PRICE ADJUSTMENT MECHANISM

 Price adjustment mechanism velies on depreciation

and devaluation of currency adjustment, current
account and BOPs.

 Elasticity of the demand and supply curves will

determine effectiveness of adjustment mechanism.

 Greater the devaluation or depreciation of the

dollar, the greater it’s inflationary impact and less
feasible is the increase of the exchange rate for
correcting BOPs deficits.

 Below figure shows OX axis US dollar QE billions. OY

axis shows exchange rate of dollar and Euro.
 DE and SE is the demand and supply curve.
 At we assumes that 1 dollar = 1 Euro.
 At 1 dollar demand curve is point But at 12 billion.
 At 1 dollar supply curve is point A at 8 billion.
 So here demand exceed supply, so deficit arises.
 First situation deficit point AB
 Demand – supply = deficit, 12- 8 = 4 , 4 billion is
deficits
 In order to reduce deficit, country adopt currency
depreciation or devaluated the currency, as a result
of devaluing the currency country export increases,
import reduces.
 The country depreciate at 20% , so that currency
devalued.
 So country attain BOP equilibrium at point E, 10
billion.
 Second situation deficit point CF , 1 dollar = 2 Euro

 The demand and supply curve is more steeper as a

result of demand curve of DE* and supply curve is
SE*.

 As a result of country depreciate currency cannot

reduce deficit. As a result at point CF. So there is no
fully reduction I deficit.

 Deficit reduced to 4 billion to 3 billion.