms:

1970s: Mexico found oil. Foreign banks said "Here, borrow our money — you have oil!" Mexico
borrowed billions.

1982: Oil prices fell. Mexico earning less. But still had to repay dollar loans. Foreign banks said "We
don't trust you anymore." Mexico couldn't pay its bills. CRISIS.

What Mexico did: Devalued the peso, cut government spending, privatised state companies,
reduced import tariffs. By late 1980s: growing again.

But then — the same trap: Economy grew. Foreign investors poured in. Easy financing of growing
current account deficit. But Mexico had HIGH inflation. Peso not depreciating fast enough. By 1992
less competitive than 1987.

The lesson: Countries rarely adjust early because tightening policy before it becomes politically
inevitable is very difficult. When confidence collapses (as in 1982), the central bank runs down
reserves trying to fill the financing gap, then faces forced devaluation and deep recession. Mexico
went through this TWICE (1982 and 1994).

Table 1: Mexico's External Balance (billions of US dollars)

Item 1989 1990 1991

Current account ($bn) -6.05 -7.11 -13.28

Trade balance -0.40 -0.88 -6.93

Capital account ($bn) +6.05 +7.11 +13.28

Private +5.56 +3.88 +5.78

Reserve increase +0.40 +3.23 +7.51

*Including errors and omissions | Note: Capital account exactly offsets current account each year — deficit fully externally
financed

✍■ EXAM-READY ANSWER — Write This in Your Paper

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Mexico Case Study: In the 1980s, Mexico's excessive external borrowing led to a debt crisis when
oil prices fell and world interest rates rose. Forced adjustment involved currency depreciation, import
liberalisation, privatisation, and deregulation. Recovery came by the late 1980s.

Table 1 shows that Mexico's current account deficit was exactly offset by capital account surpluses
each year (balance of payments identity: current account + capital account = 0). In 1991, a $13.28bn
current account deficit was matched entirely by foreign investment and reserve accumulation.

The danger: Capital account financing can disappear overnight when investor confidence collapses,
forcing abrupt and painful adjustment. Countries rarely tighten policy pre-emptively because it is
politically difficult — leading to crisis-driven adjustment as in 1982 and 1994.

Section 20-2 addresses two empirical questions: (1) Do nominal devaluations achieve real
devaluations, or do domestic price rises cancel them? (2) Even if relative prices change, does the
trade balance actually improve, or might it worsen (J-curve)?

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610 Wage-Price Spiral — Why Devaluation Can Fail

■ NEWCOMER EXPLANATION — Understand Like a Story

The wage-price spiral in plain words:

You devalue the rupee. Imports (petrol, raw materials) cost more in rupees. Consumer prices rise.
Workers see their salary buying less. They demand higher wages. Companies grant the raise but
also raise their product prices to cover the higher wage bill. This again raises consumer prices.
Workers demand more wages. Prices rise again. On and on.

The result: After the full spiral, all wages and prices have risen in proportion to the exchange rate. A
foreign buyer still pays the same price for your goods as before devaluation. The nominal
devaluation had zero effect on the real exchange rate.

When does the spiral STOP? Only if the government does NOT increase the money supply. With
fixed money supply, higher prices reduce purchasing power, demand falls, economy slows,
companies cannot keep raising prices. The spiral is choked off — but creates some unemployment.

Sticky real wages: Workers resist real wage cuts. If export demand falls permanently (say, superior
technology abroad makes your products less desirable), you need domestic goods to become
relatively cheaper. But if workers always restore their real wages after each devaluation, prices just
rise back. The only remaining way to reduce real wages is protracted unemployment.

✍■ EXAM-READY ANSWER — Write This in Your Paper

The Wage-Price Spiral — why nominal devaluation may not achieve real devaluation:

If workers' real wages are indexed to the CPI (which includes imported goods), a devaluation that
raises import prices triggers demands for higher nominal wages. Firms grant raises, then pass the
cost into higher prices. Higher prices → more wage demands → prices rise further. This wage-price
spiral can completely neutralise the devaluation.

Mathematical result: If wages fully index to CPI and firms fully pass wage costs into prices, then
after the spiral completes, wages and the price level have both risen in proportion to the exchange
rate. The real exchange rate R = ePf/P is unchanged. The nominal devaluation has had no effect on
the real exchange rate.

Critical policy condition: For real devaluation, the central bank must NOT accommodate price
increases by expanding the money supply. This prevents the spiral but accepts some unemployment
as a cost.

Sticky real wages and permanent shocks: If export demand falls permanently, relative prices must
fall. If workers always restore real wages after devaluation, the only mechanism is protracted
unemployment to force real wage reductions. This explains why structural adjustments are extremely
painful and slow in countries with strong real wage rigidity.

■ Numerical Example — Wage-Price Spiral

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Start: e=80, Pf=10, P=100. R = (80×10)/100 = 8.0.

Devaluation: e rises to 100. Initially R = (100×10)/100 = 10.0 ■ — real devaluation achieved.

Import prices rise → CPI rises → workers demand 25% wage rise → firms raise P to 125:

New R = (100×10)/125 = 1000/125 = 8.0 ■ — back to original. Devaluation completely cancelled.

Lesson: Only if government keeps money supply tight (accepting some slowdown) does the spiral stop
before fully reversing the devaluation.

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The J-Curve — Formula (3) + Why Trade Worsens Before

611 Improving

NX = X − (ePf/P) × Q

Formula (3): Trade balance = Exports − Value of imports. The VALUE of imports = relative price × volume. After
devaluation, price rises immediately but volume adjusts slowly → J-curve.

■ NEWCOMER EXPLANATION — Understand Like a Story

The J-Curve is about TIMING. After devaluation, does the trade balance improve immediately? NO
— it gets WORSE first, then improves.

Why worse first? The day of devaluation, import prices jump. But import volumes CANNOT change
overnight. Factories have existing contracts. Consumers haven't found alternatives yet. They still buy
roughly the same quantity of imports, but now pay more per unit. Import BILL rises (price × same
quantity = higher total). Export earnings haven't increased yet — foreign buyers need time to notice
your goods are cheaper, test quality, sign new contracts, ship orders. Result: trade balance worsens
immediately.

Why better later? Over 6 months to 2 years: foreign buyers start ordering more of your cheaper
goods. Indians switch to domestic alternatives as imports stay expensive. Export volumes UP, import
volumes DOWN. Trade balance improves.

The graph looks like the letter J — goes down first, then comes back up. USA 1985: dollar
depreciated from February 1985. Trade balance kept worsening through all of 1986. Only improved
in 1987, continued in 1988. Almost 2 full years of J-curve!

TIME PRICE EFFECT VOLUME EFFECT TRADE BALANCE

Immediately (Day
Import price ↑ (large) Volumes unchanged (small) WORSENS ↓
1)

0–6 months Import price ↑ Small volume adjustment Still worse ↓

Export/import volumes adjust

6–24 months Price stabilises IMPROVES ↑
significantly

Long run Prices fully adjusted Volumes fully adjusted Improved ■

■ Numerical Example — J-Curve (Formula 3)

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India imports 1,000 barrels oil. Pf=$50, e=80, P=100.

Import value = (ePf/P) × Q = (80×50/100) × 1000 = 40 × 1000 = 40,000 units

Devaluation: e rises to 100. Immediately, volumes unchanged (Q still 1000):

Import value = (100×50/100) × 1000 = 50 × 1000 = 50,000 units → WORSENS by 10,000!

After 18 months: Q falls to 700 as people find alternatives:

Import value = (100×50/100) × 700 = 50 × 700 = 35,000 units → BETTER than before devaluation! ■

US example: Dollar depreciated Feb 1985. Trade deficit kept worsening through 1986. Improved
1987-88.

✍■ EXAM-READY ANSWER — Write This in Your Paper

The J-Curve Effect explains why trade balances typically worsen immediately following a
devaluation before eventually improving.

Formula (3): NX = X − (ePf/P)Q. When the exchange rate depreciates (e rises), the term ePf/P rises
immediately. If physical import volume Q is unchanged (inelastic in the short run due to existing
contracts and habits), the value of imports rises — worsening NX.

However, two volume effects work in the opposite direction: exports should rise (goods are cheaper
for foreigners) and import volumes should fall (imports more expensive). These volume effects are
empirically small in the short run (within a year) but large in the long run — enough to dominate and
produce a normal, improving trade balance response.

The pattern: Short-run: price effect dominates → balance worsens. Long-run: volume effects
dominate → balance improves. The path looks like the letter J — hence J-curve.

Real-world evidence: US dollar depreciated from February 1985; current account continued
worsening through 1986; improved from 1987. Approximately a two-year J-curve lag.

Why lags? Tourism patterns take 6–12 months to adjust. International production relocation (e.g.,
Toyota shifting from Japan to California) takes years. These lags explain why exchange rate
changes have delayed trade effects.

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612 Hysteresis Effects of Overvaluation

■ NEWCOMER EXPLANATION — Understand Like a Story

Hysteresis: Some damage is PERMANENT. Normal economics says: if something changes and
then changes back, you return to where you started. Hysteresis says: sometimes you do NOT return,
because the change left permanent marks.

The car industry example (real history): US dollar was very strong 1980–1985. Japanese car
companies (Toyota, Honda, Nissan) entered the American market heavily — they were cheap
relative to American cars during those years. They built dealerships, service networks, brand loyalty.

When the dollar weakened after 1985, American car companies expected to recapture their market
share. But Americans had already gotten used to Toyota and Honda. The Japanese companies were
too well established. American imports remained higher than pre-1980 even after exchange rate
returned to 1980 level.

The economic point: For US firms to recapture their market, they would need to be significantly
cheaper than Japanese firms. This would require the dollar to depreciate BELOW its original level —
to overshoot in the opposite direction. The hysteresis argument says large, prolonged
overvaluations cause permanent damage that is hard and costly to reverse.

Policy lesson: Never let your currency be overvalued for too long. The damage to your export
industries and domestic market share can outlast the overvaluation itself.

✍■ EXAM-READY ANSWER — Write This in Your Paper

Hysteresis Effects refer to the phenomenon where a change in the exchange rate that is later
exactly reversed nonetheless leaves a permanent long-term impact on trade patterns.

During the sharp US dollar overvaluation from 1980–1985, import prices fell, encouraging foreign
firms — particularly Japanese manufacturers — to establish themselves in the American market.
Once established with distribution networks, brand recognition, and consumer loyalty, these foreign
firms retained their market share even after the dollar depreciated back toward its 1980 level during
1985–1988.

The hysteresis argument: Reversing the exchange rate to its original level is insufficient to dislodge
established foreign firms. US firms would need to make costly investments to re-enter markets and
compete with entrenched foreign suppliers. This would only be profitable if the exchange rate
depreciated significantly below its original level — an overshoot in the opposite direction.

Evidence: Despite the 1985–1988 depreciation restoring the real dollar exchange rate to
approximately its 1980 level, the import share in the US market remained persistently higher, and the
US external balance did not fully correct. This supports the view that overvaluation damage may be
lasting.

Policy implication: Avoid permitting large, persistent currency overvaluations. The resulting loss of
market share in both domestic and export markets may prove difficult or impossible to reverse even
after exchange rate normalisation.

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613 Section 20-3: Monetary Approach + Sterilisation

■ NEWCOMER EXPLANATION — Understand Like a Story

A completely different way of looking at deficits — the MONETARY ANGLE.

The claim: Balance of payments deficits are fundamentally caused by TOO MUCH MONEY in the
economy. Too much money → people feel rich → spend more → buy more foreign goods → deficit.

The automatic mechanism: Under fixed exchange rates, when there's a deficit, the central bank
sells foreign exchange. This removes domestic currency from circulation. Money supply FALLS
automatically. Less money → less spending → fewer imports → deficit corrects. No government
policy needed — it happens by itself!

Sterilisation breaks this: Central bank sells dollars (money falls) but SIMULTANEOUSLY buys
government bonds (money rises back). Net effect: money supply unchanged. The automatic
correction is blocked. The deficit can persist forever.

The bucket analogy: Without sterilisation: water leaks from bucket (deficit) → bucket empties →
you're forced to use less water (spend less) → leak becomes manageable. WITH sterilisation: water
leaks but you keep refilling from another tap → bucket stays full → leak never stops.

✍■ EXAM-READY ANSWER — Write This in Your Paper

The Monetary Approach holds that balance of payments deficits are a monetary phenomenon — a
reflection of excessive money supply. A money supply contraction restores external balance by
raising interest rates, reducing spending and income, and therefore reducing imports.

The automatic mechanism under fixed rates: A deficit → central bank sells foreign exchange →
domestic high-powered money falls → money supply falls (assuming no sterilisation) → spending
falls → imports fall → deficit corrects. In surplus countries, the reverse occurs. The money supply
automatically adjusts to restore external balance — this is the classical adjustment process.

Sterilisation: Central banks frequently offset (sterilise) the money supply impact of foreign exchange
intervention through open market operations. A deficit country selling foreign exchange (which
reduces money supply) may simultaneously purchase government bonds (which injects money),
leaving money supply unchanged. With sterilisation, the automatic adjustment is suspended
and the deficit can persist indefinitely.

Key conclusion: Persistent external deficits are truly a monetary phenomenon — they are sustained
by sterilisation, which actively maintains a money supply too high for external balance.

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614 Formula (4): ∆NFA = ∆H − ∆DC + IMF Balance Sheet

Table 20-1: Balance Sheet of the Monetary Authorities (Central Bank)

ASSETS LIABILITIES

Net Foreign Assets (NFA) = foreign exchange High-powered money (H) = all currency in circulation
reserves, gold, claims on foreign central banks created by central bank

Domestic Credit (DC) = loans to government (govt

debt) + loans to private sector (bank loans)

∆NFA = ∆H − ∆DC

Formula (4): Change in foreign reserves = Change in money supply − Change in domestic credit | ∆NFA =
Balance of Payments

■ NEWCOMER EXPLANATION — Understand Like a Story

Think of RBI like a business with a balance sheet. Assets = what it owns (foreign reserves +
loans given out). Liabilities = what it owes (all the rupees in existence).

The simple accounting: Assets = Liabilities → NFA + DC = H → changes: ∆NFA + ∆DC = ∆H →

rearranging: ∆NFA = ∆H − ∆DC

∆NFA = Change in foreign reserves = THE BALANCE OF PAYMENTS. If reserves rise = surplus. If
reserves fall = deficit.

∆H = How much total money the economy NEEDS to grow (depends on economic growth +
inflation).

∆DC = How much NEW credit the central bank is creating (lending to government and banks).

The key insight: If RBI creates more new loans (↑DC) than the economy needs, the excess leaks
out as a balance of payments deficit (foreign reserves fall). IMF uses this formula to set a MAXIMUM
on how much credit RBI can create.

■ Numerical Example — Formula (4)

Economy needs ∆H = ■1,000cr new money this year. IMF target: ∆NFA = +■200cr (gain reserves).

IMF calculates max domestic credit: ∆DC = ∆H − ∆NFA = 1,000 − 200 = ■800cr ceiling

If RBI ignores ceiling and creates ∆DC = ■1,200cr:

∆NFA = 1,000 − 1,200 = -■200cr → Reserves FALL by 200cr → balance of payments DEFICIT!

The excess credit (■400cr above ceiling) directly caused ■400cr worse balance of payments.

✍■ EXAM-READY ANSWER — Write This in Your Paper

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The balance sheet identity NFA + DC = H gives Formula (4): ∆NFA = ∆H − ∆DC.

∆NFA = change in net foreign assets = the balance of payments (official reserve transactions). ∆H
= required growth in high-powered money (for economic growth and inflation). ∆DC = expansion of
domestic credit (central bank loans to government and banks).

IMF Stabilisation Procedure: Step 1: Set ∆NFA* (maximum reserve loss acceptable). Step 2:
Estimate ∆H* (money the economy needs). Step 3: Calculate domestic credit ceiling ∆DC* = ∆H* −
∆NFA*. Step 4: Require country to keep credit expansion within this ceiling.

This ceiling prevents the central bank from financing budget deficits through money creation and
forces interest rates high enough to restore the balance of payments.

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615 How the IMF Monetary Approach Works in Practice

■ NEWCOMER EXPLANATION — Understand Like a Story

Why doesn't every country just control domestic credit automatically? Why do deficits
persist?

Because tight credit is PAINFUL. When RBI stops creating new loans: Banks have less money to
lend → interest rates rise → borrowing expensive → spending falls → some businesses shut →
unemployment rises → recession.

The country goes through a recession to fix its balance of payments. This is the price of the
treatment.

Technical subtlety: In an open economy with fixed exchange rates, the central bank cannot directly
set the total money supply. It must provide however many rupees people need to exchange for
foreign currency (it promised to maintain the fixed rate). So money supply is endogenous
(determined by market demand). What the central bank CAN control is domestic credit (DC).

By limiting DC growth, it ensures that the only way money can grow is if foreign exchange flows IN
(balance of payments surplus). This forces the economy to earn its money through export success
rather than credit creation.

Why IMF likes this approach: Simple formula → clear target → easy to monitor → gives definitive
policy recommendations → particularly valuable when dramatic action needed and government
credibility must be restored.

■ How Credit Ceiling Improves Balance of Payments — Step by Step

Economy growing at 5%, inflation 3% → money demand rising 8% → need ∆H = ■800cr.

IMF sets ∆DC ceiling at ■600cr (below ∆H needed by ■200cr).

Shortfall of ■200cr → excess demand for money develops.

Excess money demand → interest rates rise.

Higher interest rates → spending falls, capital flows in.

Less spending → fewer imports. Capital inflows → foreign exchange reserves rise.

∆NFA = ∆H − ∆DC = 800 − 600 = +■200cr → Balance of payments SURPLUS ■

✍■ EXAM-READY ANSWER — Write This in Your Paper

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Controlling domestic credit means operating tight monetary policy. In a growing, inflationary
economy, demand for money is rising. If domestic credit expansion is slowed below this rising
demand, an excess demand for money develops — causing interest rates to rise and spending to
decline. Higher interest rates improve the balance of payments through both reduced imports and
capital inflows.

Important distinction: Under fixed exchange rates with capital mobility, the money stock is
endogenous — the central bank must meet whatever demand for foreign currency arises and cannot
directly control total money. But it can control domestic credit growth. Limiting DC means the only
source of money growth is foreign exchange reserve inflows — the economy must earn its money
through balance of payments improvement.

The domestic credit ceiling is crude but effective because: its simplicity makes it easy to monitor; its
definiteness provides clear policy recommendations; it is particularly valuable when dramatic action
is needed and government credibility must be restored. The main cost is that restricting credit
typically induces recession or significant interest rate rises — which is why IMF programmes are
often politically difficult.

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Monetary Approach & Depreciation + Section 20-4:

616 Flexible Exchange Rates
■ NEWCOMER EXPLANATION — Understand Like a Story

What do monetary approach supporters say about devaluation? They say it only helps in the
SHORT RUN. Long run: improvement vanishes.

Their argument: Devaluation creates trade surplus → more foreign money coming in → money
supply increases → prices rise → competitiveness erodes → back to where you started. Transitory
effect only.

Where they are RIGHT: In the long run under fixed rates, prices do adjust and economy returns to
equilibrium. Tight credit does improve balance of payments.

Where they are WRONG: It's incorrect to say exchange rate policy cannot affect competitiveness
even in the short run. And exchange rate changes often happen precisely when a country has BOTH
deficit AND unemployment — devaluation speeds adjustment in that situation.

Now Section 20-4 — Flexible Exchange Rates: A completely different world. Government doesn't
promise any fixed rate. Exchange rate moves freely based on supply and demand. Capital moves
between countries in seconds. Prices can change. How does the economy adjust over time?

✍■ EXAM-READY ANSWER — Write This in Your Paper

Monetary approach and depreciation: Proponents argue depreciation only helps in the short run.
Short run: better competitiveness and trade surplus → money supply rises → aggregate demand and
prices rise until full employment and external balance are restored. Devaluation's effect is thus
transitory — it lasts only until prices and money supply have fully adjusted.

Where correct: The long-run perspective is right — prices and money adjust to restore equilibrium
under fixed rates. Credit restraint does improve balance of payments.

Where misdirected: The monetary approach is wrong to claim exchange rate policy cannot affect
competitiveness even in the short run. Exchange rate changes frequently arise from positions of
deficit AND unemployment; devaluation can usefully speed adjustment in such cases.

Section 20-4 — Flexible Exchange Rates, Money, and Prices: Capital is perfectly mobile. The key
new feature is that prices are now allowed to change. Analysis examines how output, exchange
rate, and prices respond to monetary and fiscal policies over time, and how the response evolves
from short run to long run.

Feature Fixed Rate System vs Flexible Rate System

Exchange rate Fixed: government sets it | Flexible: market determines freely

Central bank role Fixed: must intervene to maintain rate | Flexible: no obligation to intervene

Adjustment mechanism Fixed: through prices and money supply | Flexible: through exchange rate
movements

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Feature Fixed Rate System vs Flexible Rate System

Exchange rate as policy Fixed: is a deliberate policy tool (can devalue) | Flexible: reflects market
conditions

Capital flows Both: perfect capital mobility means rates equalise rapidly across countries

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617 Figure 20-5: The Four Zones of Adjustment

■ ORIGINAL TEXTBOOK FIGURE

Figure 20-5: Adjustment of Exchange Rates and Prices. The diagram divides the economy into four zones based on
whether output is above or below Y* (full employment) and whether the interest rate is above or below i_f (world interest
rate = BB line). Prices rise in Zones I & IV, fall in II & III. Currency appreciates in Zones I & II, depreciates in III & IV.

■ NEWCOMER EXPLANATION — Understand Like a Story

Figure 20-5 — Two simple questions create four zones:

Question 1: Is output above or below Y*? Above Y* → economy overheating → prices RISING.
Below Y* → economy underperforming → prices FALLING.

Question 2: Is interest rate above or below world level (i_f = BB line)? Above world rate →
foreign money rushes IN → currency APPRECIATES (strengthens). Below world rate → money
rushes OUT → currency DEPRECIATES (weakens).

Why does interest rate affect exchange rate so instantly? You have ■1 lakh. Indian bank offers
5% interest, American bank offers 8%. Obviously you send money to America. You sell rupees, buy
dollars. Everyone doing this → rupee weakens. The moment Indian rate falls below world rate,
money leaves → rupee depreciates. With modern technology, this happens in SECONDS.

With perfect capital mobility: interest rate cannot stay far from world level. Any divergence triggers
immediate large capital flows, pulling the rate back toward BB. Exchange rate adjusts almost
instantly.

Zone Output vs Y* Interest vs i_f Price Movement Currency

I (Top-Right) Above Y* Above i_f Rising (Inflation) Appreciating

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II (Top-Left) Below Y* Above i_f Falling (Deflation) Appreciating

III (Bot-Left) Below Y* Below i_f Falling (Deflation) Depreciating

IV (Bot-Right) Above Y* Below i_f Rising (Inflation) Depreciating

✍■ EXAM-READY ANSWER — Write This in Your Paper

Figure 20-5 divides the (output, interest rate) space into four zones using two reference lines: the
vertical line at Y* (full employment) and the horizontal BB line at i_f (world interest rate).

Prices: Rise when output is above Y* (Zones I and IV); fall when output is below Y* (Zones II and III).

Exchange rate: With perfect capital mobility, any interest rate above i_f attracts capital inflows →
currency appreciates (Zones I and II). Any rate below i_f causes capital outflows → currency
depreciates (Zones III and IV).

Perfect capital mobility rule: The economy is always being pushed rapidly back toward the BB
schedule. Exchange rates adjust almost instantaneously to any divergence, so the economy is
always close to the BB line. This means exchange rates respond instantly to monetary or fiscal
shocks, while prices adjust gradually.

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618 Figure 20-6: Monetary Expansion — Short and Long Run

■ ORIGINAL TEXTBOOK FIGURE

Figure 20-6: Short- and Long-Run Effects of a Monetary Expansion. LM shifts right to LM'. Interest rate falls below i_f →
capital outflows → exchange rate depreciates → IS shifts right to IS'. Economy moves E → E' → E''. At E'' output above
Y*, prices rise, LM drifts back left, exchange rate appreciates, IS drifts back. Long-run return to E with higher M, P, e all
proportionally.

■ NEWCOMER EXPLANATION — Understand Like a Story

Short run — what happens the moment money supply increases:

More money → banks compete to lend → interest rates FALL → Indian rate now below world rate →
investors pull money out of India → they sell rupees, buy dollars → rupee DEPRECIATES → Indian
goods cheaper internationally → foreigners buy more → exports rise → output increases above Y*.
Good short-term effects!

Long run — what happens over the next 1-2 years:

Output above Y* → factories running overtime → workers have more money → too much demand →
PRICES START RISING. Rising prices → real money (M/P) actually FALLS even though nominal
money is high. Interest rates start rising → currency starts APPRECIATING (partially reversing the
depreciation). Competitiveness falls back. Output returns to Y*. Only difference: everything nominal
is higher.

The final result: Money went up 20%? Long run: prices up 20%, exchange rate up 20%, nominal
money up 20%. Real money (M/P): unchanged. Real exchange rate (ePf/P): unchanged. Output:
unchanged. Money is neutral in the long run — it only changes the price level and exchange
rate, nothing real.

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Table 20-2: Short and Long-Run Effects of a Monetary Expansion

M/P (real eP_f/P
Period e (exchange rate) P (prices) Y (output)
money) (competitiveness)

↑ RISES ↑ RISES (more

Short run ↑ RISES No change ↑ RISES
(depreciates) competitive)

Long run No change (0) ↑ RISES ↑ RISES No change (0) No change (0)

■ Numerical Example — Monetary Expansion (20% increase)

Start: M=100, P=100, e=80, R=ePf/P = (80×10)/100 = 8.0, Y=Y*.

Short run (after 20% money increase): M=120, e depreciates to ~96, P still=100.

R = (96×10)/100 = 9.6 — more competitive. Output rises above Y*.

Long run (after full price adjustment): P rises to 120 (20%). e settles at 96 (20% depreciated).

Real money M/P = 120/120 = 1.0 (unchanged). R = (96×10)/120 = 8.0 (unchanged). Y = Y*

(unchanged).

Conclusion: Money is entirely neutral in the long run. All nominal variables rise 20%, all real variables
unchanged.

✍■ EXAM-READY ANSWER — Write This in Your Paper

Short-run: Monetary expansion shifts LM rightward to LM'. Equilibrium at E' has interest rate below
i_f → capital outflows → immediate exchange rate depreciation → IS shifts right to IS' → economy
moves rapidly to E'' (output above Y*, improved competitiveness).

Long-run: At E'', output exceeds Y* → prices rise → real money M/P falls → LM drifts back left →
interest rates rise → capital inflows → exchange rate appreciates → IS drifts back left → economy
returns to E.

Final result: Nominal money, prices, and exchange rate all rise in the same proportion. Real money
M/P, real exchange rate ePf/P, and output Y all return to original values. Money is entirely neutral
in the long run.

Table 20-2 summary: Short run: M/P+, e+, P=0, ePf/P+, Y+. Long run: M/P=0, e+, P+, ePf/P=0,
Y=0. The + signs that are 0 in the long run reflect the neutrality of money.

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619-6 Figure 20-7: Exchange Rate Overshooting

20
■ ORIGINAL TEXTBOOK FIGURE

Figure 20-7: Exchange Rate Overshooting. At time T0, money increases 50% (from 100 to 150). Exchange rate
immediately shoots to 170 — more than the long-run 50% increase. Prices barely move initially. Over time, prices rise
gradually to 150 and exchange rate falls back to 150. Long run: all three variables at 150. All real variables unchanged.

■ NEWCOMER EXPLANATION — Understand Like a Story

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The KEY observation: Exchange rates react in SECONDS. Prices react over MONTHS AND
YEARS. This mismatch causes overshooting.

Story: Government increases money supply by 50%. Long run: exchange rate should settle 50%
higher. But on Day 1, prices haven't moved at all. The exchange rate cannot wait for prices to catch
up. It must immediately jump to whatever level equilibrates the money market RIGHT NOW — with
today's unchanged prices. Since prices are still low, the exchange rate must jump by MORE than
50% to compensate. It jumps to 70% depreciation. Then as prices gradually rise over the next year
or two, the exchange rate gradually appreciates back toward the 50% target.

Figure 20-7 in numbers: Money: 100 → 150 (50% increase, instant). Exchange rate: 100 → 170
(70% jump — OVERSHOOT!). Prices: barely move initially. Over time: prices rise to 150, exchange
rate falls back to 150. Final: all three at 150. All real variables (M/P, ePf/P, Y) unchanged.

Why does this matter? A 10% monetary expansion might cause a 25% short-run depreciation. This
creates massive uncertainty for businesses. An importer signed a contract to buy machines for $1M,
expected to pay ■8cr at ■80/$. Suddenly exchange rate jumps to ■120/$. Must pay ■12cr!
Business destroyed. This is why countries sometimes want to intervene in currency markets.

1985: World's major countries agreed to cooperate to prevent excessive exchange rate moves. But
exchange rates still swing wildly. The overshooting problem continues.

■ Numerical Example — Overshooting (50% money increase)

Start: M=100, P=100, e=100. Long-run prediction: all rise to 150.

At time T0 (prices sticky, P stays at 100): Money jumps to M=150.

Exchange rate must do ALL adjustment work with P=100 → overshoots to e=170 (70% jump).

Why 170 not 150? With P=100 still, a 50% e change alone is insufficient to equilibrate money market.
Exchange rate must overshoot to create enough income expansion and competitiveness to absorb extra
money.

After 1-2 years: Prices gradually rise from 100 toward 150 as inflation develops.

As P rises, exchange rate gradually falls from 170 back toward 150.

Long run: M=150, P=150, e=150. M/P = 150/150 = 1.0 (unchanged). ePf/P = (150×1)/150 = 1.0
(unchanged). Y = Y* (unchanged).

✍■ EXAM-READY ANSWER — Write This in Your Paper

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Exchange Rate Overshooting occurs because exchange rates adjust instantaneously while prices
adjust gradually. When a monetary disturbance occurs, the exchange rate must initially move beyond
its long-run equilibrium to equilibrate the money market with still-unchanged prices. As prices
subsequently adjust, the exchange rate gradually returns toward its long-run level.

Mechanism: Money supply increases by 50%. Long-run: exchange rate should settle 50% higher.
But immediately, with P unchanged, the exchange rate must depreciate more than 50% — say to
70% — to create sufficient competitiveness and income expansion to absorb the extra money. Over
time, as prices rise to absorb the monetary expansion, some of the exchange rate's work is taken
over by prices, and the exchange rate appreciates from 70% back to 50% depreciation.

Figure 20-7: Money rises from 100 to 150 at T0. Exchange rate immediately jumps to 170
(overshoots). Prices barely move initially. Over time, prices rise toward 150 and exchange rate falls
toward 150. Long-run: M=150, P=150, e=150 — all rose proportionally. Real variables unchanged.

Policy significance: Overshooting creates exchange rate volatility disproportionate to the

underlying monetary change. A 10% monetary expansion can cause a 20% short-run depreciation.
This creates uncertainty for businesses and competitiveness disruptions. The sharp US dollar
appreciation 1980–1985 reinforced calls for intervention. In 1985, major countries agreed in principle
to intervene to prevent excessive moves — though large exchange rate swings continue and often
remain difficult to explain.

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CHAPTER 20: International Adjustment and Interdependence Complete Study Guide

SUM Master Summary — All Formulas + 5 Key Concepts for

MAR Exam
Y
■ COMPLETE FORMULA REFERENCE
Formula Name What It Means Key Exam Point

R = eP_f/P Real Exchange Rate True competitiveness of a R falls = more competitive. For real
country's goods devaluation: e must rise MORE than P.

NX ≡ Y−(C+I+G) Trade Balance Trade surplus = income Deficit = spending exceeds income. Cut
Identity (2) minus total spending C/I/G or raise Y to fix.

NX ≡ S−I+T−G Twin Deficit Formula Trade balance linked to Budget deficit → trade deficit. Cutting
(2a) budget balance budget deficit improves trade balance.

NX = X−(eP_f/P)Q J-Curve Formula (3) Trade balance = exports After devaluation: import price rises
minus import VALUE immediately, volumes slow → balance
worsens then improves.

∆NFA = ∆H−∆DC IMF Monetary Balance of payments = Too much domestic credit → deficit. IMF
Formula (4) money growth minus credit sets DC ceiling.
growth

■ 5 KEY CONCEPTS EVERY EXAM WILL ASK

• 1. Automatic Adjustment (Classical Process)
■ NEWCOMER EXPLANATION — Understand Like a Story

Works by reducing money supply → lowering prices → restoring competitiveness. But takes years
and requires painful unemployment and wage cuts. No government action needed — but too slow
and costly in practice.

✍■ EXAM-READY ANSWER — Write This in Your Paper

Automatic adjustment works through money supply reduction leading to deflation and restored
competitiveness, but requires a protracted recession and takes very long — which is why policy
intervention is preferred.

• 2. Devaluation + Wage-Price Spiral

■ NEWCOMER EXPLANATION — Understand Like a Story

Devaluation makes exports cheaper and imports expensive. But ONLY achieves real devaluation if
domestic prices do NOT rise equally. The wage-price spiral (devaluation → import prices rise →
workers demand wages → prices rise → spiral) can completely cancel the benefit. Central bank must
NOT expand money supply after devaluation.

✍■ EXAM-READY ANSWER — Write This in Your Paper

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CHAPTER 20: International Adjustment and Interdependence Complete Study Guide

Devaluation raises the exchange rate e, switching expenditure from foreign to domestic goods. It
succeeds only if it achieves a real devaluation (e rises more than P). The wage-price spiral — where
import price rises feed through to wages and then prices — can neutralise the nominal devaluation
entirely, leaving the real exchange rate unchanged.

• 3. The J-Curve
■ NEWCOMER EXPLANATION — Understand Like a Story

Trade balance worsens immediately after devaluation because import volumes cannot adjust
overnight (contracts, habits). Worsens short term, improves long term as volumes respond. US 1985
example: worsened through 1986, improved from 1987.

✍■ EXAM-READY ANSWER — Write This in Your Paper

The J-curve occurs because short-run volume effects are small (existing contracts and habits persist)
while the price effect (higher import bill per unit) is immediate. The trade balance initially worsens,
then improves as import volumes fall and export volumes rise. Pattern looks like the letter J
diagrammatically.

• 4. Sterilisation and the Monetary Approach (∆NFA = ∆H − ∆DC)

■ NEWCOMER EXPLANATION — Understand Like a Story

Balance of payments deficits reflect excessive domestic credit creation. The automatic correction
(deficit → reserves fall → money supply falls → spending falls → deficit corrects) is broken by
sterilisation (central bank buys bonds to offset the money fall). IMF sets a domestic credit ceiling to
restore adjustment.

✍■ EXAM-READY ANSWER — Write This in Your Paper

The monetary approach holds that persistent deficits reflect excessive money supply, maintained by
sterilisation operations. The key formula ∆NFA = ∆H − ∆DC shows that excess domestic credit
expansion directly reduces foreign reserves. The IMF uses this to impose a domestic credit ceiling:
∆DC* = ∆H* − ∆NFA*, restoring adjustment through tight monetary policy.

• 5. Exchange Rate Overshooting

■ NEWCOMER EXPLANATION — Understand Like a Story

Under flexible exchange rates, when money supply increases, the exchange rate depreciates by
MORE than its long-run amount initially — because exchange rates react in seconds but prices take
months/years. The exchange rate then gradually reverses back toward its long-run level. Creates
exchange rate volatility.

✍■ EXAM-READY ANSWER — Write This in Your Paper

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CHAPTER 20: International Adjustment and Interdependence Complete Study Guide

Overshooting arises because exchange rates and prices adjust at different speeds. Exchange rates
move instantaneously; prices adjust gradually. When money supply rises, the exchange rate must
initially depreciate beyond its long-run equilibrium to equilibrate the money market with unchanged
prices. As prices subsequently adjust, the exchange rate gradually appreciates toward its long-run
level. Produces exchange rate volatility disproportionate to the underlying monetary change.

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CHAPTER 20: International Adjustment and Interdependence Complete Study Guide

■ EXAM PREPARATION CHECKLIST

■ Can you define and calculate the Real Exchange Rate R = eP_f/P with a numerical example?
■ Can you explain automatic adjustment step-by-step (deficit → money supply → prices →
competitiveness)?

■ Can you state TWO reasons the AD curve slopes downward in an open economy?
■ Can you define devaluation and explain its effect on exports AND imports with numbers?
■ Can you distinguish nominal devaluation from real devaluation and give a number example of the spiral
cancelling it?

■ Can you draw and explain the J-curve and give the US 1985 example?
■ Can you explain the wage-price spiral in detail?
■ Can you define hysteresis and give the US car market example?
■ Can you define crawling peg and calculate the required depreciation rate given inflation differentials?
■ Can you state and apply the formula ∆NFA = ∆H − ∆DC to find the IMF domestic credit ceiling?
■ Can you explain sterilisation and why it allows persistent deficits?
■ Can you explain Mexico's crisis and what it teaches about devaluation and inflation?
■ Can you describe the four zones in Figure 20-5 and what happens in each?
■ Can you trace through Figure 20-6 showing short-run AND long-run effects of monetary expansion?
■ Can you define exchange rate overshooting and explain WHY it happens (exchange rates fast, prices
slow)?

■ Can you state in one sentence why money is neutral in the long run?

■ Study this guide page by page. For each section, first read the Newcomer Explanation until you
understand the idea. Then read the Exam-Ready Answer and practise writing it in your own words. Work
through every numerical example. Good luck! ■

Economics Study Guide — Exam Preparation Page 42