Supply-Side Effects of Exchange Rate, Exchange Rate Expectations and Induced Currency Depreciation

Abstract

This paper examines the repercussions of induced currency depreciation in a small open economy. The results presented in this paper are based on a model which has firmer microeconomics foundation and that takes into account both the supply side and demand side effects of exchange rate variations. The distinguishing feature of our model is the role of exchange rate expectations. We have considered three kinds of expectations; adaptive expectations, extrapolative, and regressive expectations and have performed several sensitivity tests based on these expectations. Our simulation exercise shows that the effect of induced currency depreciation depends largely on the supply-side effects of the exchange rate. In most cases, we found that currency depreciation results in fall in output, an increase in prices and an improvement in balance of trade. In the absence or weak supply-side effects of exchange rate, we learn that if Marshall-Lerner conditions holds then depreciation of the home currency would have favorable effects on output but has adverse effects on balance of trade.