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Journal of Asian Economics 34 (2014) 27–41

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Journal of Asian Economics

Is devaluation expansionary or contractionary: Evidence
based on vector autoregression with sign restrictions
Lian An a,*, Gil Kim b, Xiaomei Ren c
a

Department of Economics and Geography, Coggin College of Business, University of North Florida, Jacksonville, FL 32224, United States
Department of Economics, California State University, Fresno, United States
c
Reliant Energy, 1201 Fannin Street, Houston, TX 77002, United States
b

A R T I C L E I N F O

A B S T R A C T

Article history:
Received 28 November 2012
Received in revised form 4 March 2014
Accepted 15 March 2014
Available online 25 April 2014

The purpose of the paper is to examine the impact of real exchange rate changes – real
devaluation or real depreciation – on outputs in 16 countries that fall within one of the
three groups: Latin American countries, Asian countries, and non-G3 developed countries.
For the first time in the contractionary devaluation literature, the analysis is based on a
Vector Autoregression (VAR) model with sign restrictions method by Uhlig (2005) and Fry
and Pagan (2011). The exchange rate shock is identified by imposing restrictions on the
signs of impulse responses for a small subset of variables. The findings are as follows: (1)
whether output increases after a real devaluation or not has little to do with whether the
current account improves or not; (2) Latin American countries are quite homogenous in
that the current account generally improves while output decreases after real devaluation;
and (3) contractionary devaluation could happen in developed countries as well as in
developing countries.
ß 2014 Elsevier Inc. All rights reserved.

JEL classification:
F31
F41
Keywords:
Contractionary devaluation
Vector autoregression
Sign restrictions

1. Introduction
Research on the relationship between the exchange rate and output is an important topic that has been the subject of an
extensive debate for a long time. The conventional wisdom on the exchange rate-output nexus is that a competitive
exchange rate encourages exports and hence, encourages growth. However, much of the empirical evidence usually suggests
the contrary. According to Kamin and Klau (1998), many developing countries have tended to resist devaluation, because
such policy would be contractionary, rather than expansionary. For example, depreciation of the Mexican peso has been
consistently associated with decline in output, while appreciation has been linked to expansion (Kamin & Klau, 1998).
Therefore, one natural question to be raised: is devaluation contractionary or expansionary after all?
The importance of understanding the effect of devaluation on output cannot be ignored, as it provides important policy
insights. For example, in a textbook model, adverse external shocks lead to a depreciation of the real exchange rate that, by
stimulating net exports, boosts aggregate demand and offsets the effects of the initial shock. If devaluation is genuinely
contractionary, the benefits of exchange rate flexibility may be overrated. In addition, contractionary devaluation may pose a
dilemma to policy-makers seeking to achieve simultaneously both high output growth and a strong balance-of-payment
position. It is of great significance to understand the nexus between exchange rate and output.

* Corresponding author. Tel.: +1 8594202878.
E-mail address: lian.an@unf.edu (L. An).
http://dx.doi.org/10.1016/j.asieco.2014.03.003
1049-0078/ß 2014 Elsevier Inc. All rights reserved.

28 L. There are several advantages in using the sign restriction approach. First. to the Euro from 1999. 1977. Empirical studies. whether devaluation is contractionary or expansionary depends on two opposing forces. we strive to make the sample as diverse as possible. Indonesia. 1978). Argentina.. Switzerland. the Netherlands. which is in European Union (EU) but does not adopt Euro. / Journal of Asian Economics 34 (2014) 27–41 Is devaluation contractionary or expansionary? In the context of AD-AS model of a typical textbook. foreign firms will find that the country with currency depreciation can supply intermediate production inputs more cheaply. the German auto manufacturer BMW can shift production from Germany to its US plant if dollar depreciation lowers the relative cost of production in the US (Krugman. 1963. New Zealand. which may result in decreased output. For example. The sample countries also encompass different exchange rate regimes. p. Because the economy has been globalized with multinational firms. and Shi (2006). . 1978). supply side. we use ‘devaluation’ and ‘depreciation’ interchangeably.1 As a result. Switzerland. Indonesia. and Chile). Frankel. 1985). 2 Devaluation usually applies to exchange rate changes under a fixed exchange rate regime. the Krone. Austria. Brazil. the Netherlands. Ahmed. Second. Third. as argued by Cooper (1971) and Lizondo and Montiel (1989). Canada. and etc. such as Kamin and Rogers (2000). devaluation often triggers capital outflow and acts as a caveat on foreign borrowings. because the economies of these countries are large enough to influence many of the external control variables. 2009. Latin American and Asian countries have alternated between fixed and floating exchange rate regime but generally have had fixed regimes. restrictions that are often used implicitly. and Mixon (2000) indicate that devaluation almost uniformly results in reduced output without significant evidence for subsequent reversal. different model specifications. Upadhyaya and Upadhyay (1999) and Edwards (1986) find the effects of devaluation to be neutral in the long run. Gust. central banks may be depleted of foreign reserves. Although many studies find that contractionary devaluation is more prevalent in developing countries. Japan. are made more explicit in the sign 1 For example. 2009. while unanticipated depreciation is found to have a contractionary effect on output growth in the long-run via an increase in the cost of imported inputs. which will cause an upward shift in the aggregate demand curve and an expansion of output. Fifth. The purpose of this paper is to investigate the empirical relationship between output and devaluation for 16 countries: Mexico. Australia. Asian countries (Korea.). and non G-3 developed countries (Australia. For example. 1989.and medium-run for a number of countries. and enables us to study if contractionary devaluation is particular to a certain group of countries. and thus increase of output.2 Studying a sample of countries as diverse as this allows a direct comparison of the output-exchange rate relationship across different groups of economies. Therefore. which is likely to have a contractionary effect on output. Australia. First. 1971. Argentina. A fairly comprehensive vector autoregression (VAR) model is used. the devaluation of the domestic currency makes foreign goods and services more expensive relative to domestic in the short-run. 1988. if there is redistribution of income from a low saving group (wage) to a high-saving group (profit). Fourth. 424). While the choice of countries is mostly dictated by data availability. which will induce a decline in consumer spending and investor confidence in the domestic economy. Kamin. firms can shift their production to the country with currency depreciation for lower production cost. and Portugal). Denmark. Sachs. compared with the traditional structural VAR model. Obstfeld. Malaysia. 424). Kwan (1994) finds that currency devaluation appears strongly expansionary in East Asian countries. Canada. Germany. Empirical studies also produce conflicting evidence on the connection between output and devaluation. devaluation raises the price of imported intermediate goods and results in an upward shift in the aggregate supply (see the works of Findlay & Rodriguez. and balance-sheet side effects. An et al. as it allows consideration of the endogeneity of the exchange rate. Krugman & Taylor. Sixth. The contractionary effects of devaluation may occur from the demand side. consistent with the conventional view. 1980. Dhakal. fixed its currency. and the US are not included. devaluation can be contractionary if government revenues are increased (Krugman & Taylor. the domestic price level will increase due to higher prices of imported goods and thereby the real money balance is lowered and aggregate demand is reduced (Frenkel & Johnson. The sample is large enough to be divided into three groups: Latin American countries (Mexico. 1976). while reviews by Kamin and Rogers (2000) and Upadhyaya. Denmark. when a country’s currency depreciates in real terms. and the Philippines). and New Zealand have floating exchange rate regime for most of the sample time period. which results in a contraction in aggregate demand. an opposing opinion contends that devaluation can have adverse effects on domestic output if contractionary effects outperform expansionary demand-side effects (Cooper. the VAR model based on the sign restriction approach is employed. if the price elasticities of demand for exports and imports are too low. p. Canada. Austria. Many past studies that have adopted VAR models. Kamin and Klau (1998) show that contractionary devaluation applies to other developed economies. Kim and Ying (2007). according to the monetary model. Diaz-Alejandro. the Philippines. Switzerland. 1978). For the countries in this study. and data spans. Malaysia. & Melitz. In addition. the country with depreciation might have an increase of demand for their labor and output (Krugman et al. However. Lastly. and Portugal. real devaluation may increase the real domestic currency value of the country’s foreign liabilities. the Netherlands and Portugal belong to the Euro area. all else being equal (see Edwards. Goldstein & Khan. have resorted to the Choleski decomposition to identify the shocks. In this paper. Chile. New Zealand. In addition. and Huntley (2002). Denmark. or if the country faces an initial large trade deficit. also provide evidence of the expansionary devaluation in the short. aggregate demand will be reduced (Krugman & Taylor. such as Goldstein and Khan (1985) and Gylfason and Schmid (1983). Different results might be due to different countries. Korea. Brazil. some of them maintained a floating exchange rate. while Austria. For the first time in the devaluation output literature. Bahmani-Oskooee and Kandil (2009) find that the expansionary effect of unanticipated depreciation is only transitory on output growth.

and (3) contractionary devaluation could happen in developed countries as well as in developing countries. if any. the evidence is divided. which is automatically systematic and can be universally applied. 3 The description of the data is in Appendix A. the relative price of nontradable goods would rise faster and thus lead to appreciation of the real exchange rate over time. the Bayesian method is applicable irrespective of whether or not the variables are nonstationary. For example. To make the results robust to the method of detrending. This paper first evaluates the bivariate relationship between real exchange rates and seasonally adjusted GDP using cross correlations with leads and lags of up to four quarters. We use real effective exchange rate. 2006. depreciation is associated with output contraction. real output growth could cause real exchange rate to appreciate or depreciate. but lagged real exchange rates help to explain the movement of real outputs to some extent. A positive (negative) lag indicates the number of quarters by which the real income leads (lag) the real exchange rate. except that Switzerland and New Zealand have evidenced causality from real exchange rates to output. this paper has the following findings: (1) whether output increases or not after a real devaluation has little to do with whether the current account improves or not. causality runs in both directions. sign restrictions are weak in the sense that they do not lead to exact identifications of the reduced form VAR. first difference. In sum. The cross correlation at positive lags. This concurs with the phenomenon of the Balassa–Samuelson effect that income growth precedes the appreciation of real exchange rate. and the Hodrick–Prescott filter. Foreign income. the sign restriction method involves the Bayesian Monte Carlo procedure. thus obviating the need for pre-testing the variables for unit roots. are unanimously negative for Latin American countries.L. Table 2 reports the results. Third. respectively. depreciation of real exchange rate is followed by a cyclical downturn. The paper is organized as follows: Section 2 provides bivariate data analysis between the real exchange rate and output for each country. Granger Causality tests are carried out. 2007). depreciation of real exchange rates is followed by output growth. As for the East Asian countries. In Latin American countries. . because it circumvents ‘‘incredible’’ zero restrictions on the contemporaneous and the long-run impact of shocks. 2. causality runs from the real exchange rate to output in Mexico and Brazil. foreign interest rate. and there is no clear-cut consensus on the relationship. In general. However. For Asian and developed countries. 2. Peersman (2005) finds that impulse responses based on traditional zero restrictions can be considered as a single solution of a whole distribution of possible responses that are consistent with the imposed sign constraints. Section 3 presents a comprehensive VAR model with the discussion of the sign restrictions methodology. four lags are employed. / Journal of Asian Economics 34 (2014) 27–41 29 restriction approach. For Argentina and Chile. On the other hand. while in Malaysia and the Philippines. Correlations at negative lags are clearly negative in the four Latin American countries. Korea particularly has five out of six positive correlations and Switzerland has six positive correlations. rendering minor evidence for the Balassa–Samuelson effect. As a preview to the results. this does not necessarily mean that the Balassa– Samuelson effect is present as the relationship maybe due to spurious correlation. The paper concludes in Section 6. results from the sign restriction approach can provide an important complementary method of analysis. The evidence is murky for non-G3 developed countries. for a comprehensive survey on the empirical evidence). To further explore the bivariate relationship. real exchange rate depreciation could be both expansionary and contractionary on output. That is to say. indicating that real exchange rate does not appreciate despite the rapid catching-up. (2) Latin American countries are quite homogenous in that the current account generally improves while output decreases after real devaluation. for the three groups of countries. On the one hand. According to Sims (1988). According to the Balassa–Samuelson effect. Table 1 reports the representative short-term cross correlations between real exchange rates and output at lags 4. 0. For Asian countries. As for the developed countries. it is very interesting to note that there is unanimous lack of causality in both ways. real devaluations are uniformly associated with recessions and real appreciations with expansions in Mexico (see Kamin & Rogers. which is quite sensitive to the mechanism of detrending. 2000). 2. existing empirical studies seem to suggest that the growth effects on real exchange rates are nonexistent or small (see Tica & Druzˇic´. We regard this as an important advantage. Second. in fast-growing economies. However. Estimation results and robustness checks are reported in Sections 4 and 5. this paper employs three filters: linear detrending. the evidence is mixed: In Korea and Indonesia. consistent with the fact that the contractionary devaluation hypothesis has received surprisingly strong empirical support in the context of Latin American countries (Kim & Ying. the causality generally runs from the real exchange rate to real income with Malaysia observing bilateral causality.3 In all regressions. Bivariate data analysis It is well-known from macroeconomic data that output and real exchange rate exhibit a feedback relationship. An et al. current account. which summarizes the effect of output growth on real exchange rates. which is constructed in a way that a decrease reflects a real appreciation of the domestic currency. The possible effects of devaluation on output can be gleaned from correlation at negative lags while correlation at positive lags suggests the possible reverse causation effect of output growth on real exchange rates. and real money supply are included to control external influences that affect both real exchange rate and output simultaneously. the results indicate that lags of real output do not help to explain movements in real exchange rates. 4.

05 0.54 0.12 0. 3.09 0.10 0.03 0.04 0.21 0.03 0. .12 0.10 0. The VAR model with sign restrictions The section comprises two parts.04 0.22 0.03 0.52 0.20 Brazil LT DIF HP 0.18 0.04 0.14 0.10 New Zealand LT DIF HP 0.01 0.29 0.34 0.18 0.01 0.06 0.11 0.24 0.02 0.12 0.13 0.06 Korea LT DIF HP 0.35 0.07 0.01 0.01 0.08 0. The first part sets up the baseline model.08 0.01 2 4 0 2 4 Australia LT DIF HP 0.15 0.11 0.03 0.11 0.03 0.16 0. Lag 4 2 0 2 4 Mexico LT DIF HP 0.04 0.16 0.01 0.14 0.26 0.35 0.02 0.01 0.24 0.06 0.17 0.13 0.21 0.41 0.18 0.04 Chile LT DIF HP 0.35 0.07 0.L.02 0.13 0.15 0.30 0.13 0.03 0.16 0.44 0.10 0.07 Denmark LT DIF HP 0.30 0. A positive (negative) lag indicates the number of quarters by which the real income leads (lag) the real exchange rate.01 0.15 0.01 0.19 0.04 Portugal LT DIF HP 0.06 0.17 0.16 0.22 0.16 0.07 0.01 0.15 0.13 0.05 0.10 0.08 0. The second part illustrates the implementation of the sign restriction approach.17 0.01 0.08 0.31 Philippines LT DIF HP 0.23 0.53 0.10 0.05 0.24 0.02 0.11 0.07 0.2 0.08 0.07 0.33 0.19 0.38 0.11 0.00 0.11 0.14 0.07 0.03 0.09 0.15 0.12 0.06 0.07 0.11 0.18 0.12 0.26 0.12 0.19 0. ‘‘DIF’’ denotes ‘‘first difference’’.26 0.11 0.11 0.45 0.32 0.10 0.04 0.07 0.05 0.11 0.41 0.14 0.22 0.00 0.11 0.05 0.27 0.35 Netherlands LT DIF HP 0.23 0.51 0.03 0.28 0.29 0.16 0.10 Switzerland LT DIF HP 0.07 0.24 0.08 0.04 0.18 0.07 0.24 0.07 Lag Source: Authors’ calculations.20 0.01 0.32 0.04 0.03 0.26 0.24 0.30 0.09 0.39 0.08 0.26 Argentina LT DIF HP 0.06 0.12 0.14 0.14 0.21 0. / Journal of Asian Economics 34 (2014) 27–41 30 Table 1 Cross correlations between exchange rate and output.05 0.22 0.02 0.04 0.56 0.02 0.06 0.48 0.11 0.39 0.13 0.23 0.30 0.10 Austria LT DIF HP 0.01 0.07 0.05 0.33 0.02 0.01 0.03 0.22 0.54 0.35 0.00 0.04 0.05 Malaysia LT DIF HP 0.11 0. and ‘‘HP’’ denotes ‘‘Hodrick–Prescott filter’’.10 0.04 0.25 0.10 0.16 0.16 0.23 0.11 0.25 0.37 0.05 0.01 0.53 0.62 0.03 0.08 0.13 0.17 0. An et al.28 0.07 0.16 0.19 0.04 0.03 0.12 0.11 Canada LT DIF HP 0.07 Indonesia LT DIF HP 0.07 0.12 0.12 0.02 0.03 0.07 0. Note: ‘‘LT’’ denotes ‘‘linear detrending’’.14 0.25 0.21 0.

73 (0.00) 3.94) 0.33 (0. a higher money supply will reduce the value of currency.10 (0. and Sensier (2010).84 (0.81 (0. measured by the index of seasonally adjusted GDP.90 (0.45 (0.51) 0.19 (0.32) 3.09 (0.54 (0.00) 0. This paper designs a comprehensive VAR model.13 (0.11 (0.33 (0.97 (0.1.33 (0.97) Canada RX GC Y Y GC RX 1.07) 1.84 (0.80 (0.58) 0.36) 0.02) 4.00) 2.10 (0.50) 8. consisting of five endogenous variables: current account (CAR). measured as a ratio to GDP.87) 0.67) Malaysia RX GC Y Y GC RX 5. are incorporated to capture the external shocks. denominated as units of domestic good per unit of foreign good.16 (0. Thus.21 (0. In addition.95) 0.54 (0.76 (0.64) 0.74) Argentina RX GC Y Y GC RX 2.49 (0.27 (0. causing them to move in opposite directions.98) New Zealand RX GC Y Y GC RX 3.69 (0.46 (0.58 (0.73) 0.39 (0. large capital inflows lead to a temporary boom and real appreciation.01) 0.35 (0.L. reduces borrowing costs.88) 0.86) Netherlands RX GC Y Y GC RX 0.43) 0. and GC denotes ‘‘granger cause’’.54) 0.00) 0.04) 2. Real money supply is included.34 (0.00) 0.37 (0. price level (CPI).50 (0.50) 2.64) 0.77) 0.02) 0.68) Switzerland RX GC Y Y GC RX 7. This paper also incorporates the price level to control for the price environment for an economy.77 (0. and Aamir (2012).52 (0.39 (0. Model setup The documented relationships – either positive or negative – between real output and real exchange rates in the previous section might arise due to spurious correlation. sharp changes in oil prices may depress output and depreciate the real exchange rate.96) 0.00) 2. ‘‘RX’’ denotes real exchange rates.09) 3.82 (0. ‘‘LT’’ denotes ‘‘linear detrending’’.71) Philippines RX GC Y Y GC RX 2.24 (0. In addition.87 (0.00) 1.71 (0.83 (0.11 (0.19 (0.75 (0. According to Mejı´a-Reyes.01) 5. money supply affects investment and output.14) 0. where both variables are affected by some third factor.78 (0. two exogenous variables.29 (0.07 (0. ‘‘HP’’ denotes ‘‘Hodrick–Prescott filter’’.00) 1.74 (0.25 (0.88) 2.44 (0.77 (0.34 (0. ‘‘RX GC Y’’ tests the hypothesis that the real exchange rate granger causes real income. foreign income (Y*) and foreign interest rate (R*). an inflationary environment may affect output negatively because it .95) 0.08) 0.85) Portugal RX GC Y Y GC RX 0.71) 0. we include money supply in the model. An increase in money supply lowers interests.29 (0. ‘‘Y GC RX’’ tests the hypothesis that real income granger causes the real exchange rate.29 (0. it is important to have a control for macroeconomic conditions and to separate exchange rate changes that may be classified as exogenous policy shocks from those that are reactions to macroeconomic events.63) 1.88 (0. For example.67) Austria RX GC Y Y GC RX 0.72) 6.77 (0.04) 4.15 (0. Osborn.25 (0. ‘‘DIF’’ denotes ‘‘first difference’’.60 (0.58 (0. In Asian and Latin American countries.04) 0. The US 3-month treasury bill rate and the US real GDP are used as foreign interest rate and income.34) Australia RX GC Y Y GC RX 0.19) 0.19 (0.93) 1.05) Chile RX GC Y Y GC RX 3.18 (0. Note: Reported are F-statistics with P values inside the parentheses.98) 0.55) 2.91) 1.32 (0.44) 0.04) 1.71 (0.32) Denmark RX GC Y Y GC RX 0.53 (0.59) 0.94 (0.30) 11.00) 2.64 (0.66 (0.21 (0. LT DIF HP Mexico RX GC Y Y GC RX 6.58) 2.06) 11.69 (0.47) 0. Thus.08) 2.00) 2. ‘‘Y’’ denotes real outputs. 3.59) 6.08) 4.76) 1.69) 7.09) 2.00) 0.00) 0.20 (0.71 (0.59 (0. An et al.13 (0.32) 2. real effective exchange rate (REER).63 (0.05) 1. real output (Y). / Journal of Asian Economics 34 (2014) 27–41 31 Table 2 Granger causality tests between real exchange rate and output.18 (0.51) 0. According to Shahbaz.26) 1.00) 0.14 (0.24) 0.05 (0.00) Korea RX GC Y Y GC RX 2.60) 0.51 (0.89 (0.70 (0.94) 0.48) 0.30 (0.18 (0. and promotes investment which might enhance domestic output.01) Indonesia RX GC Y Y GC RX 11.03) 1. Islam. and real money supply (MS).57 (0.78) 0.76 (0.59 (0.27) 0.03) 0.50 (0.54) 0.18) 0.06 (0.73) Source: Authors’ calculations.07 (0.49 (0.20 (0.38 (0.14) 1.75 (0.48) 0.74 (0.65 (0.16 (0.07 (0.37) Brazil RX GC Y Y GC RX 1.

Canada (1973:1-2012:1). 1989). as they can be reasonably agreed upon across many economists. because current accounts and capital accounts are mirror images of each other. and the standard recursive identifying assumptions may be over-identifying restrictions that have been developed over time in a data-mining like manner as researchers looked for restrictions that can provide sensible results (see Rudebusch. shocks to capital flow have been important to movements in the real exchange rate and output for Mexico. our primary interest is to obtain evidence on how exchange rate devaluation affects output. and some ordering may not be justified by the economic structure. In addition. and whether the shocks have known short-run or long-run effects or some combination (see Blanchard & Quah.4 On the other hand. analysis based on nominal exchange rate has been usually confined to short-run effects (see Lizondo and Montiel. this paper chooses to use real exchange rate. this paper uses minimal restrictions that are sufficient to identify the depreciationary exchange rate shock and examines its effect on the output. An et al. real exchange rate depreciation. generates the process of expenditure-switching. instead of using nominal exchange rate as in Kim and Ying (2007). Indonesia (1980:1-2012:4). As the focus of this paper. For example. Furthermore. that is. while we tried to be comprehensive in controlling for various factors. The information on capital flows is very important. For example. According to Mejı´a-Reyes et al. These parametric restrictions can vary according to whether particular variables appear. Current accounts are included for two reasons. Five methods are present in the literature. thus. whose income balance is the main component of the current account balance. and export-led growth in Latin American or Asian countries depends upon international economic conditions. Each type has its own disadvantages as well as advantages. Denmark (1975:1-2012:1). Korea (1976:12012:1).2. this paper circumvents the ‘‘incredible’’ zero restrictions on the 4 Trade balance is the dominant part of the current account in other countries. such as a reversal of capital inflow or a decline in foreign country GDP. whether there is recursive causal structure (Sims. Instead of identifying all structural disturbances. Uhlig (2005) does not aim at a complete decomposition of the one-step-ahead prediction errors into all components due to underlying structural shocks. balance-of-payments improvement and economic expansion. the VAR model controls for both internal and external shocks that might simultaneously induce devaluation and economic contraction. and Philippines (1973:1-2011:4). four of which are parametric restrictions. Reinhart (2000) also maintains that. The data set is quarterly and has been primarily collected from International Financial Statistics (IFS). real output and exchange rate are naturally included. there is no clear consensus about the ordering. leading to a spurious correlation between the two variables. In the long run. First. Because current accounts and capital accounts are mirror images of each other. . except for the Philippines. Kim and Ying (2007) also include this variable in their model. Third. how to identify the structural shocks. (2010). Direction of Trade Statistics (DOTS). it allows direct investigation of the effect of exchange rate fluctuation on output through the demand channel (net exports). that is. generate contractionary effects on output. including both variables will include redundant information. According to Kamin and Rogers (2000). Implementation of the sign restrictions Disagreements start when researchers discuss how to decompose the prediction errors into economically meaningful fundamental innovations. parsimony is also sought. The sample periods are generally from 1973:1 to 2012:4. The zero contemporaneous impact may not be consistent with a large class of general equilibrium models (Canova & Pina. Mexico (1985:4-2012:4). the current account incorporates information of capital flows implicitly. including the US interest rate and GDP can proxy for the US (or international) business cycle. / Journal of Asian Economics 34 (2014) 27–41 might provoke inefficient allocation of resources due to distortions in relative prices and higher administration costs for firms. Faust and Leeper (1997) show that substantial distortions in the estimations are possible due to small sample biases and measurement errors when using zero restrictions in long-run effects. this paper pursues the recent sign restriction approach by Uhlig (2005) to identify exchange rate shocks with the median response calculated by Fry and Pagan (2011). but rather concentrates on identifying only one shock. we do not include the capital account as in Kim and Ying (2007). an essential element in the traditional view of devaluation is that it is the improvement in the domestic relative price of tradables to nontradables. Eq. 1999). As such. 3. 1989). Department of Statistics and from central banks for each country. Uhlig (2005) suits best here for two reasons. 1998). nominal devaluations are believed to lead to a proportionate increase in prices that leave real exchange rates and economic activity unchanged. There are several features of the model. except for Brazil (1980:1-2011:4). (1) summarizes the model in a compact reduced form: 2 3 2 3 2 3 2 3 e1t a1 CARt1 CARt 27 6 CPIt 7 6 a2 7 6 CPIt1 7   6 e 6 7  6 7 6 7 6 7 6 t3 7 6 Yt 7 ¼ 6 a3 7 þ Ai j ðLÞ6 Y t1 7 þ Bi j ðLÞ DYt1 þ (1) 6 et 7  6 7 6 7 6 7 DRt1 6 47 4 REERt 5 4 a4 5 4 REERt1 5 4 et 5 MSt a5 MSt1 e5t All the variables are in log except the interest rate and the ratio of current account to GDP. devaluation can lead to a loss of access to international capital markets and. As an alternative. Appendix A lists the details of the data sources and the sample periods.32 L. The intention is to be minimalistic and to impose not much more than the sign restrictions themselves. 1988). Second. The US short-term interest rate and real GDP are included to capture international markets conditions. First. On the one hand. In this paper.

e. termed as median target method. We generate n numbers from a normal distribution with mean zero and standard deviation one. S) belong to the Normal-Wishart family. As we are only interested in responses to one particular shock. In sum. the exchange rate shock. and q is a column of Q in the corresponding location. We simulate 500 pairs of . . containing the contemporaneous responses of n endogenous variables to the exchange rate shock. Second. S). Eq. are made more explicit in the sign restriction approach. The reduced-form residuals and structural disturbances are linked through: V t ¼ AW t (3) where it is assumed that the structural disturbances are mutually independent and normalized to be of variance 1: it can therefore be written as E½W t W 0t  ¼ I. The only restriction on A thus far that emerges from the covariance structure is: AA0 ¼ S (4) the identification problem amounts to uncovering the n(n  1)/2 free elements in A by imposing identifying restrictions. we provide a brief review of the method. ^ denotes a diagonal matrix with the eigenvalues of S on its principal diagonal. S) is covered in a Bayesian manner. (5) shows that choosing elements in an orthonormal set can determine the free elements in A. . we can compute impulse vectors and hence impulse response functions corresponding to different unit vectors in an n-dimensional sphere. Specifically. we assume that prior and posterior distributions for (B. the jth column of A (or its negative) represents the immediate impact on all variables of the jth structural innovation one standard error in size. We can repeatedly generate n-dimensional vectors to uniformly cover the sphere. consistent with the conventional view. then the shocks identified will actually be a linear combination of several underlying shocks. this paper employs the Uhlig (2005) method to identify the exchange rate and uses the Fry and Pagan (2011) method to calculate the median response. According to Uhlig (2005). treat them as coordinates. The normalized n-dimensional vector corresponds to each point on the sphere. One way to avoid this problem would be to identify other shocks explicitly. minimal and neat. t ¼ 1. the matrix A can always be written as: A ¼ X ^Q (5) where X is an orthogonal matrix whose columns are the orthonormal eigenvectors of S. We term this as the Uhlig (2005)–Fry–Pagan (2011) method. restrictions which are often used implicitly. Nonetheless. This does not uniquely identify a but supports ranges of possible responses consistent with the sign restrictions. if the true data generating mechanism have more shocks than variables. For example Fry and Pagan (2011) have cast doubt with regard to the shocks identified and the optimal responses using median criteria. (2) where B(k) are coefficient matrices of size n  n and Vt is the one step-ahead prediction error with variance–covariance matrix S. . 2008). Fry and Pagan (2011) point out that the optimal response using median criteria for different shocks and horizons may combine information from several identification schemes and thus is a composite of different structural response functions. exchange rate shocks. that is. An et al. . In the following. it is important to note that sign restrictions are not without criticism. QQ0 = I). According to Uhlig (2005). Following Uhlig (2005). and Q denotes some orthogonal matrix (i. combinations of other shocks could potentially look like exchange rate shocks. The detailed methodology can be found in Uhlig (2005). compared with the traditional structural VAR model. the multiple shocks problem is not particular to the sign restrictions method. As such. with identifying only one shock. termed as impulse vector by Uhlig (2005). This is because the sign restriction identification strategy identifies shocks using mild restrictions on multiple time-series. The use of the Uhlig (2005) sign restrictions identification methodology allows for a very similar identification to be achieved across countries despite these data problems. For example. The sampling uncertainty about the VAR parameters (B. data availabilities differ across countries. but rather they are particularly reasonable. They propose an alternative method to overcome this problem by choosing a response as close as possible to the median while imposing that the responses are generated from one single identifying matrix. / Journal of Asian Economics 34 (2014) 27–41 33 contemporaneous and long-run impact of shocks. T. Let Wt be an n  1 vector containing time-t values of structural disturbances.L. Let Yt be a vector of n endogenous variables containing time-t values whose dynamic relationships are described by the following vector autoregression of order k (VAR(k)): Y t ¼ Bð1Þ Y t1 þ Bð2Þ Y t2 þ    þ BðkÞ Y tk þ V t . this paper does not claim that the identifying assumptions are ironclad or perfect. the problem amounts to determining an orthonormal vector q in the following equation: 1=2 a¼X^q (6) where a is a column of A. The main idea of the identification scheme is to impose a set of inequality constraints. In addition. given the nature of multi-country study. For each set of the estimates for (B. and normalize the resulting vector into a unit vector. and because the sign restrictions put no quantitative restriction on the responses. it does not matter which definition of the variable is used (see Rafiq & Mallick. In addition.. and if one uses a conventional Cholesky decomposition to identify an exchange rate shock by ordering it last.

and money supply. In Asian countries. exchange rate. Switzerland. However. exchange rate depreciation. Second. First. as the exchange rate depreciates. / Journal of Asian Economics 34 (2014) 27–41 (B. There are two reasons. the observed improvement in the current account may not be achieved through an export boom but through a deep contraction in imports as a result of output contraction (see Frankel. we leave it unrestricted to let the data determine it. First. Therefore. As shown in Fig. Farrant and Peersman (2006) impose that the interest rate differential does not fall after an exogenous depreciation of the exchange rate.34 L. and Portugal. However. The current account also improves and output deteriorates in response to exchange rate depreciation in the Philippines and Indonesia. and leave other possible values of K for robustness check. the real money supply will fall. we choose to set K = 2. the current account improves in the Philippines and Indonesia. Kim and Ying (2007) have similar findings. which is consistent with the conventional view that the depreciation of real exchange rate increases the trade balance by making domestic goods more competitive. For each pair. New Zealand. while it decreases significantly in Australia. find empirically that real exchange rate depreciation lead to significant decrease in money supply. 1. when the price level increases in response to the exchange rate depreciation. Results are available upon request. Diaz-Alejandro (1963) points out that an observer of devaluation could be puzzled to see that devaluations resulted in an improvement of the trade balance which was accompanied by a decline in the level of total output. 2 displays the response of output to a positive exchange rate shock. the exchange rate will not decrease (0) in response to its own positive shock. 6 . central banks will tend to decrease the money supply to support the currency. In the developed countries. After computing each set of the impulse response functions corresponding to each unit vector. In a similar spirit. Only the impulse vectors that meet the following restrictions are stored: 1. which is quite consistent with the uniformly negative cross correlations at negative lags reported in Table 1. Because the response of output is the focus of the paper. We follow the convention of setting K = 2. Thus a total of 250. The price level does not decrease (0) in response to a positive exchange rate shock. making the overall output decrease. the current accounts in Malaysia and Korea exhibit the phenomenon known as ‘‘J-curve’’. in Latin American countries.000 q’s and impulse vectors are evaluated. The effect is least discernible in Switzerland and New Zealand. An et al. These restrictions seem reasonable as they only make use of a priori appealing and consensual views about the effects of exchange rate shocks on price. we check if the sign restrictions are satisfied. that is. the contractionary effects from exchange rate depreciation may offset the expansionary effect on trade balance. 5 Uhlig (2005) sets K = 5 in the baseline. the current account first worsens (marginally significantly for Malaysia) before improving and eventually reaching the long-run equilibrium. The results of the impulse responses of other variables with sign restrictions are not reported in this paper due to the length of the paper. This is not a bizarre result. whose current account and output behave quite consistently. Fig. The phenomenon of current account and output responding oppositely might pose a dilemma for policy-makers: Exchange rate policy aiming to result in expenditure-switching that leads to a boost in the production of tradable goods may have contractionary side effects on the overall economic activity. It is noticeable that. in response to exchange rate depreciation. the current account generally improves for the first 4–8 quarters after the exchange rate depreciation. As an example. Therefore. The current account is left unrestricted because it reflects the response of trade balance to the exchange rate. Second. Does improvement in current accounts after exchange rate depreciation imply unambiguous expansion of output? Not necessarily. The Latin American countries are very homogenous in that the current account generally improves while output decreases after exchange rate depreciation.6 The median target responses in each chart with 16 percent and 84 percent quintiles are plotted. Results Figs. (2002) for more discussion. the method remains agnostic with respect to the responses of the key variables of interest. the behavior of the current account does not have a direct bearing on the behavior of output in response to an exchange rate shock. Rogers and Wang (1995). S). By definition. one degree of the choice remains: the horizon K for the sign restrictions. 3. considering that our data are quarterly rather than monthly as in Uhlig (2005).5 4. 2005). Austria (marginally significant). there will be a trade-off between achieving high output growth and a strong balance-of-payments by using exchange rate policy. There is no significant change in Denmark or the Netherlands. More interestingly. 1 and 2 present the impulse responses of current account and real output to a one-standard-deviation positive exchange rate shock (indicating depreciation) in each country over 48 quarters. that is. among many others. we evaluate 500 unit vectors on the n-dimensional sphere. the current account improves significantly in Canada. because the price level is likely to be driven up by an increase in net export due to the exchange rate depreciation. 2. current accounts generally improve but outputs are depressed simultaneously in all Latin American countries. in Latin American countries. See Ahmed et al. Thus. The real money supply does not increase (0) facing exchange rate depreciation.

vertical axis: percent. We assume that prior and posterior distributions for (B. S). Impulse response of current account to a positive exchange rate shock (K = 2). . S) belong to the Normal-Wishart family. / Journal of Asian Economics 34 (2014) 27–41 35 Fig. Source: Author’s calculations.000 q’s and impulse vectors are evaluated. An et al. Thus a total of 250. For each pair. Note: Horizontal axis: quarters. 1. We simulate 500 pairs of (B.L. we evaluate 500 unit vectors on the 5-dimensional sphere.

/ Journal of Asian Economics 34 (2014) 27–41 Fig. (Continued ). 1. . An et al.36 L.

S) belong to the Normal-Wishart family.000 q’s and impulse vectors are evaluated. For each pair. We simulate 500 pairs of (B. vertical axis: percent. We assume that prior and posterior distributions for (B. 2. Thus a total of 250.L. . An et al. S). Impulse response of real output to a positive exchange rate shock (K = 2). Source: Author’s calculations. Note: Horizontal axis: quarters. we evaluate 500 unit vectors on the 5-dimensional sphere. / Journal of Asian Economics 34 (2014) 27–41 37 Fig.

(Continued ). An et al. . / Journal of Asian Economics 34 (2014) 27–41 Fig. 2.38 L.

and could exist in any exchange rate regime. Indonesia.13 0.16 0.26 0.11 0.13 0. and the Philippines.15 0.12 0.16 Switzerland CA Y 0.4–3.30 0. Exchange rate shocks play a similar role in the three groups of countries.08 0. Eichengreen.19 Chile CA Y 0. Latin American countries are quite homogenous in that current account generally improves while output decreases.12 0. and Panizza (2002) estimate the original sin measure of one for Latin American countries.13 0.14 Portugal CA Y 0.22 Malaysia CA Y 0. (2002).14 0. However.18 0.23 0.10 0.L.08 0.13 0.14 Brazil CA Y 0.11 0.11 0.13 New Zealand CA Y 0.17 Canada CA Y 0.09 0.15 0. from the standpoint of the exchange rate regime. or in a common currency area. we acknowledge that Table 3 Variance decomposition of current account and output due to exchange rate shocks. (2002) also report that contractionary devaluation in the developed countries is as strong as in the developing countries.14 0.09 0.11 0. generate stagflationary effects (Gylfason & Risager.16 0.03 0.07 Indonesia CA Y Source: Authors’ calculations. Table 3 reports the fraction of the fluctuations of current account and output that is attributable to exchange rate shocks at 0-. because exchange rate depreciation induced by adverse external shocks cannot boost aggregate demand.20 0.11 0. the Netherlands.10 0.09 0. that is.17 0. we find a slightly larger role of the real exchange rate shocks than that found in Ahmed et al. Hausmann. Asia and the developed countries are also subject to contractionary devaluations.06 0.12 0.33 0.12 0.14 0.14 0.23 0.04 0.15 0.16 Austria CA Y 0.13 0.12 0.17 0.17 0. currency devaluation will increase debt-servicing obligations and.14 0. In addition.17 Korea CA Y 0.13 0.09 0.14 0.15 0 4 8 Mexico CA Y 0. Ahmed et al.11 0.10 0.29 0.14 0.13 0. An et al.16 Denmark CA Y 0. which is consistent with the uniform negative cross correlations between real exchange rate and output at the negative lags.17 0.14 0.07 0.10 0.13 0.11 0. several conclusions emerge: (1) whether output increases or not after a real devaluation has little to do with whether the current account improves or not.13 Argentina CA Y 0.25 0.14 0.08 0.18 Australia CA Y 0.11 0.15 0. contractionary devaluation may not be a function of exchange rate regimes nor types of economies.13 0.2 percent in Asian countries.20 0.20 0. variance decompositions are a convenient measure of the importance of such shocks in the system.16 0. and 0.14 0. Australia and New Zealand may not enjoy the benefit of a flexible exchange rate regime to a full extent. devaluation may cause the countries to lose access to international capital markets and accelerate capital outflow. Latin American countries are well-known for being subject to ‘‘original sin’’.11 0. which reports about 8.13 0. which constitutes another negative supply-side shock. 8-.15 0. and Portugal. While impulse response functions reveal the dynamic effects of a one-time shock. whether it is a flexible exchange rate. the phenomenon is not particular to Latin American countries.09 0.12 0.09 0.26 0. Denmark.42 0.17 0. similar to a negative supply shock.08 0. In developed countries.16 0. output contracts significantly in Malaysia. and thus has limited effects in offsetting adverse shocks.06 0. Note: ‘‘CA’’ denotes current account.18 0.13 0.09 0.16 0. 12 .1–11 percent in Latin American countries.11 0.16 0.11 0.16 0.6–12. In comparison. 1.09 0. not being able to borrow abroad in their domestic currencies. 1984).10 0.15 0. Output in Canada and Austria does not respond significantly to an exchange rate shock. 0 4 8 12 0. In Asian countries. (2) compared with Asia and the developed countries. 12-quarter horizons.16 0.15 0. and (3) although Latin American countries exhibit obvious contractionary devaluation. Therefore. or a fixed exchange rate. 4-. and ‘‘Y’’ denotes output. Contractionary devaluation could happen in developed countries as well as in developing countries.25 0.10 0.10 0. In sum. output contracts significantly after exchange rate depreciation in New Zealand and Australia while it expands significantly in Switzerland.14 0.16 0.16 0.15 0.10 0.13 0.15 0.32 Philippines CA Y 0.13 0.13 0. meaning that these countries issue almost all of their securities in foreign currency.9 percent in developed countries.12 0.11 0.22 0.12 0.19 0.25 0. In addition.15 Netherlands CA Y 0. / Journal of Asian Economics 34 (2014) 27–41 39 This homogeneity may illustrate the importance of the balance sheet effect. Exchange rate shocks account for between 3 and 33 percent of the current account variation and 7 to 42 percent of the real output fluctuations. Therefore.

Indonesia (1980:1–2012:4). foreign income (Y*) and foreign interest rate (R*). In developed countries. S. In the Latin American countries. Mexico. Here. The domestic consumption price index is measured by the consumer price index (CPI).40 L. the output-reduction effect of devaluation is not a function of types of economies or of the exchange rate regimes. and Malaysia. 5. Countries with contractionary devaluation. because there is consensus that the real exchange rate cannot be viably targeted on a sustained basis and such policy may be very inflationary. Meanwhile. J. REER. 737. the results are generally very robust. Monetary policy misspecification in VAR models. the results are quite robust. & Kandil. because real depreciation may follow periods of sustained real appreciation. In sum. the current account balance is approximated by the difference between exports and imports. and Switzerland (1973:1–2012:4). Robustness check How sensitive are the results to the different values of horizon K for the sign restrictions? In the benchmark case.. (2009). The real output. In a similar vein. The US 3-month Treasury bill rate and US real GDP is used as foreign interest rate and income. Denmark. F. B. is the trade weighted exchange rate measured by the weighted average of the bilateral exchange rates against the US dollar. MS.. For the money supply. Univ. Bahmani-Oskooee. the Philippines (1973:01–2011:4). O. M1 is used for most countries and money in the national definition is used for Switzerland. Data and definitions The current account variable. (2002). Direction of Trade Statistics (DOTS). Chile (1973:1–2012:4). & Pina. An et al. Does this mean that countries with ‘‘expansionary devaluation’’ can resort to exchange rate depreciation to stimulate the economy? We believe that it is dangerous to draw conclusions like this as well because currency depreciation tends to reduce the growth potential of the economy.. C. 420. except that the decrease of output in Indonesia is not significant when K = 1 and 4. S. are incorporated to capture the external shocks. & Huntley. The data set is quarterly and has been collected from International Financial Statistics (IFS). The results show that whether output increases or not after a real devaluation has little to do with whether the current account improves or not. we consider the cases for K = 1 and K = 4 for robustness check. We established a model with plausible restrictions for a small subset of variables with which to identify the exchange rate shock. J. Australia (1973:1–2012:4). The sample periods are as follows: Argentina (1973:1–2012:4). Brazil (1980:1–2011:4). Appendix A. New Zealand (1973:1–2012:4). The dynamic effects of aggregate demand and supply disturbances. the results are not sensitive to the different specification of restriction horizons. Kamin. Are depreciations as contractionary as devaluations? A comparison of selected emerging and industrial economies. 139–150. & Quah. the empirical evidence based on a VAR model with sign restrictions is provided. Mexico (1985:4–2012:4). such as Latin American countries. . No. and Portugal does not mean that the exchange rates in these countries should be targeted at increasing competitiveness. American Economic Review. Canova. Asian countries. Contractionary devaluation may happen in developed countries as well as in developing countries. should not rely on exchange rate depreciation to grow the economy. Portugal (1973:1–2012:4). 79(4). Economics and Business Working Paper. and non-G3 developed countries) have been analyzed using quarterly data from 1973 to 2012. Denmark (1975:1–2012:1). the effects of real exchange rate changes on real output growth for 16 countries that belong to three groups (Latin American countries. the detailed results are not reported here. and while contractionary devaluation is quite a homogeneous phenomenon for the Latin American countries.. Blanchard. is obtained as the ratio of the current account balance to the trend nominal GDP. Due to space constraint. CAR. this paper attempts to offer some policy implications. Based on these results. Two exogenous variables. as real exchange rate appreciation may lead to renewed balance of payment crisis in the future. finding that real devaluation is contractionary in Latin American and other developed countries does not provide a basis for encouraging real exchange rate appreciation. References Ahmed. Gust. Malaysia (1973:1–2012:4). D. overvaluation should be prevented. Are devaluations contractionary in MENA countries? Applied Economics. International Finance Discussion Papers. J. finding that a real devaluation increases output in Switzerland. For the first time in the contractionary devaluation literature. the Netherlands. Conclusion In this paper. the Netherlands (1973:1–2012:4). Canada (1973:1–2012:1). The real effective exchange rate. the dynamics of the output response are similar to those in our benchmark specification. If the balance of payments statistics are unavailable. M. J. (1999). Korea (1976:1–2012:1). 41(2). 655–673. and central banks and Department of Statistics of these countries. 6. but they are available upon request. Korea. For example. (1989). All variables are in logarithm except R* and CAR ratios. and correction of the exchange rate will have severe consequences in countries with contractionary devaluations. Pompeu Fabra. Y is measured by the index of seasonally adjusted GDP... / Journal of Asian Economics 34 (2014) 27–41 it may not be appropriate to draw straightforward policy implications from the results in this paper. The results are robust to several different choices of the restrictions horizon. In Asian countries. M. Austria (1973:1–2012:4). K is set to 2. and introduce an additional uncertainty which acts as a deterrent to the investment needed to build production capacity.

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