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by
OF DEVAlUATION
Numbe r 191
Octobcr, 1976
October
1976
Contractionary
Effects
* of Devalue..tion
by Paul Kr~en
l.
Introduction Tbe analysis of devaluation is rivaled has occupied quite a few func-
tion and the demand for Doney as en exercise theorists. But despite
theory has ch~~ged hardly at all since the classic ander (1952). story: Ne ar Ly al1 mode1s tell some variant
by A1ex-
of the folloving
The initial
effect of devaluation
foreign goods relative to home goods, domestic prices, balance production. or both go up. of pa~~ents In response,
creating
on current
due to rising
income and/or demand for money. Tbe emphasis frem the money-less
"monet.ary
in tellingthis "Keynesian
neutral" (1973)
differ only in how the system reacts to the excess demando bility that
thp
The possi-
:-,ricer.ovemerrt s caused by d eva Luat.Lon will create to reduce effective home goods de-
enQugh losers in real incor;::e te~s mand is a~ost always left out.
~~------------------------------------------2
persists,
suggesting
that devaluation
(vide Cooper
(1971a)).
(1949), Diaz-Alejandro
(1971b) have
Lon
after de vs.Luat
are
quite frequently
a8sertlons, rates.
however,
have
about exchange
i8 general1y
is expansionary
is not
have been knovn to suggest c1ass bias -- as ve does typical1y redistribute income that
vill argue 1ater, devaluation from vages to profits the ortbodox persuasive
view of devaluation
from tbe
it is presented.
Since skeptics bave rnostly relied on journalism equilibrium i5 dominated analysis, it is not surprising
that theoretical
the contractionary
especially
those trans-
propensities
tion can create an excess of saving over planned and reductions in real output and imports ~ are the follo~ing:
post.
i~l~ortant circumstfulces
(i)
~nen devaluation
trade deficit,
since foreign
currency
fall along
the contractionary
outcome. (ii) raises ~ndfall Even if foreign trade is initially prices of traded goods relative profits in balance, devaluation giving rise to If money to save goes
to home goods,
industries. propensity
is higher than froID '\oIages, ex ante national of the resulting contraction depends
savings
The magnitude
on the difference
redistributes
'\oIhich has a saving propensity the final outcome Casual empiricism is Teduction suggests especially impact
in aggregate
pre-
In these
from devaluation
possibility;
The purpose
devaluation
economists;
into a theoretically
appealing
them accessible
2.
en open economy with the following characteristics: (i) There are two dis~inct sectors, en export sector producing market and a bornegoods sector producing for domestic
Prices of exports and imports are fixed in foreign currency; ,bome goods prices are determined by a markup on direct costs of labor dU),dimportedinputs
:.p:8.Il
oil-short country). .Tbe vage_rate.is fixed in domestic currency. the short run, substitution responses of both exports and negligible. Export production is determined coefficients Int.o
,(:tU)
,(iv)'I.n
tbey appear to correspond fairly vell to the stylized characteristics -of m~~ partially industrialized countries. In tbese countries most
export earnings come f'r-om an agricultural or m n ng sector producing for .. orld markets. Domestic industry hes oeen built up by import sub-
stitution va protection, so that the remaining imports are nonco~petitive, chiefly intermediate goods e.ndraymeterials, ~or which little substitution is possible in the short run. The essu@ption of an accornnodatir~ lionetary policy is rrade temporarily in order to allcw us to focus on the incor.:.e effects of
devaluation.
analysis
in a later section.
vhere and t P M
is the exchange
rate of domestic
currency
for do11ars~
tax on exports
and imports,
the dollar prices of exports and imports on world markets. (1) - (3)
that
goods prices relative to the vege rate and the price of home goods, 8ut does not affect the terms of trade. Recipients of income may be divided into tvo classes: or rents. those vr.o income
receive vages and those vho receive profits of each class is determined by the equations
The nominal
(4)
(5)
Here
and
are outputs
13 the
input of labor per unit of exports. For s1mpIicity of exposition, 1t viII ce ass~ed that a1l imis no
ports are inputs loto home goods production, direct final demand for imports. if ve varrt to measure
deflator
consumption
( G)
Rere,- M
r- i6 the interest-rate,
is-real- investment,-and convenieoce, define
G is real government
consumption.~1
For
r at e- is held
fixed, equations
(4)
(7)
make
up a- standard Keynesien
compute multipliers
open=economy
modelo
te
The multiare
expenditure,
for example,
dR
dG
1,
dJ-.1= ~rn:/D
dG
1
Tbe
r-ep r e s erit.e d by
e,n e Lereent.eryKeyne s i an
by the l~ne
LOLO
~ay be determined
lmports
then be read off from the schedule production in the lower partion.
An increase in government
ta E1El. tbe unfamiliar
results
appear by
substitution
leaving
just these.
3.
Income Effects
changes
of the country
as a whole.
Within
the country
it produces
to cepitalists,
nto separable
income effects
of devaluation
individually,
to c ons de r spec
FIGlJ?2
/
/
E,
/
I
E,
/' I
I
t
t
e,
/
t f
I
f
t
f
....- ......
_----_.-..
_.-------fV'
/"'l
V\
M ti
Devaluation
Cooper
Lrab e.Lan c e :
H i r s chman
(194')) and
C~
trade deficit
d~~land.
while taking
away vith the other, by raising and the terms of trade each other. are not ext~e
If trade is balanced,
But if imports
The income loss can be quantified paper by considering within-country fiscal effects. eIasticity result
a special
of this
case.
eliminating
distribution
effects,
x =
O, eliminating
to the exchange
expression
in that form):
dH
de
K .
Ptf
In wcrds, pIoyment,
em-
and ireports -- viII rise or faII depending i~ s~rp:~s cr deficit. at the time, there devaluation Since countries is contraction.
trace are
is i~itiaIIy usuaIIy
which devalue
i~ deficit
Its rnagnitue
is proportional
10
deficit
Figure
n.
There
, be balanced, Devaluation
EOEO to rotnte
cloc}yise
to a ney schedule
is to reduce
output
and imports.
effects:
If money Yages
redistributes the
de Ly believed,
propensi ty to
s ave
s ave
out of profi ts
ch
ang e
demand
mports, by
is initially
Pf<
=
G
O.
1,-re assume
"YW >y R
We can solve,
once again,
to the exchange
<iR
~ = __ "Y~R~__Y~~_T
H
y
de
D
+ y
where
is total prvate
income.
of
e'
It i3 also an increasing
11
FIGC~~
Ir
'7
/
/
/ /
/
,/
/
/
1
I
/,,"115
~)~I~.~--------------~)
M . --
M M
:: aMt{
rr
,1
l2
fucction valuation
of ~he ~kup.
If cons~ption
has no short-run
effect on output,
reluctance
Fiscal
Theoretical
models budget,
payments
tions of devaluaticn
importance. buget
is no~ ~nitially
an increased
on exports
Eoods prices vill redistribute at this last point is than it earns from as a whole~ so discussed.
ve get another
effect already
To illustrate deflationary,
Y R
and a ssume
\1 = O,
=
=
YW
y . Further
government
YR
ePXX + P~
dH
de
E=
13
Tbe devaluetion
elasticity
~s proportiocal
08
exports a
Althougb
is the ~0rginal
exports must be sold to the state at fixed prices, the marginal is quite strcng.
4. A Numerical Example
It seems worthwhile for two reasons. model analytically to provide a numerical example at this point,
example
the reader that the effects we have been not merely requires Assume functions Then curiousities. sorne, though not much, that workers and capcon-
considering
model
of the functional
forms.
consumption
with constant
respectively.
the special
(6' )
Tbe equations
(1) -
The numbers
for semi-ini.l::;:.:-::'=-'::"~z~d
--
-------------------------------------------14
Table
1:
Assumed
Values
~ ~
~
p* X
1 1 20 10 15 1.0
"r.x
YW YR
t
1
G
x
M
X e
z.
increases
the value
of
and exogenous
1s devalued by 25 percent.
values of some importent are show~
by camputing e
far both
1.0 and
1.25.
The results
in Table
'l'nble11: Effects
of a Devnlu;ion
e = 1.0 Nominal GDP at factor cost GDP at constant prices Price of home goods Cutput of
h orie goods
e = 1.25
change
I-~-
15
of 8.4 all
It exhibits
of the f'e at.ur es that ve h ave seen can raa ke a deva Lua t i on deflatior;ary initial deficit, differentia1 savings behavior, degree. ad valorem taxes
deflation.
put of home goods fall, while the trade balance terros oecause GDP of i~ports decrease
to devaluation.
elasticity
"ould have
to be close to two in the short run to restore to its pre-devaluation a responsive level.
export industry
quite differently
in real and nominal terroso The fall in current price GDP is less than half the fall in constant worsens when measured prices, while the trade balance The difference actually
in domestic
currency.
between analysis
has obvious
importance
for monetary
16
5.
Monetary
Effects
irrelevant
to economists of pay-
to the balance
that the incorne effects if the rnonetary authority, were to ~eep point
of devaluainstead of
some monetary
aggregate
ls a correct
in one respect:
if a
aggregate
such as M.2 were n e.Ld.. con st.arrt,the mul tichanges them in,real income would be dampened,
perhaps hand,
insignificant.
On the
other for
devaluation.
increases
the demand
is held
on real
with money
held
ccnstant
devaluation
holding
rates
effect quantity
side, ,
we were to adopt
is a strictly aggregate
relationship
sorne monetary
,.
(8)
aggregate
fixed
be negative. place
Thus
a deflationary
effect
of models.
in monetarist example
numerical state
the central
valuation.
results
of a 25 percent
in Table II!I
Table
Holding
Nominal
Income
e == 1.0
Real GD~ Output of home goods 127.7 102.7
e == 1. 25 122.9
change
-).8
-4.0
98.6
-9.7 -12.1
-10.7
+9.3
-13.1
18
resulting
under but
i8 still substantial. All of this has as sume d that the rnonets..ry authority can determine so. monetary aggregates, something operations really
of payments
in the'absence discount
of open-l!laI"ket operations(and
substitutes
such as re-
= government
of payments. increase
that devaluation
government
can cause the trade deficit to vorsen in dollars. So it is possible, in the rate of
currency
it improves
of the mone t.ary base -- an additional is exactly the opposite approach" models,
de 'Lat.Loner-y influence.
Thisresult "monetary
6.
Imp1ications
for Policy of this paper has been to argue that, in the short may not work the way ve usually assume; that ~~desirable
at
least, devaluation
taken by itself it is quite likely to have the presumably effects of shifting the income distribution
19
-tnat does this do to our reconmendations of paywents because proble~g? Should we abandon
to de-
as a prescription
of its undesirable
side effects?
The theorist's
answer
-- and he has a point -- would be that demand are irrelevant. If Governt ney
on aegregate
ments have other tools wi th vh ch they can rianage demand , don't like the demand effects with fiscal or monetary primary purpose of devaluation, leaving
policy,
devaluation
of inducing
Practical Governments,
especially
coun t r i es , are not sufficiently Thus one cannot take it for by appropriate devaluation's stabilizademand
their
that devaluations
will be accompanied
cannot dismiss
is a reasonable as follows:
argument
which
of payments
of devalua-
tion on the trade balance rather than substitution. Devaluation d i str 1"':'"':'0:" ;
econorric contraction
output
and employment,
but re-
"'C',,:::e
(iv)
Thus devaluation
of payments
in the sho~t
1r-----~_7
20
or borro", to meet the short-term its structural io the medium difficulties run.lI
d eliminating
by expansion
structural
In economies
",hich are closely tied to the world market, is not likely to be too helpful. Govern-
investment
can build and manage roads, daros, and even steel plants; but are fev countries vhere they can effectively or peasant agricultural produce ",igs, or yet
false teeth,
-
or cosmetics,
products;
or substituting
So a policy
of tools: rates.
subsidies,
tariffs,
distortions profitability
to rectify balance
...
4/
In challenging
the established
of devaluation as
on e.ggregate demand , then, this pap e.r does not deny its usefulness a policy tool. It is important, effects. hovever, that policymakers
be a"'are as
of its contractionary
;:orrIally,devaluation
.i s regarded
be comb i ned v t h an
s that
21
devaluation
reducing
effect.
stabilization
devaluation
on deflation,
In any case, it is not the purpose of this paper to give policy advice valid for all countries that devaluation at all tiwes. The important point is
may be deflationary,
22
Footnotes
The autbors
Institute
of Technology.
He
to Rudiger
Jagdish
Bhagwati, Workshop
and Development
11
on theoreticel.
countries
rightly
the contractionary
of currency
depreciation
critics
But informal
even of something
insights
only aftcr
persuasive
theoretical evidence,
until another
persuasive
"Practical
influence,
are usually
~/
We abstract
In practice,
response inventory
to devaluation adjustment.
we are about to sketch would take place via Again, the ~~failingly rnessy details are omitted
11
23
countries
deficit,
fiscal poliey
at full e:n-
=
precisely
private because
1s so large. deficit
finance",
unavoidable
!:...I
The medium-term
by
example.
a sudden
increase
in wages
tbe profitability
of investment
widening
balance
After four or five years the country might well external defici t, v i th internal The proper policy of
tudget
deficit.
inflation
by depreciation of payments
24
REFERENCES
Alexander,
Sidney,
S. (1952),
"The Effects
of Devaluation papers,
00
a Trade
Balance",
Interoational
2: 263-78.
Cooper,
Ricbard
N.
(1971a),
"Currency Finance
Countries Sec-
,"
Essays tion,
in International Princeton
Finance
University.
'CooEer, ,Richard. N,
(1911b),'
"Devaluation
in J. N. Bhagwati Amsterdam:
of'Payments
and Grovth,
Nortb-Ho1land.
:..Di.az..,.A1eJandro, Carlos
F. (1963), Effect,"
.end :the-Redistributive
'571-80.
of ?01itica1
.Dornbus ch , Rudiger,
(1973),
"Devaluation,
871-80.
Hirschman, Note,
It
Albert
O. (1949),
"Devaluation
Balance:
ll:
50-53.
Johnson,
"The Mone t ar-y Approach to BeLance=of -Payments a!1d Quanti tati ve P-Jia1ysis,
Theory," 1555-1572.
of Financia1
1:
25
Meade, James E. (1951), ~he Theory of Internationa1 ~cono~ic Polic~f, 1: The Balance of Pa~ents. (Oxford, Oxford Cniversity Press).