Macroeconomics help pls!?!? Urgent!!!?

Question

"A devaluation of the exchange rate may cause inflation. This is because AD increases, import prices increase and firms have less incentive to cut costs."

"An oil importer may face a balance of payments deficit if oil price increases, but in a fixed exchange rate there is little chance to devalue."

"A fixed exchange rate uses up foreign reserves defending the value of the currency."

Pls explain to me what the above sentences mean. I don't understand how these came to be.

Answer 1

Okay, here goes:

Devaluation of the exchange rate means that domestic currency "buys" less foreign currency - it becomes weaker and can buy fewer goods. This alone will cause import prices to increase, but the statement here is asking in terms of the AD-AS model. All things equal, AD-AS assumes an economy is operating and maximum output, and so if demand (AD) increases, the only additional output that can be purchased must be imported. Increased imports causes devaluation (more domestic currency out there for exchange to foreign currency to buy the imports). Because imported goods compete with domestic goods, if the price of imported goods increases, there's no reason to cut costs of domestic goods. So, really, inflation hits at several points here (only one of which is for monetary purposes).

The second sentence is a little unclear. Since a balance of payments deficit is the excess of imports over exports, a company that only imports a good for resale domestically will always be in a deficit (because it doesn't export - it doesn't sell outside its home country).  Also, there's a question of whether the price of oil is determined in foreign currency or domestic (for instance, global oil markets are dollar-denominated, just as a long-standing convention).

Let's assume for this example, then, that we're talking about a company that imports crude oil and exports some refined product or distillate overseas. We'll also assume that oil prices are figured in both the foreign and domestic currencies, to make it easier.

Let's start at a point where the dollar value of crude oil imported exactly equals the dollar value of refined products exported. This means there is neither a deficit nor a surplus to start with. Now say that the price of oil increases, while the price of other goods does not. How can this happen, you ask? If the oil refinery is sufficiently small compared with the total world output, and markets for gasoline and other oil distillates dont' increase in price, then this is possible. In such an instance, the oil company is immediately losing money because it cannot pass on this increase in cost. That aside, the statement is looking at currency markets. Here, we should see the domestic currency (that of the oil company) depreciate because more domestic currency is required to buy the same amount of oil. However, if the exchange rate is fixed, then the outflow of domestic currency to exchange for foreign currency to buy the oil increases. At the same time, the price of the oil company's products (oil distillates, etc) has not changed, so the demand for domestic currency to buy these oil products has not changed. This means that the supply of domestic currency is increasing while the demand for foreign currency is increasing, which would be expected to cause devaluation, but does not. Thus you will see less of a rise in the price of imported oil than you would in a floating rate regime exactly because devaluation would not occur.

3rd sentence:

A fixed exchange rate will always use up foreign reserves if the exchange rate is fixed above market level. This means that, say there is a fixed regime where Mark:Kroner is 2:1, but the market would drive an exchange rate of 3:1 (say because a homogenous, transportable good can be bought for 3 Marks in Denmark but 1 Kroner in Sweden). Speculators can then buy 100 of this good in Sweden for 100 Kroner, take them to Denmark, and sell them for 300 Marks. Then, they could convert those 300 Marks into 150 Kroner. This type of arbitrage would be seen as constant pressure to buy Kroner in exchange for Mark from the Danish banking system. In order to maintain the fixed exchange rate of 2 Mark: 1 Kroner, either the Danish banks would have to sell marks, or the Swedish bank would have to buy Marks. Either action would weaken the Kroner (if it is 2 marks to 1 Kroner, it is .5 Kroner to 1 Mark; if it is 3 marks to the 1 kroner, it is .33 Kroner to 1 Mark; so 2:1 Mark:Kroner is a weaker Kroner than 3:1 Mark Kroner).

Hope these have answered your questions.