Q. Use a figure to study the effects of a change in market belief with regard to the fixed exchange rate, in particular assume market participants expect the government to devaluate.

Answer: This figure below demonstrate the asset markets equilibrium at points 1 the money market and 1 the foreign exchange market with the exchange rate fixed at E⁰ and expected to remain there indefinitely. M¹ is the money supply reliable with this initial equilibrium. Fall in the current account to diminish in the future and adopt a new fixed exchange rate E¹ i.e. higher than the current rate E0. THE UPPER PART a change in prospect as a rightward shift in the curve that measures the expected domestic currency return on foreign currency deposits. To embrace the exchange rate fixed at E⁰ subsequent to the market decides it will be diminish to E¹ the central bank should use its reserves to finance a private capital outflow that shrinks the money supply and increase the home interest rate. The expectation of a future depression causes a balance of payments crisis marked by a sharp fall in reserves moreover a rise in the home interest rate above the world interest rate. Likewise an expected revaluation causes an abrupt rise in foreign reserves together with a fall in the home interest rate below the world rate.

The reserve loss supplementary a devaluation scare is frequently labeled capital flight because the associated debt in the balance of payments accounts is a private capital outflow. Capital flight may perhaps force the central bank to devalue sooner and by a larger amount than planned because the central bank's reserves are low to begin with.