Exchange Rate and the Price Response in the Czech Republic

In mainstream economic theory, the exchange rate is considered to be a policy tool which may (among others) serve to support the supply-side of the economy and to solve the problems with the current account deficit. Namely, a devaluation makes domestic goods more competitive in foreign markets, thus stimulating domestic production in export-oriented branches, either via higher profits of producers or via higher foreign demand if exports are offered for lower prices (measured in foreign currency). In case producers have temporarily limited production capacity, they may compensate the higher supply to the foreign market by lowering quantities oriented to the domestic market. This will (in the case of non-perfect competition in this market) increase domestic prices of affected commodities. In addition, such devaluation makes imports more expensive (in domestic currency) and the domestic demand is supposed to switch to domestically-produced substitutes. Domestic firms that compete with foreign suppliers in the domestic market face a higher demand for their goods, which enables them to expand production or raise prices or most probably both, thus increasing their profits. As can be clearly seen, the likely positive real supply response of domestic firms will most probably be accompanied by a positive price response, the size of which is negatively correlated with the real supply response. The price increase is limited by zero (when the domestic supply will react purely by real expansion) on the one hand, and on the other hand by the extent to which the domestic currency was depreciated (in a hypothetical case when all traded goods are internationally tradable and domestic producers do not expand real quantities and raise prices only, for example, when they operate at their short-run potential output). In the long run the causality reverses.