An economy maintains a pegged exchange rate within a fixed exchange rate system. Facing a persistent balance of payments deficit, the monetary authority decides to devalue its currency by 15%. In the immediate short-run aftermath of this policy change, the country’s current account deficit worsens before eventually improving.
What is the primary economic explanation for this initial worsening of the current account deficit?
The price elasticity of demand for both exports and imports is highly elastic in the short run, allowing consumers to rapidly adjust their purchasing behavior.
The sum of the price elasticities of demand for exports and imports is less than unity (∣PEDx+PEDm∣<1|PED_x + PED_m| < 1∣PEDx+PEDm∣<1), meaning the increased domestic currency cost of imports outweighs the short-run volume adjustments.
The devaluation leads to an immediate increase in domestic interest rates, which causes the currency to appreciate back to its original peg on the foreign exchange market.
The central bank must buy domestic currency using its foreign exchange reserves to defend the new peg, which is recorded as a substantial debit on the current account.
