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CONTRACTIONARY EFFECTS

by

OF DEVAlUATION

Paul Krugman and Lance Tay101'

Numbe r 191

Octobcr, 1976

October

1976

Contractionary

Effects

* of Devalue..tion

by Paul Kr~en

and Lance Taylor

l.

Introduction Tbe analysis of devaluation is rivaled has occupied quite a few func-

econoIDists -- the subject

only by the consumption ground

tion and the demand for Doney as en exercise theorists. But despite

for !:lacro of the

all this effort, the basic structure article

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

is to raise the price of excess demand for

foreign goods relative to home goods, domestic prices, balance production. or both go up. of pa~~ents In response,

creating

home goods output, by definition increases

domestic equal to the

Real hoarding, account,

on current

due to rising

income and/or demand for money. Tbe emphasis frem the money-less
"monet.ary

in tellingthis "Keynesian

story has changed model of Heade

over the years, (1951) to the

neutral" (1973)

epp roach" of Dornbusch

with its as sumpt on of full 'I'heirnrnediate r1ode1s

er:;p1oyment, but one basic assumption


Lmpac t Of devaluation

has always remained:

is te create excess demand

for horne goods.

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

This oversight empirical evidence

persists,

even though there is substantia1 often reduces 1ike aggr2-

suggesting

that devaluation

gate demand Hirschman suggested

(vide Cooper

(1971a)).

Even a fev theorists

(1949), Diaz-Alejandro

(1963) and Cooper

(1971b) have
Lon

that 'a lL ng output and employment to be -expected. These

after de vs.Luat

are

quite frequently

a8sertlons, rates.

however,

have

had 1itt1e impact on thinking thet devaluation

about exchange

Tbe possibi1ity regarded as a

might be contractionary case. that devaluation evidence.

i8 general1y

pe rvez-se, unimportant Tne presumption supported accepted?

is expansionary

is not

by firm empirical Leftists

Why, then, is it so videly

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

-- but this is too glib.

"(le be Ld eve , instead,

view of devaluation

derives mucb of its 8t~ength elegant mode1s in vhich

from tbe

power of tbe simple,

it is presented.

Since skeptics bave rnostly relied on journalism equilibrium i5 dominated analysis, it is not surprising

or at best partial discussion effe~t.l of de-

that theoretical

by the belief that devaluation neglecting

has an expansionary impacts

As just hinted, valuation ferring

the contractionary

amounts to ignoring real purchasing to save.

incorne effects, economic

especially

those trans-

pover toward By redirecting

actors vith high marginal devaluaex ante,

propensities

income to high savers, investment

tion can create an excess of saving over planned and reductions in real output and imports ~ are the follo~ing:

post.

The three most

i~l~ortant circumstfulces

(i)

~nen devaluation

takes place with an existing immediately

trade deficit,

traded goods price increases and increase ceipts. it abroad,

reduce real income at home payrnents exceed savings" regoes

since foreign

currency

Within the home country

the value of "foreign

up ex ante, aggregate with it.

demand goes down ex post, and imports deficit, the greater

fall along

The larger the initial

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,

in export and import-competing increase and if the marginal

industries. propensity

'\oIages lag the price fram profits up.

is higher than froID '\oIages, ex ante national of the resulting contraction depends

savings

The magnitude

on the difference

bet'\oleen savings propensities (iii) Finally,

of the two classes. taxes on exports or imports,

if there are ad valorem income

devaluation ment, again,

redistributes

from the private of unity

s~ctor to the governOnce

'\oIhich has a saving propensity the final outcome Casual empiricism is Teduction suggests especially impact

in the short run. demando

in aggregate

that all three circumstances the less developed ones.

pre-

vail in many countries, countries a deflationary

In these

from devaluation

is more than a remate of this paper con-

possibility;

it is close to a presumption. model


ho'\ol

The purpose

is to sho'\ol in a fo~al traction. policy

devaluation

can cause an economic to those

The results '\oIill come as no surprise world. But


'\ole

con cerned with practical

in the underdeveloped insights

do hope that putting

economists;

into a theoretically

appealing

frar.:evorkviii make at large.

them accessible

to the '\oIider range of the profession

2.

A Macroeconomic Model In tbis section v e develop a simple ':~{nes-ralecki rrod eI of

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

for tbeworld demando

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

required to sustain prcduction (think of pe't ro.Leum

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

imports to price changesare

,_by ',avaih.blecapacity, vh Le imports enter rithfixed


domest, i e demazid , ';(v)

'Interest rates are kept constant by action of the n:onetary

~utho~ity, so,that ve need only consider income-expenciture ~elationships. ;AB~_umptions (i)


- (v) are chosen for ane.Lyt.i ce.Ico:wenience, but

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.

We vill return to monetery

analysis

in a later section.

We begin vith an eq~ation

for the price af hame goods:

vbere ~'Bm into home goods, imports, and z

are input caefficients ~ is the vage rate,

of labor arid imports respecti vely P M tbe home damestic price af

a mar kup factor. are dete~ned by vorld prices,

Prices of imports and exports taxes, and the exchange rate:

vhere and t P M

is the exchange

rate of domestic

currency

for do11ars~

the rates of ad valorem

tax on exports

and imports,

and Px ' lJotice

the dollar prices of exports and imports on world markets. (1) - (3)

that

imply that a chane;e in the exch9.nge rate changes traded

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

of home goods and e~~orts,

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

i.e., that there


P H

This implies that

is the proper or capita1ists. so

deflator

real income of workers functions

We viII assume separate

consumption

fcr the tvo groups,

the dem.s.ndside of the model may be vritten

( G)

Rere,- M

stands for real Lmpor-t s , which we assume to be held-fixed,


I

r- i6 the interest-rate,
is-real- investment,-and convenieoce, define

G is real government

consumption.~1

For

i-:hen t.ne exchange

r at e- is held

fixed, equations

(4)

(7)

make

up a- standard Keynesien
compute multipliers

open=economy

modelo

It is a simple matter and inports.

te

on home goods production

The multiare

plier effects of a change io government

expenditure,

for example,

dR
dG

1,

dJ-.1= ~rn:/D
dG
1

Tbe

mode L may a.Lso be

r-ep r e s erit.e d by

e,n e Lereent.eryKeyne s i an

cros s , as in Figure l. tions ofthe

Becaus e both wage an d profi t

nc ome are 1unc-

output of hCEe goods, the deMand as represented Equilibrium

for hODe gooes is a func-

tion of home gQods output,

by the l~ne

LOLO

in the by the can

upper portion of the diagr&~. intersection witb a

~ay be determined

45 degree line through the origino


relating

lmports

then be read off from the schedule production in the lower partion.

iMports to horne goods spending

An increase in government
ta E1El. tbe unfamiliar

of dG raises the demand schedule

So far this is familiar ground; vben the exchange assumption,

results

appear by

rate is allowed to change. and monetary effects

The model excludes, of devaluation,

substitution

leaving

only income effects.

The next section will examine

just these.

3.

Income Effects

of Devaluation does not change a country's terms of

Even when devaluation trade, account it has a n~ber is initially

of other income effects. bal~~ced, a devaluation

Unless the trade the real income redistribu-

changes

of the country

as a whole.

Within

the country

it produces

tion from workers

to cepitalists,

and from the private

sector as a do not take

vhole te the gevernrnent. place independently--they

These real income adjustments interact,

and there is no way to decompose cOT.ponents. In order to it is

the impact ef a devaluation study the different necessary

nto separable

income effects

of devaluation

individually,

to c ons de r spec

aL cases in vh cb on Lv one of t hem is operating. followed in this section.

That will be the p~ocedure

FIGlJ?2

/
/

E,

/
I

E,

/' I
I

t
t

e,
/

t f
I
f

t
f

....- ......

_----_.-..

_.-------fV'

/"'l

V\

M ti

Devaluation
Cooper

from en ini tia1 trade

Lrab e.Lan c e :

H i r s chman

(194')) and
C~

(197lb) have sbown -- though with little imp&ct from an initia1

other theorereduces The

tical ... o~~ -- that deva1uation real national argument raising

trade deficit

income and may lead to a fall in agEregate Devaluation

d~~land.

is straightforvard. export prices,

gives ~ith one hand, by

while taking

away vith the other, by raising and the terms of trade each other. are not ext~e

import prices. changed,

If trade is balanced,

these price chenges offset

But if imports

ceed exports, country.

the net result is a reduction

in real income within

The income loss can be quantified paper by considering within-country fiscal effects. eIasticity result
a special

using the model

of this

case.

Let YR = YW = y, and let t

eliminating

distribution

effects,

x =

O, eliminating

After a good deal of manipulation

ve can derive the rate (the of the

of home goods output vith respect because

to the exchange

is given as an elasticity is clearer

the econornic meaning

expression

in that form):

dH

de

K .

Ptf

In wcrds, pIoyment,

output of home goods

-- and hence total output, on whether

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

for a given percentage

is proportional

to the ratio of the

10

deficit

to home goods productinn. The effect of trade iTbel~~ce is illustr~ted graphically in

Figure

n.

There

is SOlZe level of i.mpor ts

11 at which tre.de vou l.d


corresponding to it. around such

, be balanced, Devaluation

and a level of horne goods output causes the demand schedule

EOEO to rotnte

cloc}yise

the point corresponding as ElEl'

to that level of demand,

to a ney schedule

The effect when starting

fr8m a trade deficit

is to reduce

output

and imports.

Distribut;onal -devaluation "as is


Ls v

effects:

If money Yages

are rigid in the short run, If,

redistributes the

income from vag es to profi ts and rents.


rnar'g i ne.L

de Ly believed,

propensi ty to
s ave

s ave

out of profi ts
ch

larger than the mn.rginal propensi ty to aggregate

out of vag es , this and therefore

ang e

in income shares Yill reduce as pointed considering balanced, that

demand

mports, by

out by Diaz-Aleja..'1dro (1963). a special case f the modelo

Fe again demonstrate Suppose trade

is initially

Pf<

=
G

P~1 , so there is no trade balance effect, and also

O.

1,-re assume

"YW >y R

We can solve,

once again,

for the elasticity rate, Ybich

of h~_e goods output Yith respect

to the exchange

after some substitutior.s becomes

<iR

~ = __ "Y~R~__Y~~_T
H
y

de

D
+ y

where

is total prvate

income.

Thus the elasticity

of

v-':'::?ut (and i:r.p,:,,"'.Ti t.h respect difference income, in marginal propensities

e'

to devaluation to consume, in incone.

is pr-opor't i cna L to t.h e to the share of wages in

and to the share of imports

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

prcper.sities ~re ~Qual, deemploy;;entor trade, The tr~ditional to do vi t h this :'ac-:.

has no short-run

effect on output,

but merely leftist

shifts income [roD wages to profits. to de va.Lue may have sooething

reluctance

Fiscal

effects of devaluation: ordinarily

Theoretical

models budget,

of the be.Lance cf but the fiscal i~plica'!'bereare

payments

ignore the government

tions of devaluaticn

may te of g re a't practical if the goverDment

importance. buget

a number of possibilities: balanceo..-there

is no~ ~nitially

is an income effect comparable

to the incoTIe effect of incoEe claims taxes

o.eveluation via the trade deficit; taxes7


_.;,

if there are progressive

or higher taxes on profits

than on wa.ges, the government if there are ad velorem

an increased

share of income; finally,

on exports

or imports, higher traded

Eoods prices vill redistribute at this last point is than it earns from as a whole~ so discussed.

income to the government.

One way of looking

to say that the private sector pays Dore for ~ports


exports, even though trade is balanced

for the country

ve get another

version of the trade bal~~ce

effect already

To illustrate deflationary,
Y R

how fiscal reactions

can Dake a devaluation


t ax

consider the case of an export

and a ssume

\1 = O,

=
=

YW

y . Further

as surae that both the trade accourrt balanced, so that

and the Ylvl +

government

budget are initially - eP~~.

P~X = P*'1 and X-" M'

YR

ePXX + P~

Then we can solve for the result

dH

de

E=

13

Tbe devaluetion

elasticity

~s proportiocal

to the tax rate

08

exports a

and the share of iDports in iocome. proportional

Althougb

the model assumes io general

tax function, what is relevant

is the ~0rginal

rate, which IDay be very high. cultural

In one fairly COffiL.on case, whe~e agri-

exports must be sold to the state at fixed prices, the marginal is quite strcng.

tax rate is one, so the fiscal drag from devaluation

4. A Numerical Example
It seems worthwhile for two reasons. model analytically to provide a numerical example at this point,

First, ap effort to treat the general produces very complicated algebra.

case of the Second, ~~

example

may help persuade

the reader that the effects we have been not merely requires Assume functions Then curiousities. sorne, though not much, that workers and capcon-

considering

are in fact important, a computable

To produce specialization italists sumption

model

of the functional

forms.

have proportional shares forro YW ~~d Y R

consumption

with constant

respectively.

(6) may be written in

the special

(6' )

Tbe equations

(1) -

(7) then form a solvable system.


values of parameters and exogenous variables are

The ass~~ed given in 7able l.

The numbers

chosen are arbitrarj, range

thoueh they are

mee.nt to fal1 v i t h .n a "reasonable" countries.

for semi-ini.l::;:.:-::'=-'::"~z~d

--

-------------------------------------------14

Table

1:

Assumed

Values

of Pe.::--8!:leters anu :::x:o;-enous Va~iRtlcs

~ ~

0.75 0.25 0.25 1.0 0.5 0.5 0.2 0~4

~
p* X

1 1 20 10 15 1.0

"r.x
YW YR
t

1
G

x
M

X e

z.

Devaluation other parameters

increases

the value

of

e- . hile leaving Suppose

all of the t.he currency the

and exogenous

vs.r i ab Le s unchanged. the effects e

1s devalued by 25 percent.
values of some importent are show~

We can assess quantities 11.

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

127.7 127.7 1.47 102.7 -10.7

124.5 119.8 1.575 96.0 -9.0 -11. 2

-2.5 -6.2 +7.1 -6.5


+15.9 -4.7

Trade balance in dollars

Trade bal?-nce in -10.7 domestic money

I-~-

15

Before deva1uation percent

the economy has a trade deficit

of 8.4 all

of GDP -- 1arge, but by no me&ns unco~on.

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

on traded goods -- but nene to an unusual is devalued, tbere is a substantial

When the currency

deflation.

Real GDP and the outi~proves in dollar

put of home goods fall, while the trade balance terros oecause GDP of i~ports decrease

along with output.

The loss in real

7.9 might in practice be offset by some export responsiveness


However, even on our unrealistic is nil, the relevant assumption that the

to devaluation.

import content of exports

elasticity

"ould have

to be close to two in the short run to restore to its pre-devaluation a responsive level.

GDP in initial prices country, such

In a semi-industrialized is unlikely. measures behave

export industry

Finally, note that aggregate

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

real and nominal movements of devaluation,

has obvious

importance

for monetary

to which '.le now turno

16

5.

Monetary

Effects

of Dev8luation with its purely Keynesian

The analysis approach,

of pre'lious sections, and largely approach"

rnay seem dated

irrelevant

to economists of pay-

accustorned to the "monetary ments. It might be argued

to the balance

that the incorne effects if the rnonetary authority, were to ~eep point

of devaluainstead of

tion would be unimportant pegglng the interest This rate,

some monetary

aggregate

constant. monetary plier

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,

e.fi'ectsof impact enough to make

perhaps hand,

insignificant.

On the

other for

devaluation.

by raisingprices, level of output constant. Taking

increases

the demand

money at any given inal' money ary effect uation stock

and employrnent. this will this have

If the noma contractiondevalmore or

is held

on real

output. supply than

into account, rnay be either interest

with money

held

ccnstant

.Le s.s contractionary constant. To illustrate suppose

devaluation

holding

rates

the contractionary an extreme

effect quantity

on the monetary theory position

side, ,

we were to adopt

under which there between

is a strictly aggregate

proportional and income:

relationship

sorne monetary

,.

(8)

where A is a monetary Using equations dH . e de H


:::

aggregate

fixed

in the short run. the result

(1) - (5) and

(8), we can derive

which will always devaluation Another takes

be negative. place

Thus

a deflationary

effect

of models.

in monetarist example

as well as Keynesian Suppose as in the bank holds

numerical state

may be in order. is the s~e

that the initial last section,


M2

of the economy because


GDP does

but that now, nominal

the central

(say) constant, The

not ch ang e follo'Wing dedevaluation are displayed

valuation.

results

of a 25 percent

in Table II!I

Table

111: Effects of Devaluation Constant-

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

lrade b~1ance in do11ars


~~~d9

-10.7

+9.3

~~l~nce -10.7 in do::-!.es-.:ic currency

-13.1

18

In this case the contractio~ monetarist essumptions

resulting

from devaluation assumptions,

under but

is less than under Keynesian

i8 still substantial. All of this has as sume d that the rnonets..ry authority can determine so. monetary aggregates, something operations really

vhich is not necessarily are not available, and

In many countries open-mar~et

the government a balance

must rely on its own deficit

ano -- in rare instances base. The identity

of payments

surplus to create nev monetary

in the'absence discount

of open-l!laI"ket operations(and

substitutes

such as re-

and over dr-at't ) is base creation

= government

defici t + balance ~ll often


1tTe

of payments. increase

Nov ve have already observed revenues through

that devaluation

government

its effect on indirect taxes.

have also'seen in domestic

that devaluation although

can cause the trade deficit to vorsen in dollars. So it is possible, in the rate of

currency

it improves

even likely, that devaluation grovth

will lead to a reduction

of the mone t.ary base -- an additional is exactly the opposite approach" models,

de 'Lat.Loner-y influence.

Thisresult "monetary

of vhat comes out of orthodox (1912).

like that of Johnson

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

The purpose ron

at

least, devaluation

taken by itself it is quite likely to have the presumably effects of shifting the income distribution

against labor and reducing

19

employment countries valuation

and output. with balance

-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

the effects of devaluation

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

let the!llcompensate to accorrp.l i sb its

policy,

devaluation

of inducing

substitution. are not that simple.

Practical Governments,

men would answer that matters in less-developed economies.

especially

coun t r i es , are not sufficiently Thus one cannot take it for by appropriate devaluation's stabilizademand

flexible to fine-tune granted

their

that devaluations

will be accompanied

tion measures, effects. There and continues (i)

and one therefore

cannot dismiss

is a reasonable as follows:

argument

which

starts froID this point

In the short run the balance and exports

of payments

defici t is "s t ruc t ur a.l " to price

-- that is, both imports changes (ii)

are not very sensitive output. short-run through effects

for a given level of domestic As a consequence,

any favorable come primarily

of devalua-

tion on the trade balance rather than substitution. Devaluation d i str 1"':'"':'0:" ;

econorric contraction

not only reduces

output

and employment,

but re-

"'C',,:::e

f ron labor to capital

as well. big enough

(iv)

Thus devaluation

is a costly cure, and a devaluation deficit substantially

to reduce the balance

of payments

in the sho~t

1r-----~_7

20

run may be unacceptable.

In such a case, the gove rnme n t shou Id be g deficit and . ork


t ovar

or borro", to meet the short-term its structural io the medium difficulties run.lI

d eliminating

by expansion

of traded goods productio~

The questioo problems.

is ho", one goes about correcting

structural

In economies

",hich are closely tied to the world market, is not likely to be too helpful. Govern-

direct government ments there

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;

these may be precisely exporting

the goods that the country for imports.

has much chance of designed to expand

or substituting

So a policy

the capacity encouragement a variety exchenge

of the traded goods sector vill probably of private investment.

have to rely on with

This can be accomplished preferential vithout

of tools: rates.

subsidies,

tariffs,

credit, m~tiple the microeconomic which increases

It can also be accowplished,

distortions profitability

that these measures

create, by devaluation, ?erhaps,

in traded goods production. as a measure ln the medlum designed

then, one should of pay-

thiok of devaluation ments difficultles

to rectify balance

...

rather th~~ the short run.view of the effects

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

an "expend.iture-switc:-:::-.::;" meas ur-e, \T:-::'c~ ~rC"Jl offsetting "expendi ture-reducir..g" policy.

be comb i ned v t h an

wl1at ve nave seen

s that

21

devaluation

itsel~ illay have un xpenditure plan ~hich, say, co~bines

reducing

effect.

stabilization

devaluation

~ith tax increases


IT":E.y

may thus be piling deflation find itself confronted Devaluation demando

on deflation,

arid the gove rnne n t

~ith a steeper decline

in output than it ~anted. by measures to increase

should in rnany cases be accompanied

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,

and one should be on tbe alert

for tbat possibility.

22

Footnotes

The autbors

are at Hassachusetts Dombusch,

Institute

of Technology.

He

are grateful members previous

to Rudiger

Jagdish

Bhagwati, Workshop

EdffiarBacha and for corrments on

of tbe M.I.T. Trade drafts.

and Development

11

Note the emphasis mentioned

on theoreticel.

Our friends footnote

from underdeveloped point out that

countries

in the preceding ~pacts

rightly

the contractionary

of currency

depreciation

have long be en recogin the les s dethat "eve ryto

nized by policy makers veloped . orld.

and their intellectual statements,

critics

But informal

even of something

body lrnows", are not enough. economics, that practical embodied

It is a fact of life, not confined usually becotne influential

insights

only aftcr

they have become received

in formal theory; treatment

and that once an idea has even in the theory

persuasive

theoretical evidence,

it will persist equally

face of contradictory comes along.

until another

persuasive

"Practical

men, who believe

thef!lselves to be quite exernpt the slaves of some defunct

from any intellectual economist".

influence,

are usually

~/

We abstract

from stock changes.

In practice,

a good part of the

response inventory

to devaluation adjustment.

we are about to sketch would take place via Again, the ~~failingly rnessy details are omitted

for simplici ty.

11

If one grants the proposition

that in the short run there is

23

little that less-developed balance of payments

countries

can or should do to reduce the corollarj is large. econo~ists

deficit,

one rnust al so grant ~~ i~portant yhen the external deficit

ebout the appropriate With invest~ent

fiscal poliey

lirnited by all the factors whieh develop~ent capacity constraint",

surn up under the rubric "absorptive

at full e:n-

ployrnent the governmei1t is forced to run a deficit investment


+ balance

to satisfy tbe identity

of payments current surplus Far frorn being

=
precisely

private because

saving + gover~ent the foreign deficit a government

1s so large. deficit

"inflationary supports chasing

finance",

in sucb circumstances leakages of pur-

demand for home goods against

unavoidable

power abroad through the trade gap.

!:...I

The medium-term

role of the exchange Suppose

rate may be clarified

by

the following autonomous

example.

a country were to experience

a sudden

increase

in wages

and horne goods prices.

This would lower relative to

tbe profitability

of investment

in trsded goods production a gradually

borne ~oods production, of payments deficit.

and would produce

widening

balance

After four or five years the country might well external defici t, v i th internal The proper policy of

find itself wi t.h a large, "structural" demand would sustained by a corresponding

tudget

deficit.

have been to acco~~odatedomestic at tbe outset, in which

inflation

by depreciation of payments

tbe currency problem

case the balance

migbt never have arisen.

24

REFERENCES

Alexander,

Sidney,

S. (1952),

"The Effects

of Devaluation papers,

00

a Trade

Balance",

Interoational

Monetary Fund, Staff

2: 263-78.

Cooper,

Ricbard

N.

(1971a),

"Currency Finance

Deva Lua.t on in Developing

Countries Sec-

,"

Essays tion,

in International Princeton

No. 86, Internationa.1

Finance

University.

'CooEer, ,Richard. N,

(1911b),'

"Devaluation

and Aggregate et. al.,

Demand in Aic.Trade, Ba.lfulce

'Rece .v.-ng Countires,"

in J. N. Bhagwati Amsterdam:

of'Payments

and Grovth,

Nortb-Ho1land.

:..Di.az..,.A1eJandro, Carlos

F. (1963), Effect,"

"A Note on the Journal

Impact of Devaluation Economy, 71:

.end :the-Redistributive
'571-80.

of ?01itica1

.Dornbus ch , Rudiger,

(1973),

"Devaluation,

Money, and Non-trad.ed Goods",

American Econornic Review, 63:

871-80.

Hirschman, Note,
It

Albert

O. (1949),

"Devaluation

and the Trace

Balance:

Review of :C:conomics and Statistics,

ll:

50-53.

Johnson,

Harry G. (1972), Journal

"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).