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Chapter 8 ExchangeRate Management: Contractionary Devaluation and RealExchangeRate Rules. © PierreRichard Agénor and Peter J. Montiel. Contractionary Devaluation. RealExchangeRate Targeting. Contractionary Devaluation.
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Chapter 8ExchangeRate Management: Contractionary Devaluation and RealExchangeRate Rules
© PierreRichard Agénor and Peter J. Montiel
Consider a small open economy that operates under a fixedexchangerate system.
PT = EPT*,
PT: domesticcurrency price of traded goods;
E: nominal exchange rate;
PT*: foreigncurrency price of traded goods (unity).
Aggregate real demand for nontraded goods:
dN = cN + IN + gN,
cN: domestic consumption;
IN: investment;
gN: government demand.
cN = cN(z, y  tax, i  a, a; ).
z = PT/PN: real exchange rate (PN is domesticcurrency price of nontraded goods);
y  tax: real factor income received by households net of real taxes;
a: real household financial wealth;
i  a: real interest rate (i is domestic nominal interest rate and a expected inflation rate);
: shift parameter to capture distributional effects on aggregate consumption.
(1)
Relative Price Effects:
Real depreciation of the domestic currency (increase in relative price of traded to nontraded goods) increases demand for nontraded goods.
P = EP1  , 0 < < 1,
: share of traded goods in consumption.
(2)
N
y = yNz  + yTz1  ,
yN: production of nontraded goods;
yT: production of traded goods.
dy/dz = z1()(yNz+yTz1  ).
= zyT/(yN+zyT).
(3)
(4)
(4): impact effect on real income depends on whether traded goods have a higher share in consumption or in income.
Demand for nontraded goods may increase because of a higher level of output of traded goods.
Effects Through Imported Inputs:
Two opposing effects of a real devaluation on the real value of imported inputs:
If the price of labor does not increase by the full amount of devaluation, relative price of imported inputs raises.
Assumptions:
Nontraded goods are produced with an imported input and labor according to a CES production function with elasticity of substitution .
Lizondo and Montiel (1989):
zJN[  (1)],
JN: volume of imported intermediate goods used in the nontradable sector.
Net effect is more likely to be negative
Income Redistribution Effects:
Alexander (1952):
Díaz Alejandro (1963); Krugman and Taylor (1978):
Example of other type of income redistribution effect between workers and owners of capital:
How important is the effect on the demand for domestic output of redistribution from wages to profits?
Alexander (1952):
Díaz Alejandro (1963):
Since investment expenditure is undertaken by profit recipients, the demand for domestically produced goods declines.
How important is the redistribution of income that will lead to a change in the pattern of aggregate expenditure?
Edwards (1989b):
Effects Through Changes in Real Tax Revenue:
Krugman and Taylor (1978):
This depends on the presence of ad valorem rather than specific taxes on foreign trade.
OliveraTanzi effect:
Third channel works through discretionary tax changes:
Government's real tax receipts:
Tr = Tr(z, , ),
: parameter that captures the effects of discretionary taxes;
: inflation rate.
+

+
Government's budget constraint takes the form
Tr(z, , )
gN z  + gTz1  + i*z1  Fg – z1 (Lg/E+Fg)
gT and gN: government spending on traded and nontraded goods;
i*: foreign nominal interest rate;
Fg: net public external debt;
Lg: stock of net government liabilities to the central bank.
(7)
.
.
Effect of an increase in real trade taxes on aggregate demand will depend on the nature of this offset.
Implications of public external debt:
Reason: private disposable income would fall. Reason: private disposable income would fall.
Example: reduction in discretionary taxes may ensue with corresponding expansionary effects on aggregate demand.
.
.
If real valuation gains on the central bank's stock of foreign exchange reserves are passed along to the government, Lg/P could increase.
.
Alexander (1952):
Two effects of this reduction:
Indirect effect, when individuals try to shift their portfolios from other assets into money, thus driving up domestic interest rate.
a = (M/P) + (EFp/P) = z1  [(M/E) + Fp).
Percentage change in real wealth from nominal devaluation:
a = (1)z  ,
: share of domestic money in private sector wealth and
: devaluation rate.
Implications:
^
^
Reason: although real value of domestic money declines, real value of foreign assets increases if domestic price level does not rise by the full amount of devaluation.
^
PKT = NPN+ TE,
PKN = NPN+ TE.
T
T
N
N
(10)
T
T
(11)
N
N
Output in each sector is produced by using capital, labor, and imported inputs.
mK = FK(/E; KT),
mK = FK(/PN, z; KN),
: nominal exchange rate.


T
T



N
N
T
{
^
}
 1
KT =
qT
i +  KT
PNmK/PKN
T
{
^
}
 1
KN =
qN
i +  KN
Kh: rate of increase in the price of capital in sector h.
Net investment demand in each sector depends on the ratio of the marginal product of capital to the real interest rate.
IN = IN + IN = NKTKT + (NKT + NKN) + NKNKN.
^
^
T
N
T
T
N
N
(16)
Branson (1986) and Buffie (1986b):
Second channel through which devaluation affects the investment demand for nontraded goods operates through real profits.
van Wijnbergen (1986), Branson (1986), and Risager (1988):
Risager examined the effect on investment of holding the nominal wage constant over some fixed initial contract length and then restoring the initial real wage.
With some nominal wage flexibility, nominal devaluation results in
Reason: depressing effect on profits in the nontraded goods sector is not offset by positive effects on profits in the sector producing traded goods.

+
(
+
)
+
M + EFp
h
i, i* + a, y, ; x
(17)
= 0,
P
h(·): real excess demand function for loans;
i: nominal interest rate on loans;
i* + a: nominal rate of return on foreign assets;
i*: foreign nominal interest rate;
a: expected rate of depreciation of domestic currency;
y: real income;
(M+EFp)/P: real household financial wealth;
x: vector of additional variables.
Increase in i has a negative ownprice effect on excess loan demand.
Effect of a devaluation on i at a given initial level of y and PN with a = 0:
In this case, (M+EFp)/P falls, real excess demand for loans increases, and i rises.
van Wijnbergen (1986):
Buffie (1984a):
When the partial derivative hi, evaluated at i* + a, approaches negative infinity, domestic loans and foreign assets become perfect substitutes.
i = i* + a.
Effects of anticipated future devaluation.
Imperfect substitutability:
If the ownprice effect hi exceeds the crossprice effect hi* + , increase is lower than the anticipated devaluation.
Perfect substitutability:
a
These effects can be captured by defining x:
x = x(w, E, PN).
+

+
Because unanticipated current devaluation increases w, real excess demand for loans rises, putting upward pressure on i.
nd = n0  d1(we)  d2(wpN)  d3(epN),
= n  (d1 + d2)(w  e)  (d2 + d3)z,
n0, d1, d2, and d3 are positive parameters.
(20)
Increase in the product wage measured in terms of traded goods reduces the demand for labor in the traded goods sector by
d3: effect on demand for labor in nontraded goods sector of an increase in price of imported inputs;
Aggregate supply: current nominal wage is given by
w = w + s1(n–n0) + s2pa + s3(p–pa)
= w + s1(n–n0) + s3e – s3(1)e
+ (s2–s3)[ea – (1)za],
w, s1, s2, and s3 are positive parameters.
~
~
(21)
~
Special cases derived from Equation (21):
Phillips curve is derived with s2 = s3 = 0.
Substituting (20) in (21), equilibrium nominal wage:
1  + 23
s3 + 12

w = ea 
za +
(e – ea)
1 + 12
1 + 12
(22)
s3(1) + 23
(zza),
1 + 12
12 = s1(d1+d2), and 23= s1(d2+d3).
Observations in assessing effects on the nominal wage of an exchangerate depreciation:
w = ea 
ea +
1 + 12
(23)
s3 + s1(d1–d3)

(e – ea)
1 + 12
If d3 > d1, effects of both an anticipated and an unanticipated devaluation could be negative.
elasticity of substitution of labor for imported inputs in that sector is small.
Assumptions:
Share of labor in value added is denoted by .
N = J + ww + kr,
: percentage of the nominal devaluation;
w: exogenous increase in nominal wages;
r: endogenous increase in the return of capital.
^
^
(24)
^
^
Since labor and capital are combined according to a CobbDouglas production function and capital is constant,
r = w + n.
n = J{w + J[(1) + ]}1(w),
r = w + J{w + J[(1) + ]}1(w).
^
^
^
^
^
^
^
^
(25)
^
^
^
^
^
N =  (1J){(1J) + (1) + }1(w).
^
^
If w increase by the full amount of the devaluation, supply curve shifts upward by the same percentage as the exchange rate.
If CES function were assumed for the production of value added, when w < , increase in supply price would be larger the lower the elasticity of substitution between labor and capital.
^
Effects Through Costs of Working Capital
Assumptions:
Representative firm's profits:
N = PNyN(nN, ON)  nN – EON – iPNhn(·)
+ iPNho(·).
dyN/dnN = N[1 + ihn (·)],
dyN/dON = z[1 + iho (·)].
NnN
NnN
These equations can be solved for labor and imported input demand functions:
nN = nN(N, z, i),
ON = ON(N, z, i).
yN = yN(N, z, i).
?


d
d
?


d
d



(32)
s
s
yT = yT(T, i),
where T = w/E.
CavalloPatman effect:


(33)
s
s
shifts the output supply curve upward.
Effect of working capital costs on the elasticitiesof (32) and (33) curves.
Four alternative empirical approaches to analyze contractionary effects of devaluation:
Díaz Alejandro's (1965):
Cooper (1971):
Killick, Malik, and Manuel (1992):
Kamin (1988):
Statistical tests for significance of changes over time for each economic indicator for both
Edwards (1989b):
Donovan (1981):
Reductions in GDP growth were registered only for those programs aimed at import restraint.
Donovan (1982):
Gylfason (1987):
Sheehey (1986):
Edwards (1986):
Estimates model of real output behavior.
Edwards (1989b):
Anticipated depreciation of real exchange rate:
Unanticipated devaluation:
This implies an unanticipated increase in prices, which stimulates aggregate supply.
Kamin (1988):
Devaluations associated with other stabilization policies, but they are also large, isolated events that occur only sporadically.
Gylfason and Schmid (1983):
Gylfason and Risager (1984):
While devaluation is expansionary in developed economies, it is contractionary in developing countries.
Solimano (1986):
Branson (1986):
Uses twosector model with sticky prices, wage indexing, and imported intermediate goods.
Roca and Priale (1987):
Kamas (1992):
Distingished traditional and nontraditional exports.
Limitations of beforeafter approach:
Limitations of control group approach:
Limitations of simulation approach:
Limitations of econometric studies:
Households allocate a constant fraction of their total expenditures to each of the two goods in every period.
Real household financial wealth in terms of importables (a) consists of
Under fixed nominal exchange rates, this implies that domestic nominal interest rate (real rate r plus rate of inflation ) is equal to the foreign interest rate.
^
^
Private wealth accumulation measured in terms of importables is equal to
a = y   c(y  , i* + z, za) + i*a
– (i*+)md(y, i* + ),
md(·): real demand for money;
: devaluation rate.
.
^
(34)
Government is assumed to consume the same two goods and to finance its expenditures
Current account of the balance of payments will be equal to private saving.
yN(, z) = z1  c(y  , i* + z, za) + gN,
yN(·): supply function for nontraded goods;
gN: exogenous level of government consumption of such goods.
.
^
s
(35)
s
(34) and (35) together determine paths of real exchange rate and real wealth.
.
^
Targeting the Real Exchange Rate
So internal balance is maintained by changes in the aggregate price level.
y()   c[y(), a; i*] + i*a – (i*+)md(·) = 0,
yN()  c[y(), a; i*] – gN = 0.
.
(36)
(37)
Implication: real shocks have consequences for the equilibrium domestic inflation rate under realexchangerate targeting.
.
Figure 8.1: determination of equilibrium.
.
^
.
Effects of Macroeconomic Shocks
Effects of an improvement in terms of trade (increase in ):
.
Improvement in terms of trade raises real product wage in the home goods sector and causes reduction in the supply of nontradable goods.
With domestic credit and foreign assets being perfect substitutes, a reduction in stock of credit would be offset by private sector through reduction of its rate of accumulation of foreign assets.