AP_Krugman_Textbook

the yuan so that it would not have to buy up so many U.S. dollars on the foreign ex-
change market.
Second, devaluation and revaluation can be used as tools of macroeconomic pol-
icy. A devaluation, by increasing exports and reducing imports, increases aggregate
demand. So a devaluation can be used to reduce or eliminate a recessionary gap. A
revaluation has the opposite effect, reducing aggregate demand. So a revaluation can
be used to reduce or eliminate an inflationary gap.

Monetary Policy Under a Floating Exchange

Rate Regime

Under a floating exchange rate regime, a country’s central bank retains its ability to
pursue independent monetary policy: it can increase aggregate demand by cutting the
interest rate or decrease aggregate demand by raising the interest rate. But the ex-
change rate adds another dimension to the effects of monetary policy. To see why, let’s
return to the hypothetical country of Genovia as discussed in Module 43 and ask what
happens if the central bank cuts the interest rate.
Just as in a closed economy, a lower interest rate leads to higher investment spend-
ing and higher consumer spending. But the decline in the interest rate also affects
the foreign exchange market. Foreigners have less incentive to move funds into Gen-
ovia because they will receive a lower rate of return on their loans. As a result, they
have less need to exchange U.S. dollars for genos, so the demand for genos falls. At
the same time, Genovians have moreincentive to move funds abroad because the rate
of return on loans at home has fallen, making investments outside the country more
attractive. Thus, they need to exchange more genos for U.S. dollars and the supply of
genos rises.
Figure 44.1 shows the effect of an interest rate reduction on the foreign exchange
market. The demand curve for genos shifts leftward, from D 1 toD 2 , and the supply
curve shifts rightward, from S 1 toS 2. The equilibrium exchange rate, as measured in
U.S. dollars per geno, falls from XR 1 toXR 2. That is, a reduction in the Genovian inter-
est rate causes the geno to depreciate.
The depreciation of the geno, in turn, affects aggregate demand. We’ve already seen
that a devaluation—a depreciation that is the result of a change in a fixed exchange

module 44 Exchange Rates and Macroeconomic Policy 439

Section 8 The Open Economy: International Trade and Finance

figure 44.1

Monetary Policy and

the Exchange Rate

Here we show what happens in

the foreign exchange market if

Genovia cuts its interest rate.

Residents of Genovia have a re-

duced incentive to keep their

funds at home, so they invest

more abroad. As a result, the

supply of genos shifts rightward,

fromS 1 toS 2. Meanwhile, for-

eigners have less incentive to put

funds into Genovia, so the de-

mand for genos shifts leftward,

fromD 1 toD 2. The geno depreci-

ates: the equilibrium exchange

rate falls from XR 1 toXR 2.

Quantity of genos

XR 1

Exchange

rate

(U.S. dollars

per geno)

E 1

E 2

XR 2

S 1

S 2

D 1

D 2

1. After the Genovian interest
   rate falls, Genovians invest
   more abroad, buying more U.S.
   dollars and selling more genos...


2. ...and foreigners invest
   less in Genovia, reducing
   their demand for genos,...


3. ...leading to
   a depreciation
   of the geno.