Effects of a Devaluation on a Trade Balance

Author(s): Sidney S. Alexander

Reviewed work(s):
Source: Staff Papers - International Monetary Fund, Vol. 2, No. 2 (Apr., 1952), pp. 263-278
Published by: Palgrave Macmillan Journals on behalf of the International Monetary Fund
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 of a Devaluationon a Trade
Effects
Balance
Sidney S. Alexander *
T HE CONVENTIONAL ANSWER to the question,what is the
effectof a devaluation on the trade balance of the devaluing
country,runs in terms of the supply and demand conditionsin the
devaluing countryand in the rest of the world. It is presumedthat
the devaluation initially tends to reduce the foreignprices of the
country'sexportsin proportionto the devaluation. At these reduced
prices, foreigndemand for the country'sexports will be increased,
thus tendingto bid up the foreignprices of these exportspart-way
back toward theirpredevaluationlevels. How much the foreigncur-
rencyproceedsof the country'sexportswill changethen dependsupon
the elasticity of foreigndemand for the country'sexports and the
elasticityof domesticsupplyof exportgoods. Similarly,on the import
side, the initial effectof the devaluation is to raise the domesticprice
of imports,presumablyleading to some reductionin the country's
demand forimports,whichin turnmay tend to reducethe worldprice
of the importedgoods. The size of these reactionson importsdepends
upon the elasticityof domesticdemand forimportsand the elasticity
of foreignsupply of imports. The effectof the devaluation on the
foreigntrade balance can accordinglybe expressedin a formulawhich
involvesprincipallythe fourelasticitiesmentionedabove.'
In the presentpaper, it is suggestedthat a more fruitfulline of
approach can be based on a concentrationon the relationshipsof real
expenditureto real income and on the relationshipsof both of these
to the price levels, rather than on the more traditional supply and
demand analysis.
* Mr. Alexander, Acting Chief of the Finance Division, is a graduate of Harvard
College and the Harvard Graduate School. He was formerlyAssistant Professorof
Economics at Harvard College, and during the war was connected with the
Officeof Strategic Services. He has been consultant to the U.S. Treasury Depart-
ment, U.S. State Department, Economic Cooperation Administration, and U.S.
Department of Defense.
1 See A. P. Lerner, The Economics of Control (New York, 1946), p. 378; Joan
Robinson, "The Foreign Exchanges," Essays in the Theory of Employment (2d
ed., Oxford,1947), p. 143, fn.,reprintedin Readings in the Theory of International
Trade (H. S. Ellis and L. Metzler, eds., Philadelphia, 1949), p. 93, fn. 10; A. J.
Brown, "Trade Balances and Exchange Stability," Oxford Economic Papers,
No. 6 (1942), pp. 57-76; Lloyd Metzler, "The Theory of International Trade,"
A Survey of Contemporary Economics (H. S. Ellis, ed., Philadelphia, 1948),
p. 226.
263
264 INTERNATIONAL MONETARY FUND STAFF PAPERS

The ElasticitiesApproach
The conventional analysisis an extension, to imports and to exports
as a whole,of the familiarMarshalliansupplyand demandanalysis
ofthepriceand production of a singlecommodity. Whilesupplyand
demandcurvesare veryusefultools foranalyzingthe factorsthat
determine priceand outputfora singlegood,theirvalueis muchmore
questionable whenappliedto importsand exportsas a whole.Simi-
larly,the extensionof the Marshallianpartialequilibrium analysis
to thedetermination of totalemployment and outputhas beenfound
to be of limiteduse. The mostimportant reservation againsttheuse
of the Marshalliansupplyand demandcurvesin the analysisof the
effectsofa devaluation arisesfromthecomplexity oftherelationships
whichgovernsupplyand demandconditions in internationaltrade.
The elasticities forwhichtheconventional formulas are validmustbe
defined as totalelasticities and notas partialelasticities.
Partial elasticities measurethe effectof a changeof priceon the
quantitysuppliedor demandedwhenall otherthingsremainequal.
Total elasticities relevantto a devaluationmeasurethecorresponding
relationship when the otherthingshave changedthat are likelyto
change as a result of the devaluation.Accordingly, a totalelasticity
does notmeasurethe directeffects of pricechangeson quantity, but
the covariationof priceand quantityas the wholeeconomicsystem
seeksa newequilibrium. A totalelasticity is theratioofa percentage
changein quantity to a percentage changeinprice.But thepercentage
changein quantityis theresultnotonlyofthepricechangeto which
it is related,but also of manyotherpriceand incomechangeswhich
are themselves directand indirect ofdevaluation.The percent-
effects
age change in price is not generally equalto thepercentage devaluation,
butitselfdependsonthesamecomplicated setofrelationships. There-
forethetotalelasticities appropriate fortheanalysisofthe effects of
a devaluationdependon the behaviorof the wholeeconomicsystem,
and the statement that the effectof a devaluationdependson the
elasticitiesboils downto the statement that it dependson how the
economicsystembehaves.

The Income-AbsorptionApproach
In examining of real expenditure
the relationships to real income
and of bothof theseto pricelevels,the analysisof the effectsof
should,ofcourse,be appliedto boththedevaluingcountry
devaluation
and therestof theworld.It is generally recognizedthata country's
netforeigntradebalanceis equal to the differencebetweenthe total
goodsand servicesproducedin thatcountry and the totalgoodsand
 EFFECTS OF A DEVALUATION ON A TRADE BALANCE 265
services taken offthe market domestically. For brevity,the taking
of goods and servicesoffthe marketwill be referredto here as absorp-
tion. Absorptionthen equals the sum of consumptionplus investment
as usually defined(includingin investmentany change in the holding
of inventories). If a devaluation is to affectthe foreignbalance, it
can do so in only two ways: (1) It can lead to a change in the pro-
duction of goods and services in the country;this change will have
associated with it an induced change in the absorptionof goods and
servicesso that the foreignbalance will be altered by the difference
between the change in income and the income-inducedchange in
absorption. (2) The devaluation may change the amount of real ab-
sorptionassociated with any givenlevel of real income.
In orderto simplifythe discussion,any factorsaffecting the foreign
balance of a countryotherthan those connectedwith trade in goods
and serviceswill be ignored. Also, it will be assumed that there are
no restrictionson trade and payments,althoughthat assumptionis
not necessaryforthe validityofthe subsequentanalysis. Furthermore,
only the simplestformsof the various relationshipsinvolved will be
considered. For example,only one price level will be considered,and
the change in that level will be denotedby p. The readerwho wishes
to think of a more complex and realistic model may considerp as
denotinga whole set of price changesthat mightbe representedby a
vector. Similarly,y will denote the change in the aggregatenet pro-
duction of goods and services,i.e., in national income.2 Finally, the
relationshipsin the devaluing countrywill be examined; to complete
the picture,a similaranalysis,with some of the termsreversed,would
have to be applied to the rest of the world.
A startingpoint is the identitythat the foreignbalance, B, is equal
to the differencebetweenthe total productionof goods and services,
Y,3 and the total absorptionof goods and services,A:
B=Y-A.
Changes in these quantities may be denoted by the corresponding
small letters,so that
b=y-a (1)
2This mightbe taken by the ambitiousreader to mean the whole set of
changesin the outputof variousgoods and serviceseach taken separately.Any
linear coefficient,
such as the propensityto absorb,whichappears as a simple
constantin this discussioncould also be re-interpretedas an appropriatevector
or matrixwhichmultipliesthe incomeor pricevector.In short,the analysiswill
proceedin termsof a highlysimplified modelwhichcouldbe made muchbroader
by a re-interpretation of the symbols.
3 It makes no difference for the formalanalysiswhetherY is taken net or
gross,i.e., whetherit is national income or grossnationalproduct,providedA
is correspondingly definedas net or gross. For convenience,Y will subsequently
be referred to as nationalincome,or,morebriefly, income.
266 INTERNATIONAL MONETARY FUND STAFF PAPERS

is our fundamentalidentity.It indicatesthat the changein the foreign

balance equals the difference betweenthe change in output and the
change in absorptionof goods and services. It shows that the first
questionto be investigatedis how the devaluationwill affectthe two
terms,y and a. The above relationshipshold, of course,both in real
and in moneyterms. The presentdiscussionwill deal only with real
quantities,not with moneyvalues.
Accountmay firstbe taken of the fact that the absorptionof goods
and servicesdepends,at least in part, on real income,which itselfis
equal to the outputof goods and services. Absorptionmay also depend
on the price level, or otherfactorsrelated to the devaluation,so that
a=cy-d (2)
wherec is the propensityto absorb,equal to the propensityto consume
plus an analogous effectof incomeon investment, whichmay be called
the propensityto invest. The termd may be called the directeffectof
the devaluation on absorption. It expresseswhatevertendencythere
may be forthe devaluationto induce a change in the amount of real
absorptionat any given level of real income.
Equation (2) thereforestates that the change in the absorptionof
goods and servicesin real termsas a resultof devaluationis made up
of two parts. The first,cy, is the change in real consumptionplus
real investmentthat is induced by the change in real income that
results fromthe devaluation. The other part, d, is the change in
absorptionwhichresultsotherthan throughthe incomeeffect.
A combinationof the functionalrelationship(2) withthe fundamen-
tal identity(1) yields
b=(1-c)y+d. (3)
This formulation is usefulin that it directsthe investigationto three
basic questions: How does the devaluation affectincome? How does
a change in the level of incomeaffectabsorption,i.e., how large is c?
How does the devaluationdirectlyaffectabsorptionat any givenlevel
of income,i.e., how large is d? In orderto analyze these questionsin
precise terms,the entireeconomicstructureof the devaluing country
and of the rest of the world would have to be considered. Such an
analysis would be far more complicated than is desirable for the
presentationof the main ideas of this paper. Consequently,what fol-
lows is a summaryof these main ideas, ratherthan a preciseformula-
tion of the relationships.
 EFFECTS OF A DEVALUATION ON A TRADE BALANCE 267
Effectof Devaluationon Income
Idle resourceseffect
The principaleffect of a devaluationon incomeis associatedwith
theincreasedexportsofthedevaluingcountry and theinducedstimu-
lationofdomestic demandthrough thefamiliar multiplierrelationship,
provided thereareunemployed resources.4In additionto themultiplier
itself,the limiting factorson the processof inducingenlargedoutput
are (1) thedegreeto whichan increasedoutputofgoodsand services
is forthcoming without an extensive pricerisein thedevaluingcountry,
and (2) the degreeto whichthe rest of the worldcan absorbthe
increasein exportsthat is associatedwiththe declinein the foreign
pricesof exportsmade possibleby the devaluation-afterallowance
forthe counteracting upwardmovementof the domesticpricesof
exportgoods,whichoccursas the demandforthesegoodsexpands.
Theseconsiderations are familiarin theliterature.
It mustbe emphasized thattheneteffect oftherecovery ofincome
and production on the foreignbalance is not the total amountof
additionalproduction induced,butmerelythedifference betweenthat
amountand the inducedincreasein absorption.This difference be-
tweentherealproduction or incomeand therealexpenditure on goods
and servicesmaybe termedrealhoarding.The foreign balanceis, by
the fundamental identity, equal to the aggregate real hoardingof the
economyas a whole. The income-induced changein the balance,b,
is accordingly equal to the income-induced changein real hoarding,
i.e.,the changein income,y, multiplied by the propensity to hoard,
1-c. The existenceof the businesscyclemakesit plausiblethat c
maybe greaterthanunity,thatan increasein incomemaystimulate
an evengreaterincrement in theabsorption ofgoodsand servicesinto
consumption and investment. Many of the currenttheoriesof the
businesscycledo dependon the assumption that c is greaterthan
unity. If c is equalto or greaterthan the
unity, foreign balancewillnot
be improved as a resultof theincreasedoutput.Undersuchcircum-
stances,the devaluationmightbe effective in stimulating recovery
butnotin improving theforeign balanceexceptpossiblythrough direct
effects,whichwillbe considered below.
At any rate,underconditions of unemployment, devaluationmay
be expectedto exerta favorableeffect on production and employment.
This factbecameevidentin thedevaluations ofthethirties, and was
recognizedeven beforethe promulgation of the Keynesiantheory,
4 Fritz Machlup, InternationalTrade and InternationalIncome
Multiplier
(Philadelphia,1943) and J. E. Meade, The Balance of Payments(London,1951).
268 INTERNATIONAL MONETARY FUND STAFF PAPERS

thoughnotin so systematic oranalytica framework.5 The competitive

ofthethirties
depreciations werelargelyassociatedwitha recognition
oftheincomeeffects ofa devaluation, a recognition
thatwas perhaps
dim and intuitiveon the part of manyof thoseresponsible forthe
butnevertheless
devaluations, clearenoughto motivatethosedevalua-
tions. Of course,to the extentthat the additionalexportsof the
devaluingcountry displacethoseof its competitors,thelevelsof pro-
ductionand incomein the competitor countrieswill be adversely
affected.Recognition of thisfact,as well as directbalanceof pay-
mentsconsiderations, mustlie behindthe oppositionto competitive
devaluationfroman international pointof view,as reflected in the
InternationalMonetaryFund'sArticlesof Agreement, I (iii).
Fromthepointofviewofa devaluingcountry thathas unemployed
the effect
resources, on income,as well as the favorableeffect on the
balanceof payments if c is less thanunity,mustconstitute themost
attractive
potentialityof a devaluation.If thecountry is at fullem-
ployment, thispotentialitydoesnotexistand theeffects ofa devalua-
tionmustdependonthemoretenuousand lessattractive directeffects
on absorption.6

Termsof tradeeffect
Anotherincomeeffectfrequently consideredas influencing the
foreignbalanceis thatof thetermsoftrade. It is usuallypresumed,
frequentlywithjustification,
thata devaluation willresultin a decline
ofexportpricesin foreigncurrency greaterthanthedeclineof import
pricesin foreign
currency. Thispresumption is basedon thefactthat
a country's are
exports usually more specializedthanits imports, so
thatthe priceof exportswill be muchmoresubjectto the influence
of devaluationthan will the priceof imports.Theremay be some
compensation, thoughprobablyonly to a minordegree,if imports
greatlyexceedexportspriorto the devaluation.Thus,if beforethe
5 See Seymour Harris, Exchange Depreciation (Cambridge,Massachusetts,
1936), especiallypages 6 and 7.
6See J. J. Polak and T. C. Chang, "Effectof Exchange Depreciationon a
Country'sExportPrice Level," StaffPapers,Vol. I, pp. 49-70(February1950) for
statisticalevidencethat,as far as effectiveness
in alteringexportpricesrelative
to those of competitiors is concerned,the effectsof a devaluationtend to be
muchstronger or inflation.However,Barend
in depressionthanin fullprosperity
de Vries,in an unpublishedpaper,foundthat therewas littledifference in the
competitiveprice effectsof importantdevaluationsas between the extreme
depressionperiod 1931-33and the recoveryyears 1935-36. Deflationin non-
devaluingcountriesin the earlierperiodtended somewhatto reducethe com-
petitiveadvantagesgainedby the devaluers,whilepresumably in the laterperiod
the rise of domesticpricesin the devaluingcountriesthemselvesalso tendedto
reducethe competitiveprice effectof the devaluation.
 EFFECTS OF A DEVALUATION ON A TRADE BALANCE 269
devaluation the countryconcernedwas importingtwice as much as
it was exporting, and if as a resultof the devaluationthe fall in foreign
prices exportsis 2 per cent and of imports1 per cent,the deficitin
of
foreigncurrencywould be unchangedif the physicalvalues of imports
and exportswere unchanged. It may, however,be assumed that the
normalresultof a devaluationwill be such a deteriorationof the terms
of trade of the devaluingcountryas to make the balance of payments
deteriorateby the amountt. That is, t is the measureof the reduction
of the country'sreal income associated with the deteriorationof the
termsof trade.
A fallaciousargument,frequently encountered, is that a deterioration
ofthe termsof tradeon accountof devaluationwill improvethe foreign
balance since it reducesthe real incomeof the countryand hence the
demandforimports.It is truethat the reducedincomeassociated with
a deterioration of the termsof tradewill reducethe demandforimports
as well as fordomesticgoods. Thus the declinein income,t, resulting
fromthe changedtermsof trade will induce a reductionof absorption
by the amountct, whichwill permitan equivalentimprovement in the
foreign balance partly through the direct reduction of imports included
in ct and partly throughthe eventual transferto the productionof
exports or of import substitutesof the resources formerlyused to
producethe domesticcomponentsof ct. The effectsof the deteriora-
tion of the terms of trade accordinglywill be, after resources are
transferred,an improvementof the amount, ct. But the entire
deterioration,t, of the national income as a result of the changed
termsof trade is initiallya reductionin the foreignbalance. That is,
the changeof the termsof trade initiallyimposesa reduction,t, in the
foreignbalance and thenhas the effectof stimulatingan improvement,
ct, so that the change in the balance associated with the initial terms
of trade effecton income,t, is t-ct or (l-c)t. This mighthave been
seen directlyfromequation (3). If t is negative,as assumed, and if
c is less than unity,then a deteriorationin the terms of trade also
impliesa deterioration in the foreignbalance. Only if c is greaterthan
unity will the adverse terms of trade effectimprovethe foreignbalance.
The aggregateincomeeffectsmay then be expressedas (1-c) multi-
plied by the change of income. That change of incomewill have two
components.One, presumablypositive,is the idle resourceseffect,i.e.,
the increased productionstimulatedby the devaluation. The other,
presumablynegative,is the effecton incomeof the changein the terms
of trade. The resultingchange in income,y, will induce a change in
absorption,cy, so that it will, accordingto equation (1), result in a
change of the foreignbalance equal to y-cy or (1-c)y.
270 INTERNATIONAL MONETARY FUND STAFF PAPERS

Direct Effecton Absorption

If thereis initiallyfullemployment, orifc is almostunityorgreater
thanunity,theprincipalfavorableinfluence of a devaluationon the
foreign balanceis through thedirecteffect on absorption.This direct
effectis largelyassociatedwitha tendency fora highor risingprice
levelto discourageconsumption or investment outof a givenlevelof
real income.It is important to recognizethatthiseffect is not con-
nectedwithanytendency forhigherpricesto forcea reduction ofcon-
sumptionor investment out of a givenmoneyincome.That would
be an effect through realincome, sinceifpricesgo up relativeto money
income, real income goes down. Exceptforthe termsof tradeeffect
on income,the real incomeof the devaluingcountryshouldnot be
expectedto decline;at fullemployment, moneyincomeand money
pricescan be expectedto movetogether.The directeffect on absorp-
tionis any influence towardlowerreal expenditure as moneyincome
and moneypricesrisetogether as a resultofthedevaluation.
In ordermostclearlyto illustrate thenatureoftheforcesbehindd,
the directeffect on absorption, certainassumptions whichimplythat
all othereffects are absentcan be made. Accordingly, assumethatthe
devaluingcountry is at full employment so that real income produced
cannotbe increasedas a resultof devaluation.Furthermore, assume
thattheforeign supplyofimports and theforeign demandforexports
are perfectly elastic,so thattheforeign currency pricesofimports and
exports, and hencethetermsoftrade,willbe unchanged.Thus there
willbe noincomeeffects, eitherthrough increased production orthrough
a changein thetermsoftrade.
The higherimportand exportpricesin domesticcurrency resulting
fromdevaluationwill initiallyinducean attemptby individualsand
enterprises inthedevaluing country to shifttheirdemandfromimports
to the home marketand to exportmore. The resultingincreased
demandforthe country'sproduction wouldtend to raise domestic
and
prices money incomes to thepoint where theincreased demandsare
chokedoffby the combinedoperationof the directabsorption effect
and the narrowing price differential betweenthe foreignand the
domesticmarkets.If therewereno directabsorption domestic
effect,
priceswouldcontinueto riseuntiltherewas no longerany tendency
to substitute domestic goodsforimports, orto tryto exportmore,and
therewouldbe no changeof the foreignbalance as a resultof the
devaluation.
The relationship involvedmay be illustrated by a crudeexample.
Suppose, under the assumedconditions of fullemployment and per-
fectlyelasticforeign supplyand demand,thatthereis a 10 per cent
 EFFECTS OF A DEVALUATION ON A TRADE BALANCE 271
devaluation and an elasticityof directabsorptionof 0.1. This would
mean that a 1 per cent increasein the generalprice level would induce
a 0.1 per cent reductionof absorptionat a given level of real income.
It may also be assumedthat the substitutability of domesticgoods for
in
imports consumption, and of resourcesas between the productionof
domesticgoods and exports,is such as to link the domesticprice level
to the pricesof foreigngoods by a factorof 0.5, so that the 10 per cent
increase of importand exportprices in domesticcurrencyleads to a
5 per centrise of the generaldomesticpricelevel. Then the devaluation
would lead to a reductionof absorptionby one-halfof one per cent of
total absorption.If importsfurnishabout 20 per cent of total absorp-
tion, the improvementof the foreignbalance would amount to 2?
per cent of imports.In termsof the conventionalanalysis,the inelas-
ticityof domesticsupply of exportsand of importsubstitutesreduces
the effectofthe devaluationin spiteof the perfectelasticitiesof foreign
supply and demand. At full employment,the elasticity of domestic
supply forimportsubstitutesand exportstaken togethermust be just
anotherway of expressingthe directabsorptioneffect.
It is frequentlytaken for grantedthat, even when the devaluing
countryis at full employment,a devaluation will lead to increased
exportsand reducedimports. If it does so, then clearly domesticab-
sorptionwill have been reduced. The questionto be exploredis why,
with a given real income,when moneyincomesand prices rise in the
same proportionthere should be a reductionof real consumptionor
investment.
The directabsorptioneffectcan be dividedintoa cash balance effect,
an income redistribution effect,a money illusion effect,and possibly
into other,miscellaneousdirectabsorptioneffects.

Cash balance effect

The cash balance effectis perhaps the best known of the direct
absorptioneffects.If the money supply is inflexible,and if money-
holdersdesire to maintain cash holdingsof a certainreal value, they
must, as prices rise, accumulate more cash. This will require a re-
duction in their real expendituresrelative to their real incomes. It
mightbe possible for any individualto increase his cash holdingsby
selling other assets, but this is clearly impossiblefor the countryas
a whole as long as the bankingsystemor governmentdoes not create
more money,except to the extentthat goods or servicesmay be sold
abroad and the domestic money supply therebyincreased. Capital
movementsare ruled out here; if theywere allowed theymightchange
or eliminatethe cash balance effect.
272 INTERNATIONAL MONETARY FUND STAFF PAPERS

One result of the attemptto maintain real cash balances by in-

creasingtheirmoneyamountswhile prices rise may be to drive down
the prices of assets, i.e., to increasethe rate of interest.This in turn
mighthave some effecton real consumptionor investmentrelativeto
real income: thus the cash balance effectmay operate directlyon the
income-expenditure relationshipthroughthe foregoingof expenditure
in orderto build up cash, or indirectlythroughthe rate of interestas
the result of an attemptto shiftfromotherassets into cash-an at-
temptthat can be discouragedonly by a rise in the rate of interest.
Clearly,one of the mostimportantcomponentsof the directabsorption
effectwould be the cash balance effect.A hypotheticalexampleapplied
to the United Kingdommay illustratethe possible magnitudeof that
effect.Suppose that in the United Kingdomthe total moneysupplyis
?5 billion,and that a devaluationraises domesticpricesby 5 per cent
and thus cuts the real value of cash balances by about 5 per cent or
?250 million. Suppose that cash balances were previouslyin adjust-
mentwith the level of real incomes,and that for each ?10 that they
are out of adjustmentthere is a cut of expenditureof ?1 to rebuild
them. There would then be a cash balance effect(ignoringany re-
percussionsthroughthe rate of interestand assumingno change in
real income) of about ?25 millionper year on absorption,and therefore
on the foreignbalance.
It is possiblethat the reductionof absorptionon accountof the cash
balance effect,or of the other direct absorption effects,might be
directedtoward certaindomesticgoods and services,fromwhose pro-
ductionit is not easy to transferresourcesto the productionof exports
or import substitutes; therefore,some unemploymentmight result.
The results of this unemploymentmightthen be traced throughout
the economy. If c is less than one, the net resultof this adverse effect
on income producedwould be a deteriorationof the foreignbalance
which would tend to counteractthe improvementfrom the direct
absorptioneffects.
It is pointedout below that,beforeany of the analysis of this paper
is applied to a practical case, it is necessaryto abandon the over-
simplificationhere adopted and to recognizethat y, a, p, and c are
sets of quantities,i.e.,that theymustbe regardedas vectorsormatrices.
The economiccontentof this fact is that it will make a difference, in
view of immobilityof resourcesand otherimperfections, in what sector
of the economy a particular reductionof absorption,or change of
income,takes place.
 EFFECTS OF A DEVALUATION ON A TRADE BALANCE 273
Redistribution ofincome
The redistribution of incomeeffectis also well recognized.There
may be a of
longlag wagesbehindprices,and profits mighttherefore
gain at the expenseof wagesas a resultof the devaluation.Rising
priceswill transfer incomefromfixedmoneyincomegroupsto the
restof the economy.Taxes, at least in advancedcountries, can be
expectedto take a largershareof a givenreal incomewhentheprice
level is higher.To the extentthatincomeis shiftedfromthosewith
a highmarginalpropensity to absorbto thosewitha low propensity,
the foreign balancewill be improved by the devaluation.It mustbe
remembered, however, thatabsorption includesbothconsumption and
investment, so thatit is byno meanscertainthata shiftto profits
will
lead to reducedabsorption.Although theproportionofanyincrement
of incomeconsumedby the profitrecipient may be smallerthanthe
proportion consumedby the wage earner,the higherprofitsmay
stimulateinvestment demand. The government can, in advanced
countries, be
usually expected to have a low marginalpropensity to
absorb,so thatthetax shiftmightbe a significant factorinfluencing
therelationship of absorption to income,and so affectingthe foreign
balance.

Moneyillusion
The moneyillusionmaycontribute a favorableeffect
to a devalua-
tionif it actuallyleads peopleto pay moreattentionto moneyprices
thanto moneyincomes.If at higherpricespeoplechooseto buyand
consumeless eventhoughtheirmoneyincomehas increasedin pro-
portion,overand above whatcan be attributed to the cash balance
the resulton the balanceof paymentswill be favorable.But
effect,
risingmoneyincomesand risingpricesmay actuallyoperatein the
oppositemanner;forexample,annualsavingsmay be calculatedin
moneytermsand mayfailto risein proportion to moneyincomesand
prices.

Miscellaneous
directabsorption
effects
Theremaybe otherdirectabsorption someworking
effects, toward
a favorable,otherstowardan unfavorable, changein theforeign bal-
ance. Expectationsofpricerisesmaybe inspired, leadingto increased
absorptionwithadverseeffects on the foreign
balance,at least in the
shortrun. If investmentgoodscomelargelyfromabroad,investment
maybe muchless attractive afterthedevaluation thanbeforebecause
oftherisein thedomestic priceofinvestment goods,providedno close
274 INTERNATIONAL MONETARY FUND STAFF PAPERS

substitutesare produceddomestically.More generally,the goods im-

portedmay be such that when the domesticprices rise, the domestic
purchaserscut theirexpenditureson those goods but save or hoard the
difference, rather than shift the expendituresto other goods. The
importanceof such a tendencyin any actual case is open to doubt,but
it is a theoreticalpossibility.

Impermanenceand non-proportionality
of effects
Many of the directabsorptioneffectsmay be transitory.Thus the
moneysupplymay respondto the increaseddemandforcash balances,
so that the cash balance effectmay graduallydisappear or be counter-
balanced by additional absorptionfinancedby credit creation. Sim-
ilarly,some of the income-distribution effectsare associated with lags,
but the lagged income may eventually catch up, e.g., wages may
eventuallyrise to restorethe predevaluationwage-profitrelationship.
Other effectsdepend on dynamic movements,on risingprices rather
than on highprices. As the rise in prices comesto a halt, these effects
will tend to disappear.
Furthermore, some of the effectsmay be non-proportional.A small
devaluation may take advantage of the money illusion,or of wage
inertia; a large devaluationmay shatterthe moneyillusion,or impart
a dynamicmomentumto the wage inertia,or lead to modificationsof
tax rates, etc.
In general,then,many of the effectsof a devaluationon the balance
of paymentsthroughthe directabsorptioneffectsmay be expectedto
be transitoryand non-proportional.It does not necessarilyfollowthat,
in the absence of unemployment, a devaluation cannot have a strong
influenceon the balance of payments; that depends on the strength
of the various effectsdiscussedabove. The author'simpression,how-
ever, is that in many cases, in which the question of devaluation is
likelyto become a live issue underconditionsof full employment, the
favorabledirectabsorptioneffectsare likelyto be weak. It would seem
to be much more effectiveto operate on absorptiondirectlythrough
monetaryand credit policy-limitation of governmentexpenditures,
of privateinvestmentand, possibly,of privateconsumption-provided
these can be broughtto bear on the foreignbalance withoutadversely
affectingincomeand employment.They must,of course,"adversely"
affectabsorption,since, at full employment, it is possible to improve
the foreignbalance only throughreducingabsorption.7
This practical conclusionis not, however,the main conclusionof
this paper. The main conclusionis that the most fruitfulapproach to
7 Theoretically it is also possible through improving the terms of trade as well.
 EFFECTS OF A DEVALUATION ON A TRADE BALANCE 275
the general problemof obtaininga satisfactoryforeignbalance, and
in particular of appraising the effectson the foreignbalance of a
devaluation,is via the analysis of the income-absorptionrelationship.
It is theoreticallypossible to obtain the same answers in terms of
supply and demand elasticities,but one is more likely to be misled.
It seems morein accord withthe realitiesof the situationto recognize
that, if the foreignbalance is to be improved,the communityas a
whole must reduce its absorptionof goods and servicesrelative to its
income. The inquirycan then best followthe line of askingwho is to
cut his absorptionrelativeto his income,or what is to be the shiftof
incomefromthosewho,on the margin,absorbmoreto thosewhoabsorb
less. Supply and demandconditions,in the sense of partial elasticities,
may be useful tools in this analysis. But the total elasticities,for
which the conventionalformulasalone are valid, are not only poor
tools; they may mislead,or at least obscurethe analysis.

Devaluation Compared with Other Methods

If an improvement of the foreignbalance is required,it may possibly
be achieved eitherthrougha devaluationor throughsome othermethod
of reducingabsorptionrelativeto production.The generalalternative
to devaluationis sometimesreferredto as deflation,but that termhas
a narrowerconnotationthan it is desirableto give to the alternatives
to devaluation. These alternatives,whichmay forbrevitybe referred
to as disabsorption,may be characterizedas the discouragementof
absorptionrelativeto incomeby means otherthan devaluation. Dis-
absorptionmay be attained throughmonetarypolicy, as forexample,
by discouraginginvestmentand consumptionthroughtighteningcredit.
It may be achieved by directcontrols,such as investmentlicensingor
rationing of consumersgoods. It may be applied over the whole
economy,as in the formof a sales tax or incometax, or in selected
spheres,as in the formof investmentlicensingor importcontrols.The
means to disabsorptionare many and varied, but they may all be
characterizedas domesticmeasurescalculated to change the relation-
ship of absorptionto income,and hence to affectthe foreignbalance.
An analysis of the relative advantages,fromthe point of view of a
single country,of devaluation and trade restrictionshas been pre-
sented elsewhere.8That analysis is appropriateonly to conditionsof
full employment.It can be extendedto any otherdomesticmeasure
forachievinga given balance of trade at full employment.Measures
tendingto reduce importsare of benefitto the countryconcernedas
8 See
Sidney S. Alexander, "Devaluation Versus Import Restriction as an
Instrumentfor Improving Foreign Trade Balance," StaffPapers, Vol. I, pp. 379-96
(April 1951).
276 INTERNATIONAL MONETARY FUND STAFF PAPERS

longas therelativedomestic welfarevalue ofimportgoodsrelativeto

exportgoods does not exceed themarginal termsoftrade,i.e.,therate
at whichexportgoodscan be exchanged forimport goodsat themargin
on foreignmarkets, accountbeingtakenofanytendency fortheprices
of exportsto fallrelativeto importsas moreexportsare offered and
imports demanded.
When consideration is givento measuresto improvethe foreign
balance underconditionsof widespreadunemployment, the above
criterionmustbe so modifiedas to be abandonedforall practical
purposes.That criterion is based on theproposition that,if themar-
ginalrateofexchangeof exportgoodsforimportgoodsin theforeign
marketis less favorablethantheirdomesticwelfarevalues,it would
pay to cut back on importsand thusgain a greaterwelfarevalue in
theexportgoodssavedforthedomestic economy.But iftheresources
usedto makethoseexportgoodswould,underthoseconditions, become
unemployed, then there would be no gain from the restrictionbut
rathera considerable loss. It is generally recognized thatundercon-
ditionsof widespreadunemployment a domesticexpansionpolicyis
appropriate. Anyadverseeffects on theforeign balancecan,exceptin
extreme casesofinelasticity offoreign demandandsupply, be appropri-
ately handled by devaluation rather than by disabsorption undersuch
circumstances. Disabsorptionbecomesan attractivepolicyonly as
fullemployment is approached.
If disabsorptionofa generalnature,saythrough a broaddeflationary
policy,shouldlead fromfullemployment to the idlenessof certain
resources whichcannotbe expected to be transferred to theproduction
of exportsor importsubstitutes, it is to thatextentundesirable.It is
well recognized that whendeflation leads to unemployment it is an
undesirable measureforimproving theforeign balance. Othermeans,
such as importrestriction or devaluation,would be preferable.In
actual practice,therefore, the choicebetweendevaluationand dis-
absorption willbe affected notonlyby theconsiderations oftheterms
oftradeon whichthe above criterion is based,butmoreimmediately
by considerations of othereffects of any particularmeasureon the
domesticeconomy.Considerations of thedesirability of theresulting
changesin thedistribution ofincomeas amongindividuals are ignored
here,althoughin practicetheseconsiderations maybe important and
sometimes governing. Oneofthemostimportant effects ofanymeasure
to improve theforeign balanceis theinfluence it has on production as
wellas on absorption.
In theanalysisbothofdevaluationand of disabsorption, theissues
turnlargelyon the pricerigiditiesand generalinflexibilities of the
economy.A satisfactory analysisof the problemsdependson the
 EFFECTS OF A DEVALUATION ON A TRADE BALANCE 277
identification and the appraisal of these inflexibilities.This is strictly
analogous to the familiarquestionof whether,forstimulatingemploy-
ment,a reductionof wages can be as effectiveas an increasein aggre-
gate monetarydemand. That question hinges on whetherthe supply
of labor is related to real wages or to moneywages; that is, whether
the effectof a givenchangein real wages that comes froma reduction
ofthe generalpricelevel differs fromthatwhichcomesfroman increase
in moneywages.
Similarly,in evaluatingvarious measureslikelyto affectthe balance
of payments,an identificationof the rigiditiesand inflexibilitiesis
vital to the conclusions.Thus, in the foregoingtheoryno attemptwas
made to distinguishbetweenthose componentsof a reductionin total
absorption,a, whichactually provideadditionalexportsor importsub-
stitutesand those whichdo not. This constitutedan implicitassump-
tion that the resourcesfreedby a reductionin absorptionanywherein
the economycould be applied anywhereelse, and in particularto the
productionof exportsor importsubstitutes.It is, accordingly,neces-
sary in any actual case to deal witha farmorecomplicatedset of com-
ponentsof the quantities,such as income and absorption,than have
been used in this discussion. It must firstbe ascertainedwhetherthe
contemplatedmeasurewill actually bringabout the desireddisabsorp-
tion and whetherthere may not merelybe a shift of absorptionto
otherobjects,e.g.,to clothingif foodis rationed. It is further necessary
to considerwhetherthe resourcesto be set freeby any contemplated
disabsorptionwill in fact findtheirway into the productionof exports
or importsubstitutes.Thus what is requiredis a highlydetailedanaly-
sis of the locus of impact of the contemplatedmeasureand the nature
of the adjustmentsin absorptionand in productionthat will conse-
quently be made.
Even where some form of disabsorption-for example, restriction
of investmentsthroughlicensing-can be achieved in such a manner
that the investmentgoods can then be exported,the choice between
that measure and devaluation must depend on whetherthe economy
can spare the investmentgoods betterthan the different set of goods
that would be foregoneas the resultof a devaluation or a restriction
on imports.At this level of generality,it is possibleto distinguishbe-
tweentwo importantlines of inquirythat must be followedin evalu-
ating the relative meritsof various possible measuresto improvethe
balance of payments. The firstconcernsthe effectson income,the
second the relativewelfarevalue of the absorptionthat mustbe fore-
gone. These two considerationsmust be appraised jointly. Thus, for
example,an importrestriction may not reduceincomeat all but merely
change the level of absorptionin the countryconcerned. A devalua-
278 INTERNATIONAL MONETARY FUND STAFF PAPERS

tionat fullemployment that achievedan equal improvement in the

foreign balance might have a tendency to reduce the real income by
the termsof trade effect.Importsmay,however,have a domestic
welfarevalue sufficiently
above thatof exportsso thatthe reduction
in realincomeassociatedwitha moredesirablecomposition ofabsorp-
tionis preferableto thehigherrealincomebutlessdesirablecomposi-
tion of absorptionassociatedwithimportrestrictions. This paradox
containsan implicitcriticismofthemeasureofrealincomeusedhere;
it impliesthata lowerreal incomecan have a higherwelfarevalue.
The paradoxcouldbe eliminated by an improved methodofmeasuring
real income,but the fundamental principleremains.In evaluating
alternativemeasuresforimproving thebalanceofpayments, thefinal
criterionmustbe thewelfarevalue ofthegoodsand servicesabsorbed
at the givenbalanceof paymentsto be achieved.This will depend
not onlyon the level of employment and production but also on the
composition of that production,and on the level and composition of
trade.