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L10 (Exchange Rates).pdf

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ECON 103

PRICE AND INCOME EFFECTS OF DEVALUATIONAPPRECIATION THE PRICE EFFECT Analyzing the case of a devaluation ofor an appreciation of US With our last example see ECON103L9F12 we saw that the UK initially benefits with the devaluation of thethe UK exports more UK goods became cheaper and imports less US goods became more expensive However the UK still imports some goods from the US either food or goods that are used as inputs in the UK production If those inputs are more expensive costs of production and prices in the UK increase that is inflation happens in the UKOn the other hand deflation in the US might occur due to lower production costs since imports of British inputs are cheaper As a result inflation in the UK partially counterbalances the advantage that the UK has got with the devaluation of the exchange rate With inflation in the UK British goods become more expensive for US consumers so UK exports decrease On the other hand US goods are cheaper due to the deflation in US causing UK imports to increaseUpper Left Since British firms use some US goods as inputs in the production and US goods are more expensive after theappreciation then costs of UK goods increase Thus supply of UK goods decreases ie the supply of US imports decreases the supply curve shifts up from S to SUpper Right Since some of American firms are using UK inputs it costs them less to produce after the devaluation This means that the supply curve of US goods and the supply of US exports shifts down from S to S ie the supply increasesLower Left Since it is more expensive to produce in the UK the supply of UK goods and the supply of UK exports shifts up from S to S ie the supply decreasesLower Right After thedevaluation it is cheaper to produce in the US because UK inputs used in the production are cheaper Thus supply of US goods ie the supply of UK imports increases the supply curve shifts down from S to S
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