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Currency Devaluation and Output Growth: An Empirical Evidence from OECD

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Article  in  International Research Journal of Finance and Economics · January 2008

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 CURRENCY DEVALUATION AND OUTPUT GROWTH: AN EMPIRICAL
EVIDENCE FROM OECD COUNTRIES

Huseyin Kalyoncu
FEAS, Department of Economics, Nigde University,
Nigde, Turkey. Email: hkalyoncu@nigde.edu.tr

Seyfettin Artan
FEAS, Department of Economics, Karadeniz Technical University,
Trabzon, Turkey. Email: sartan@ktu.edu.tr

Selman Tezekici
FEAS, Department of Economics, Nigde University,
Nigde, Turkey. Email: stezekici@nigde.edu.tr

Ilhan Ozturk
FEAS, Cag University, 33800, Mersin, Turkey.
Tel: +90 324 6514800, Fax: +90 324 6514811
Email: ilhanozturk@cag.edu.tr

Abstract
This article studies the effect of currency devaluation on output level of 23 OECD countries
using unit root and cointegration test. The empirical evidence suggests that, in the long run,
output growth is affected by currency devaluations in 9 out of 23 countries. In six out of nine
countries, depreciation exerts a negative impact on output growth; however depreciation
improves output in three countries.

Key words: Currency Devaluation, Output, Cointegration analysis, Error Correction analysis
JEL Classification: O4, C32

1
1. INTRODUCTION
The relationship between the level of output and the real exchange rate is an important and
controversial issue for economies. Economists have been studying correlation between the
real exchange rate and the level of output because currency devaluation is often considered to
be a tool for improving the foreign sector of an economy. It is argued that a devaluation or
depreciation of currency raises the price of imports in comparison to that of its exports, and
this causes the trade balance to improve. This leads to an improvement in the foreign sector of
economy. The improvement in the foreign sector raises output and employment in the overall
economy. According to the traditional views such as the elasticities, absorption, and the
Keynesian argue that devaluations have expansionary effect on output and aggregate demand.
Contrary to the traditional view, there are also other theoretical reasons why devaluation
can have a contractionary impact on the economic activity. First, the devaluation can
redistribute income from groups with a lower to a higher marginal propensity to save. This
may lead to a decline in aggregate demand and output (Krugman and Taylor, 1978).
Secondly, a nominal devaluation can decrease the aggregate demand through the negative real
balance effect due to a higher price level, which in turn may decrease the level of output.
Thirdly, if the price elasticities of exports and imports are very low, then the trade balance
expressed in terms of domestic currency may deteriorate causing a recessionary effect in the
economy. In addition to these demand-side effects, there are also a number of supply-side
channels through which devaluation can be contractionary. Exchange rate depreciation raises
the cost of imported inputs, leading to a decrease in aggregate supply. Additionally, exchange
rate depreciation may raise the domestic interest rate and wage level through an increase in
the price level. This might also decrease the aggregate supply in the economy.
There are four major empirical approaches in existing studies to investigate the effects of
devaluation on output (Domac, 1997). These are; the control group approach which aims at
separating the effect of devaluation from other factors on output; the before and after
approach studies changes in country performance at the time of devaluation on output; the
macro-simulation approach employs simulation models to analyze the impact of exchange
rate changes on output; and the econometric approach applies econometric methods to time
series to investigate the effect of devaluations on output.
The relationships between currency devaluation and output growth have been investigated
by a number of studies. But empirical findings of the effects of devaluation on the economy
are mixed. Edwards (1986) claimed that devaluations have a negative effect on output in the
short-run while they are neutral in the long-run using pooled time series cross-section data for

2
12 countries. Sheeley (1986) found that devaluations have a negative impact on output for 16
Latin American countries while Nunnenkamp and Schweickert (1990) rejected the hypothesis
of contractionary devaluation. Conoly (1983), Gylfason and Schmid (1983), and Taylor and
Rosenweig (1984) found a positive relationship between currency devaluation and output
expansion. Gylfason and Risager (1984) and Branson (1986) found that currency devaluation
is contractionary to the economy. Upadhyaya (1999), did not find any significant long-run
effect of currency devaluation on aggregate output for 4 out of 6 Asian countries while he
found contractionary effect for two countries. Bahmani-Oskooee (1998) investigated whether
currency depreciation is expansionary or contractionary in 23 LDCs. He found that
devaluations have no lung-run effect on output in most LDCs. Bahmani-Oskooee et al. (2002)
investigated the effect of currency depreciation on output in Asian countries. They found that
in many Asian countries depreciation is contractionary. Chou and Chao (2001) found that
currency devaluation leads to a short-run contractionary effect but has no impact on aggregate
output in the long run (except for Indonesia) for 5 Asian countries. Christopoluos (2004)
investigated the effect of currency devaluation on output expansion in a sample of 11 Asian
countries over the period 1968-1999. He found that, in the long run, in 5 out of 11 countries
and for the panel as a whole, depreciation exerts a negative impact on output growth while for
three countries depreciation improves growth prospects. Upadhyaya et al. (2004) studied the
effect of currency depreciation using panel data and found that while the exchange rate
depreciation is expansionary in the short run, it is neutral in the medium and long run.
The aim of this study is to test the effect of currency devaluation on output level in 23
OECD countries using unit root and cointegration test for period 1980-2005. The paper is
organized as follows. In section 2, we formally define the analytical framework and
econometric methodology. Section 3 describes data and presents empirical results. Section 4
concludes the paper.

2. ANALYTICAL FRAMEWORK AND ECONOMETRIC METHODOLOGY

Following Christopoluos (2004) methods, we developed a simple model to test the
devaluation – output growth relationship.
log Yt     log rert  u t (1)

In equations 1, Y represents the level of real output and rer represents the real exchange
rate. If the coefficient on log rer is negative and statistically significant, ceteris paribus,
exchange rate depreciation is contractionary to the economy. In contrast, if the coefficient of

3
log rer is positive and statistically significant, exchange rate depreciation is expansionary to
the economy. If it is statistically insignificant, the exchange rate is neutral to real GDP
growth.
Before carrying out the estimation of Eq. (1) the time series properties of the series in each
country are investigated. Regression results are appropriate in estimating a long-run
relationship if the real exchange rate and real GDP series are stationary while cointegration
tests are appropriate if the data are nonstationary. We use the classical unit root test, namely,
the Augmented Dickey-Fuller (ADF) test for the stationarity of the series. (see Dickey and
Fuller, 1979 and 1981). ADF test is based on the null hypothesis that a unit root exists in the
time series. We use the following ADF test which include constant and trend;
n
X t     t   X t 1   i X t i   t
i 1 (2)
In this equation, X is the variable under consideration, Δ is the first difference operator, t is
a time trend and ε is a stationary, random error term.
Having established that all variables are integrated of the same order cointegration test are
the appropriate method for detecting the existence of long-run relationship. Engle and
Granger (1987) argue that, even thought a set of economic series is not stationary, there may
exist some linear combinations of the variables that is stationary. If the separate series are
stationary only after differencing but a linear combination of their levels is stationary, the
series are cointegrated.
Given that the variables in our model are found to be cointegrated following Engle and
Granger (1987) an error correction model (ECM) is developed to account for a short run
effect.
n n
 log Yt   0   1  log Yt i    2  log rert i   3 ECt 1  U t
i 1 i 0 (3)
where EC represents the equilibrium error that is the deviation from the long-run relationship
and U is the statistical noise.

3. DATA AND EMPIRICAL RESULTS

In order to test devaluation – output growth relationship two variables are constructed.
These variables are real exchange rate (rer) and real GDP (Y). Real exchange rate is defined
as nominal exchange rate times the ratio of US price index to the domestic consumer price
index. The nominal exchange rate is defined as the price of the domestic country in terms of
the US dollar (domestic currency/US dollar). All series are expressed in logarithms.

4
 All data are quarterly and gathered from the International Monetary Fund’s International
Financial Statistics (IMF-IFS) database. Due to the unavailability of data, sample sizes differ
for some countries. For Australia, Austria, Belgium, Canada, Denmark, Finland, France, Italy,
Japan, South Korea, Netherlands, Norway, Portugal, Spain, Sweden, Switzerland and United
Kingdom data from 1980:q1-2005:q4 is used. For Germany 1991:q1- 2005:q4, Hungary
1995:q1-2005:q4, Mexico 1981:q1-2005:q4, New Zealand 1987:q2-2005:q4, Poland 1995:q1-
2005:q4 and Turkey 1987:q1-2005:q4 are used.
Firstly, we investigate the time series properties of the series in each country. The results
of the ADF test on the levels and first differences of the variables are in Table 1. The lag
length was selected using the Schwarz Criterion. For each country’s real exchange rates and
real GDP, there are three possible outcomes: series can be stationary, both can be
nonstationary, or one variable can be stationary and other variable can be nonstationary.

Table 1. Augmented Dickey-Fuller (ADF) unit root tests

LEVEL FIRST DIFFERENCE
Country log Y log rer log Y log rer
Australia -1.617 (1) -2.078 (1) -7.184 (0) -8.028 (0)
Austria -1.420 (4) -2.241 (1) -4.390 (3) -7.352 (0)
Belgium -2.413 (4) -2.548 (1) -4.403 (3) -7.137 (0)
Canada -2.061 (1) -1.946 (3) -5.266 (0) -6.180 (1)
Denmark -3.354 (4) -2.319 (1) -5.535 (3) -7.493 (0)
Finland -2.562 (4) -2.005 (1) -8.886 (1) -7.526 (0)
France -1.941 (1) -2.431 (1) -7.493 (0) -7.286 (0)
Germany -2.382 (0) -1.700 (1) -7.426 (1) -6.746 (0)
Hungary -2.528 (4) -1.311 (0) -3.689 (3) -4.557 (0)
Italy -0.988 (0) -2.139 (1) -10.06 (0) -7.466 (0)
Japan -0.824 (1) -1.167 (0) -13.03 (0) -8.116 (0)
Korea -0.196 (6) -2.381 (1) -5.415 (5) -7.302 (0)
Mexico -3.416 (4) -4.941 (3) -5.392 (4) -8.967 (0)
Netherlands -3.176 (1) -2.674 (1) -15.03 (0) -7.515 (0)
New Zealand -2.214 (0) -2.460 (3) -10.68 (0) -5.355 (0)
Norway -0.925 (7) -2.283 (1) -4.940 (6) -7.792 (0)
Poland -2.071 (4) -1.602 (0) -6.859 (1) -6.561 (0)
Portugal -1.548 (0) -2.230 (1) -11.08 (0) -7.548 (0)
Spain -2.566 (2) -2.003 (1) -5.835 (1) -7.287 (0)
Sweden -2.806 (5) -2.055 (1) -3.984 (3) -7.342 (0)
Switzerland -1.192 (0) -2.338 (1) -8.652 (0) -7.772 (0)
Turkey -2.388 (4) -2.711 (1) -5.308 (6) -7.186 (1)
United Kingdom -3.717 (4) -3.057 (1) -2.927 (3) -8.045 (0)
Notes: Figures in parentheses denotes lag order and the lag order was determined using the Schwarz criterion (BIC). ADF
test for a unit root in the model constant/trend. The critical values for ADF test are -4.05 and -3.45 at %1 and %5 statistical
level respectively.

The results show that except UK all countries real GDP series have unit roots in their
levels, but no unit roots in their first difference forms.The results also show that all countries

5
real exchange rate series except Mexico have unit roos in their level, but no unit roots in their
first difference forms.
For other two countries, one variables are stationary and other variables are nonstationary
in levels (real exchange rate is I(0) for Mexico and real GDP is I(0) for UK). If one variable is
stationary and the other nonstationary, it can be concluded that the two variable are not
cointegrated and do not share a long-run relationship (Enders 1995).
Having established that all variables are integrated of the same order for 21 (of 23) OECD
countries, we used Engle-Granger (E-G) cointegration test for detecting the existence of long-
run relationship. E-G cointegration test results are reported in Table 2. Cointegration test
results confirms the presence of a long run equilibrium relationship between log rer and log
Y for Germany, Poland, Sweden and Turkey at % 5 level and Austria, Finland, Hungary,
Portugal and Switzerland at the % 10 level.
The results indicate that currency devaluation exerts a negative impact on output expansion
and coefficient of log rer is statistically significant in Austria, Hungary, Poland, Portugal,
Switzerland and Turkey. In three countries, namely, Finland, Germany and Sweden, this
relationship is found to be positive and the coefficient of log rer is statistically significant.

Table 2. Engle-Granger cointegration results

Country Constant log RER ADF
Australia 0.631 (30.43) 0.702 (5.24) -0.155 [1]
Austria 1.149 (10.53) – 0.341 (3.43) -1.792 [1]
Belgium 1.547 (9.93) – 0.146 (1.46) -0.743 [4]
Canada 0.838 (55.45) 0.950 (7.24) -0.567 [3]
Denmark 0.628 (8.33) – 0.231 (2.58) -1.178 [4]
Finland -0.067 (0.88) 0.372 (3.39) -1.675 [4]
France 1.294 (18.69) 0.014 (0.16) -0.662 [2]
Germany 0.953 (160.79) 0.160 (6.36) -1.970 [0]
Hungary 2.680 (10.22) – 0.491 (4.41) -1.840 [4]
Italy 1.130 (3.20) – 0.140 (1.28) -0.924 [1]
Japan 4.836 (40.50) – 0.570 (9.95) -1.440 [0]
Korea -0.383 (0.33) 1.099 (2.82) -1.118 [5]
Netherlands 0.300 (8.26) – 0.141 (1.18) -0.187 [2]
New Zealand 2.358 (95.10) 0.254 (2.39) -0.272 [3]
Norway 0.067 (0.47) 0.420 (2.48) 0.657 [4]
Poland 3.525 (31.07) – 0.451 (2.34) -2.261 [4]
Portugal 3.983 (12.43) – 1.039 (7.42) -1.928 [0]
Spain 2.922 (10.00) – 0.286 (2.13) -0.122 [2]
Sweden 0.381 (5.15) 0.320 (3.73) -2.049 [0]
Switzerland 0.017 (1.60) – 0.274 (4.60) -1.627 [1]
Turkey 2.394 (66.15) – 0.346 (2.00) -2.464 [2]
Notes: Number inside the parentheses next to each coefficient is the absolute value of the t-satistics.
Number inside the square bracket next to ADF statistic is number of lags in the ADF test. Lag order was
determined using the Schwarz criterion (BIC). ADF test for a unit root in the model no constant/ no trend. The
critical values for ADF test are -1.94 and -1.61 at %5 and %10 statistical level respectively.

6
 Given that the variables in our model are found to be cointegrated for Austria, Finland,
Germany, Hungary, Poland, Portugal, Sweden, Switzerland and Turkey, an error correction
model is estimated to account for a short run effect. Lag order was determined using the
Schwarz criterion (BIC). Estimates of the ECM are presented in Table 3. We did not report all
results because of space constraints.
Table 3. Error-correction test results

Country ΔLog RERt ΔLog RERt-1 ECt-1 R2

*
-0.031 -0.002 -0.028 0.91
Austria (-0.77) (-0.04) (-2.46)
-0.076*** 0.019 -0.015
Finland (-1.72) (0.43) (-1.32) 0.85
-0.019 -0.056** -0.052
Germany (-0.79) (-2.37) (-1.37) 0.33
0.250*** 0.090 0.112**
Hungary (1.87) (0.67) (2.34) 0.86
-0.046 0.099 -0.111**
Poland (-0.45) (1.04) (-2.10) 0.95
-0.022 -0.048 -0.006
Portugal (-0.36) (-0.80) (-0.52) 0.05
-0.029 -0.031 -0.005
Sweden (-0.76) (-0.78) (-0.44) 0.94
-0.013 0.027*** -0.006
Switzerland (-0.82) (1.71) (-0.68) 0.11
-0.420* 0.067 -0.095
Turkey (-4.21) (0.62) (-1.38) 0.97
Notes: Number inside the parentheses next to each coefficient is the absolute value of the t-satistics.
Lag order was determined using the Schwarz criterion (BIC). *, **, *** indicate significance at the 1%, 5% and
10% levels, respectively.

The results show that for Finland, Germany and Turkey depreciation exerts a negative
impact on output while for Hungary and Switzerland depreciation exerts a positive impact on
output growth in the short run. For the remaining countries the impact of currency devaluation
on output growth is neutral in the short run.

4. CONCLUSION
The main goal of this paper was to assess the long and short-run effects of real exchange
rate depreciation on output level in OECD countries. Before carryin out the estimations, the
time series properties of the data are investigated by unit root and cointegration test. For the
countries that the data series are found to be integrated of order one and the null hypothesis of
no cointegration is rejected, an eror correction model is employed. There are mixed results. In
the long run currency devaluation exerts a negative impact on output expansion in Austria,
Hungary, Poland, Portugal, Switzerland and Turkey while in three countries, namely, Finland,
Germany and Sweden, this relationship is found to be positive. In the short run depreciation

7
 exerts a negative impact on output for Finland, Germany and Turkey while depreciation
exerts a positive impact on output growth for Hungary and Switzerland.

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