A Stylized Model of the Devaluation-Inflation Spiral (Modle stylis de la spirale dvauationinflation) (Un modelo estilizado de la espiral devaluacin-inflacin)

Author(s): Carlos A. Rodriguez

Source: Staff Papers - International Monetary Fund, Vol. 25, No. 1 (Mar., 1978), pp. 76-89
Published by: Palgrave Macmillan Journals on behalf of the International Monetary Fund
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A Stylized Model of the

Devaluation-InflationSpiral
CARLOSA. RODRIGUEZ*

EVALUATIONS,or the monetizationof the resultingbalanceof pay-

ments surpluses, are frequentlymentionedas contributingfactors

to an inflationaryprocess. Aside from the direct initial inflationary
effect owing to the rise in the prices of traded goods (and the repercussion on the prices of nontradedgoods), a devaluationusually contributes to a (transitory)balance of payments surplus, 1 the monetizationof which, it maybe claimed,furthercontributesto the sustenance
or accelerationof the inflationaryprocess.
It is thus possible to understandthe reluctanceto devalue in countries
that, having achieved a stable domestic price level, face a persistent
balance of payments deficit. Alternative corrective measures range
fromreducingthe degreeof monetizationof the fiscaldeficitto obtaining
external loans that may help to postpone the required inflationary
adjustment.
Ratherthan resortingto the permanent,but politicallycostly, fiscal
correction, many countries have chosen the way of periodic devaluations, the timingof each being markedby that point at which domestic
prices are "well out of line" or internationalreservesare "dangerously
low." The outcome of such a process is a devaluation-inflationspiral
with no clear relationof causality, althoughthe externalsector is often
blamedfor the inflationaryoutcome.
In this paper, the author has constructed a simple model in which
to analyze some of the basic elementsof the devaluation-inflation
spiral.
In the context of the model developed here, the main fuel behind the
spiral is the monetizationof the fiscal deficit and devaluation,and the

*Mr. Rodriguez, associate professor at Columbia University, was on leave as a visiting

scholar in the Asian Department of the Fund when this paper was prepared. He is a
graduate of the University of Chicago.
'The transitory effect of a devaluation on the balance of payments is emphasized in
the recent literature on the monetary approach to the balance of payments; see, for
example, Dornbusch (1973) and Frenkel and Rodriguez (1975).

76

STYLIZED MODEL OF DEVALUATION-INFLATION

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77

subsequent inflationis the only alternativeopen given the fiscal constraint. In the absence of a steady flow of foreign aid that matches the
fiscal deficit, the model generates a devaluation-inflationcycle, devaluation taking place at that point where internationalreserves reach a
minimumacceptable level even though the price level may then be
stable. With the possibility of the devaluationtaking place when the
price level has finallystabilized, there is the temptationof blamingthe
resulting inflationon the devaluation, and attention may be diverted
away fromthe more basic underlyingdisequilibrium,which is the fiscal
deficit.
Section I of this paper describes the basic structure of the model
(a variantof Salter's (1959) traded-nontradedgoods model) in the absence of a fiscal deficit; Section II incorporatesthe fiscal deficit and
describes the devaluation-inflationspiral; Section III brings a brief
discussion of flexible exchange rates; and Section IV presents the
conclusions.

I. Basic Structure of Model in Absence of Fiscal Deficit

The economy that is describedhere is small enough in international
markets that all prices of traded goods are fixed in terms of foreign
exchange. Thus, all tradedgoods are groupedinto a single composite
good whose output and consumptionrates are denoted by QTand CT;
the price of the traded good in terms of foreign exchange is assumed
to equal one. The domestic price of the traded good is then equal to
the exchange rate, E (units of domestic currency per unit of foreign
exchange). The economy also produces and consumes a nontraded
"home good" whose outputand consumptionrates are QHand CHand
its price, PH. Given full employmentof the fixed factor endowments,
the supply of QH and QT depends on the relative price between both
E
- e, the real exchange rate,
goods,
PH

QT = QT (e)

QH = QH (e)

(1)

and supply responses are assumed to be normal, that is,

OQT

Oe
QH
Oe

(1')

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78

The author has abstained from the dynamic considerations of investment and capital accumulation and has assumed that domestic
money, M, is the only store of value available to domestic residents.
Demand for traded and home goods depends on the nominal prices
of both goods and the nominal money stock; furthermore, the author
has assumed away "money illusion," so that demands must be homogeneous of degree zero in all nominal quantities. Choosing the nominal price of the home good as the deflator for nominal variables, demands are given by
CT= CT (e, m)

CH = CH (e, m)

(2)

where
m =

M
PH

CH and CT are assumed to change with e and m according to

OCH
de >0,
CT

Oe

OCH
m >0
Am
>CT0

Om

(2')

The stock of international reserves held by the central bank is R,

and its rate of change (in the absence of capital flows) equals the excess
supply of traded goods (the balance of trade payments surplus):

dR =
dt

= QT (e) - CT (e, m)

(3)

It follows from the signs assumed in equations (1') and (2') that a
higher e improves the trade balance, since it increases QT and reduces
CT, while a higher m deteriorates the trade balance, since as consumption increases, the export surplus is reduced.
Market equilibrium for home goods is assumed to prevail at all times;
this is achieved through movements in the domestic nominal price of
home goods, PH, which, given the fixed M and E at any time, imply
opposite movements in e and m:
QH (e) = CH (e,

m)

(4)

As shown in Figure 1, a higher stock of real cash balances--mincreases CH and requires a higher relative price of home goods-a
lower e-to clear the market. Thus, for the market equilibrium for

STYLIZED MODEL OF DEVALUATION-INFLATION

79

SPIRAL

e
CHfe,mo)
CH e,m1 >mo)
/

eO
_ __

el

_ _ _ _

_ _
I

QH(e)

QH,CH
FIGURE I

home goods, e and m are inversely related. Denote the reduced form
relationshipbetween m and e so that the home goods marketclears by
m = H (e),

H' (e)< O

(5)

Since equation (5) must prevail at all times, we can substitute it in

equation(3) to obtain the change in reserves only as a function of the
real exchange rate:
R = f(e)-QT(e)

- CT[e,H(e)]

(6)

where
OQT OCr OCT

ae

Oe

Om

The author has assumed that there is some value of e such that the
excess supply of traded goods is zero, that is, R is not changing.Denoting e as that value of the real exchange rate, e must satisfy
R =f(e) = 0
Associated with e, there is a level of real cash balances, rm,that
guaranteesmarketequilibriumfor home goods:
m = H (e)

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80

If the only source of money creation is reserve purchases by the

centralbank, it is clear that mhand e are the long-runequilibriumvalues
for e and m, since when e equalse, the nominalmoney supply remains
unchanged,andthus thereis no reason for eitherPH, e, or m to change.
A more detailed analysis of the dynamic adjustmentof the economy
follows.
In the absence of domestic credit creation, the nominalmoney stock
increases by the value of foreign exchange purchases by the central
bank:
M = E R, or, using equation (6),

= f (e)

Thus, -

(7)

will be greateror less than zero as the balanceof payments

is in surplusor deficit.
Figure2 describes the dynamicbehaviorof the economy. The downward sloping schedule HH shows the combinations of m and e for
which the home goods marketis in equilibrium,as in equation (4) or
(5). The vertical line at e = e represents the only level of e for which
M=

= 0.

At any instant, the nominal money stock is a predeterminedvariable, as is, of course, the nominalexchange rate; thus, the ratio MIE
is fixed at any time, althoughthroughtime it changesaccordingto equation (7). Since MIE

-, it follows that at any instant the ratio m/e is

e

a predeterminedvariable.In Figure 2, the line 0 E0 shows the preEo

vailing mle ratio at time to, given the nominalmoney stock M(to)and
the (fixed) exchange rate E0o.Short-runequilibriumis then attainedat
the intersection of the 0

?) line with the HH schedule, at point a.

Eo

below a would imply an excess

Eo
supply of home goods that is corrected througha lower PH, increasing
both m and e and thus moving the equilibriumpoint toward a. Correspondingto the initialratioM(to)are the short-runequilibriumvalues
Any point on the feasible locus 0

Eo

m(to)and e(to). Since e(to) is shown to be less than e, the balance of

STYLIZED MODEL OF DEVALUATION-INFLATION

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81

M(to)
Eo

mfto) -

---

^^
^HH

~~0 ~

e(to)

FIGURE 2

payments is in deficit, so that R and M are falling. As M falls, the

M(t) line rotates clockwise, and thus the short-runequilibriumposition
Eo

moves southeast along HH until e is reached, at which point external

balance is attained, so that the money supply remainsunchangedand
the motion of the M(t) line stops as the system reaches its steady state
Eo

equilibriumwith external balance an(l price stability.

An alternativeand more intuitiveexplanationof the adjustmentprocess is as follows. Startingwith an initial stock of cash balances such
that the balance of payments is in deficit, the subsequent fall in M
owing to reserve losses decreases the demand for home goods, thus
requiringa lower nominalprice of home goods to clear that market.
The fall in both PH and M work toward a reduction in the balance of
payments deficit, as consumptionof tradedgoods is decreased while
productionincreases. As long as the balance of payments remains in

INTERNATIONAL MONETARY FUND STAFF PAPERS

82

deficit, M andPH keep fallingthroughtime and the balanceof payments

keeps improving;eventually, M and PH fall to a level low enough to
yield balanceof paymentsequilibrium,at which point M, and thus PH,
tends to remainstable as external balance is finally achieved.

II. Structure of Model with Fiscal Deficit and

Description of Devaluation-Inflation Spiral
Assume now that the governmentis committedto purchase a fixed
amount,go, of tradedgoods per unit of time, and that those purchases
are financedthroughcentralbankcredit(assumingthat the government
purchasesof home goods wouldnot changeany of the basic conclusions
of the model). There are now two sources of monetary expansion:
reserves, R, and credit to the government, D. The nominal money
supply changes accordingto
M = ER + D
(8)
Dividing equation (8) by E
M

*D
-R/ +--

(9)

Notice that DIE is the rate of governmentspending on traded goods

(DIE = go), so that equation (9) becomes
ME=R + go

(10)

We must now account for the fact that the rate of changein reserves
equals the private sector's excess supply of traded goods-equation (6)-minus the rate of governmentpurchasesof tradedgoods (go),
so that
R

=f(e)-gO

(11)

from which, it follows that for R to equal zero, a real exchange rate
higher than e is requiredin order to induce a positive excess supply
of tradedgoods by the privatesector to matchthe governmentdemand.
Let e denote that level of e for which R = f (e) - go = 0; necessarily,
e must be larger than e (e being such thatf (e) = 0).
Substitutingequation(11) in equation(10), we obtainthe finalexpression for the change in the nominalmoney stock:

STYLIZED MODEL OF DEVALUATION-INFLATION

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83

-f(e)

(12)

Thus, for M/E to equal zero, e must equal e. Therefore, the level of
the real exchange rate that is consistent with a stable money stock (and
thus, price stability) is smaller than the one required for external balance, e: price stability can be achieved only at the expense of a continuous balance of payments deficit. Figure 3 describes the dynamic
behavior of the economy, given a positive level of deficit-financed
government spending on traded goods.

M=0

R=O
M(to)
Eo

Mfto)
E1
. HH

FIGURE 3

Before the introduction of the deficit-financed spending, the economy

was at its steady state equilibrium at point a, for which both R and M
were zero. With the introduction of a positive rate of government
spending, go, the R = 0 line shifts to the right up to e = e, such that
f (e) - go = 0. Neither the market equilibrium schedule for home goods
nor the 3M = 0 schedule is affected by the new rate of government
spending. At the instant of the change, nothing happens with e and m,
as all of the government deficit is financed with reserve losses. (Since

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INTERNATIONAL MONETARY FUND STAFF PAPERS

e = e is now less than e, the balance of payments is in deficit.) Thus,

the introductionof governmentspendingon tradedgoods does not have

an instantaneousinflationaryimpact on the prices of home goods, as
all the excess demandfor tradedgoods is equilibratedthroughreserve
losses.
Assume now that in the initial situationinternationalreserves were
at a level (Ra) that was judged to be an acceptable long-runaverage.
Assume also that there is a minimumacceptable reserve level (Rm)at
which the central bank has to take corrective action. Assuming that
the fiscal deficit cannot be removed and that a permanentinflow of
foreign aid cannot be obtained, the only corrective action left to the
bank is devaluation.Furthermore,it is not sensible to assume that the
devaluationwill be aimed at yielding precisely external balance, because in that case reserves would be stabilized only for a moment:
since the money supply keeps increasingon account of domestic credit
creation, the balance of payments would turn into deficit immediately
afterwardand thus reserves would fall againbelow Rm.The authorhas
thus assumed that the central bank would devalue sufficientlyto generate a period of balance of payments surpluses that would bring the
stock of reserves back to the average acceptable level, Ra.
Going back to Figure 3, after the increase in g, the system remains
motionless at point a while reserves are runningdown; when Ra-Rm
of reserves is lost, a devaluationtakes place. At the prevailingnominal
price for home goods, the immediate effect of the devaluationis to
increase the price of tradedgoods, and thus resources are shiftedaway
from the productionof home goods into that of traded goods, while
the demandfor home goods is increased;there is thus a potentialexcess
demandin the home goods marketthat is cleared througha higherPH.
The increase in the nominal price of home goods must, however, be
smaller than the rise in the nominalexchange rate, so that the impact
effect of the devaluationis to increase the level of the real exchange
rate. To see this, assume that in response to the rise in E, the price of
home goods were to increase in the same proportion,such that e remainedunchanged;abstainingfrom any real cash balanceseffect, both
supply of and demandfor home goods would then remainat theirsame
predevaluationlevels (since e would then be the same). Real cash
balances, however, must be lower, since PHhas risen and thus CHmust
have fallen, even thoughe is unchanged;there must then be an excess
supply of home goods calling for a lower PH. It follows that, after the
devaluation,PHmust rise but in a smallerproportionthan the increase
in E.

Following the impact effect on the prices of home goods, the higher

STYLIZED MODEL OF DEVALUATION-INFLATION

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85

real exchange rate induced by the devaluationis assumed to turn the

balance of paymentsinto surplus.The previously stable money supply
now starts risingon account of both credit creationto financethe fiscal
deficit and the monetization of the reserve inflow. As M increases
throughtime, the demand for home goods also increases, requiringa
rising nominalprice of home goods to clear the market.The risingPH,
in turn, impliesa fallingreal exchange rate, and thus the initialresource
shift toward the traded sector is slowly reversed. Eventually, the reductionin the realexchange rateand the accumulationof cash balances
is enough to eliminatethe excess supply of tradedgoods, and reserves
stop increasing as external balance is achieved. The nominal money
supply, however, is still rising owing to the domestic credit creation
to finance the fiscal deficit. Thus, the nominal price of home goods
continuesincreasing,andas the realexchangeratestill falls, the balance
of payments turns into deficit. For a while, the contractionaryeffects
on the money supply of the reserve losses are not enough to offset the
expansionary effects owing to domestic credit creation, so that the
money supply keeps rising. However, as M and PHgo on increasing,
the balanceof paymentsdeficitgrows largeruntil eventuallyit reaches
a level for which the value of reserve losses precisely equals that of
domestic credit creation, and the money supply stops rising. With M
stabilized, there is no tendencyfor the price of home goods or the real
exchange rate to change, and thus a periodof price stabilityand falling
reserves is reached.
In terms of Figure 3, the impact effect of the devaluationis to shift
the - line from
to
instantaneously,and the real exchange
E
Eo
El
rate is increased from e to e1, which has to be largerthan e in order
for the balance of payments to be in surplus. The impact effect of the
devaluationis to reduce realcash balances, and this is achievedthrough
a jump in the price of home goods; notice, however, that since e has
increased, the proportionalincrease in PH must be less than that of the
devaluation.
Following the impact effect, the money stock starts increasing, as
e 1 > e, so that the MIE line shifts counterclockwise, and the equilibrium

point shifts along HH from b towardc. Duringthis transitionalperiod,

the money supply increases because of both reserve purchases and
domestic credit creation. As time passes, m rises while e falls. Given
the fixed nominalexchange rate E = E1, the fall in e is due to a rising
price of home goods. Thus, afteran initialperiod of price stability, the
outcome of the devaluationis an instantaneousjump in the prices of
home goods followed by a smooth rate of increase. Therefore, the

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INTERNATIONAL MONETARY FUND STAFF PAPERS

temptation to blame the devaluation for the subsequent inflation is

almost unavoidable, although careful analysis shows that the devaluation was the only corrective measure left, given the structuralimbalance provided by the fiscal constraint.
If the rate of devaluationwas properly chosen, reserves must have
reached the target level Ra when the turningpoint c is reached. At c,
the balance of payments turns again into deficit and the equilibrium
point keeps moving along HH towarda. In the transitionfrom c to a,
the money stock keeps growing as domestic credit creation exceeds
the value of reserve losses. As e keeps falling, PH must keep rising.
Since m is also rising, the rateof monetaryexpansion must exceed that
of inflationin the prices of home goods (which in turn is largerthan
that of the overall price level, since the prices of tradedgoods remain
constant). Eventually e falls enough so that the balance of payments
deficit equals the rate of domestic credit creation, and, as point a is
reached again, the nominal money stock stabilizes, as also do m, e,
andPH.If reserves then still exceed Rm,anotherperiodof price stability
may ensue, although eventually a new devaluationwill be necessary
as reserves hit Rmand the cycle starts again.
In this devaluation-inflationcycle, the price of home goods experiences three distinct phases: (1) a stable period, as the system rests at
a while decumulatingreserves; (2) a jump at the moment of the devaluation, as the equilibriumpoint moves from a to b; (3) a positive
but deceleratinginflationrate, as the equilibriumshifts back from b to
a along HH.

Internationalreserves follow a cyclical patternwith the troughsbeing

reached when devaluationstake place and the peaks when the equilibriumpath reaches point c alongHH. The nominalmoney stock follows
two phases: (1) a stable money supply, as the system rests at point a;
(2) a positive but decelerating rate of expansion, as the equilibrium
moves from b to a.
Figure4 shows the typical path for the price level. Even thoughPH
has periods of stability, the system has a built-ininflationrate that, on
average, will equal the average rate of monetary expansion for the
typical cycle. Since over the typicalcycle, internationalreserves transactions do not contributeto the money supply (at the given exchange
rate reserves are built up from Rmto Ra and then lost again), all the
increase in the nominalmoney supply must be due to domestic credit
creation; thus, on the typical cycle
go~

AD

AM

AM M

M
ME E

STYLIZED MODEL OF DEVALUATION-INFLATION

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87

time
FIGURE 4

AM
so that --

= go/mT

M
where mT = - is the average value of real cash balances in terms of
traded goods. The average inflation rate in the prices of home goods
and of traded goods, Tr,equals the average rate of monetary expansion
over the cycle, so that
7T = go/mT

III. Flexible Exchange Rates

As we have seen, given the fiscal constraint, the objectives of external balance and price stability are incompatible with each other under
a fixed exchange rate. The result is a series of periods of balance of
payments crisis and devaluations followed by rising prices. The nominal

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INTERNATIONAL MONETARY FUND STAFF PAPERS

price of home goods goes throughphases of stability, suddenjumps,

and steady inflation, an outcome that certainlyis not conducive to an
orderlyand efficientallocationof resources. In this circumstance,neither a stable nor a smooth path of prices is achieved underfixed rates,
and a free floatingor crawlingpeg system may be preferable. Under
the floating system, the central bank abstains from interveningin the
foreign exchange market,and the nominalexchange rate will adjustso
that externalbalanceis continuouslyachieved. SinceR = 0 at all times,
the economy will always be at point c in Figure3 with the realexchange
rate at the level e and inflationproceeding at the stable rate T =g-

mT

An alternativeto a freely floatingrate is a crawlingpeg with periodic

but small devaluations.In this case, the signalfor the devaluationcan
still be given by the level of reserves, but in order to reduce the size
of exchange rate adjustment,the minimumacceptablelevel Rmshould
be put as close as necessary to the acceptable level Ra, since the size
of the exchange adjustmentand the length of the typical cycle vary
directly with the difference between R, and R,m

IV. Conclusions
In this paper, the author has developed a simple model to analyze
some of the essential elements of the inflation-devaluationspiralin the
presence of a real governmentdeficit financedthroughcredit creation
by the central bank. He has shown that underthose circumstancesthe
objectives of price stability and external balance are mutuallyinconsistent, and that the likely outcome, as the economy moves along the
stages of the typical cycle, is successive periods of price stabilityand
externaldeficit, devaluationfollowed by inflationand externalsurplus,
and finally deceleratinginflationand external deficit. While casual observationwould indicatethat inflationis being precededby devaluation
and monetizationof the resultingbalance of payments surpluses, the
conclusion that the external sector is the cause of the inflationwould
be inappropriate.Although it is correct that over a short period following the devaluation external sector developments lead the movement in domestic prices, over the entire typical cycle the price level
follows the path of the money supply, which is determinedentirely by
domestic credit creation to finance the fiscal deficit. (As we saw in
Section II, the external sector does not contribute at all to money
creation over the whole of the typical cycle.) Once the proper time
dimensionis recognized, it follows clearly that the price level and the

STYLIZED MODEL OF DEVALUATION-INFLATION

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89

exchange rate are endogenous variables with no direct causality relations between them, both being led by developments in the monetary
sector, which are in turndeterminedby the monetizationof the internal
fiscal deficit.
REFERENCES
Dornbusch, Rudiger, "Currency Depreciation, Hoarding, and Relative Prices," Journal
of Political Economy, Vol. 81 (July/August 1973), pp. 893-915.
Frenkel, Jacob A., and Carlos A. Rodriguez, "Portfolio Equilibrium and the Balance
of Payments: A Monetary Approach," American Economic Review, Vol. 65 (September 1975), pp. 674-88.
Salter, W. E. G., "Internal and External Balance: The Role of Price and Expenditure
Effects," Economic Record, Vol. 35 (August 1959), pp. 226-38.