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Date: Sat, 11 Dec 1999 19:59:00 -0800 (PST)
From: bhash1@earthlink.net
To: e201b-1@haas.berkeley.edu, e201b-2@haas.berkeley.edu
Subject: devaluation and lm curve
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For those who attended section I promised to clarify whether the LM
needed to shift if a country on fixed exchange rates chose to devalue
when suddenly facing a higher risk premium.

Because of the risk premium and the outflow of capital at the prevailing
interest rate, r*, the absence of any central bank action combined with
allowing the exchange rate to float, automatically lowers the exchange
rate.  So no shift of the LM curve is required.

Basically the demand for assets denominated in the currency has declined
thereby putting downward pressure on the currency. The decision to float
the exchange rate "accomodates" this decline in demand and the central
bank does not need to increase money supply to cause the devaluation, it
happens on its own.

Of course, the new exchange rate should be pegged at the level where
r=r* + theta.  Now in the future, the central bank will do whatever is
required to keep the exchange rate at the new level.

For those who don't follow this, don't worry it is a fairly technical
point, but I wanted to make sure I clarified it.

bhash