1. reduces the level of output under less-than-full-employment conditions.
2. lowers the domestic price level when there is full employment.
3. reduces the stock of official foreign exchange reserves regardless of whether there is full employment.
4. does all of the above.
Choose the option above that is correct.
Option 4 is the correct one. A revaluation of the domestic currency shifts world demand off domestic goods and onto foreign goods. This shifts the IS curve to the left in the less-than-full-employment case and puts leftward pressure on it when the economy has flexible prices and is at full employment. Output will decline in the former case, and the price level will decline in the latter. In both cases the desired stock of money (and base money) will decline, causing individuals to purchase assets abroad with their surplus cash balances. The authorities will be forced to decumulate foreign exchange reserves to maintain the exchange rate at its new level.
The revaluation makes domestic goods less attractive in international markets causing expenditure on them to decline. As output or prices fall the amount of money people have to hold to make transactions also declines. They will get rid of their excess money holdings by converting them into assets on the international market. This will create an excess supply of the domestic currency and an excess demand for foreign currency on the foreign exchange market, making it necessary for the authorities to sell official reserves to keep the currency from devaluing back to its original level.