Daz Alejandro Deva Contrac

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A Note on the Impact of Devaluation and the Redistributive EffectAuthor(s): Carlos F. Daz AlejandroSource: The Journal of Political Economy, Vol. 71, No. 6 (Dec., 1963), pp. 577-580Published by: The University of Chicago PressStable URL: http://www.jstor.org/stable/1828441

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A NOTE ON THE IMPACT OF DEVALUATION ANDTHE REDISTRIBUTIVE EFFECT'

CARLOS F. D]AZ ALEJANDROYale University

IIT HAS become ustomaryn the theoreticalliterature dealing with the impact of de-valuation on the trade balanceto distinguishtwo stages of such an impact: the initialeffect and the reversaleffect.2The sign andsize of the first effect will be determined bythe price elasticities of demand and supplyof imports and exports.3Whilethe first effectdepends on changes in relative prices, thereversaleffect depends mainly on the incomemechanism and tends to offset the originalimpact of the devaluation on the trade bal-ance. Although the initial and reversaleffects arise from static models, a time se-

II would like to thank Professors Charles P.Kindleberger, of the Massachusetts Institute ofTechnology, and George L. Perry, of the Universityof Minnesota, for their helpful comments. I am alsoindebted to the referee of this Journal who read anearlier version of the note and suggested a usefulstreamlining of the argument.

2 See, for example, S. S. Alexander, Effects of aDevaluation: A Simplified Synthesis of Elasticitiesand Absorption Approaches, American EconomicReview, XLIX (1959), 22-42. For a prenatal mar-riage of the elasticities and absorption approachessee A. C. Harberger, Currency Depreciation, In-come, and the Balance of Trade, Journal of Polit-ical Economy, LVIII (1950), 47-60. Policy-orientedmodels of devaluation have been more fully devel-oped by J. E. Meade and J. Tinbergen. See Meade,The Theory of International EconomicPolicy, Vol. I:The Balance of Payments (London: Oxford Univer-sity Press, 1951); and Tinbergen, On the Theory ofEconomic Policy (Amsterdam: North-Holland Pub-lishing Co., 1952).

3 Plus the Laursen-Metzler effect, if any. SeeS. Laursen and L. A. Metzler, Flexible ExchangeRates and the Theory of Employment, Review ofEconomics and Statistics, XXXII (1950), 281-300;also A. C. Harberger, op. cit. A complete analysiswould also take into account a possible de-stockingeffect. See H. G. Johnson, International Trade andEconomic Growth(Cambridge, Mass.: Harvard Uni-versity Press, 1961), chap. vi.

quence is suggested by their names andnature, with the reversal effect coming intoplay only after the first effect has takenplace. A further implication is that a suc-cessful first effect will tend to increase realdomestic output by stimulating the produc-tion of exports and import competing goods.Through the multiplier such expansionarystimulus will spread to other sectors of theeconomy. As long as the reversal effect doesnot fully offset the initial effect, a successfuldevaluation will be associated with both anexpansionarypressureon output and an im-provement in the balance of trade. On theother hand, a devaluation yielding a nega-tive initial effect (a worseningof the tradebalance)will result in a decreaseof domesticoutput. An observer of devaluations in thereal world may thus be puzzled to find sev-eral devaluations that have resultedin quickimprovements in the balance of trade andwere accompaniedby decreases in the levelof total output in those economies. It couldbe arguedthat thedecrease noutput was duesimply to deflationary fiscal and monetarymeasures adopted simultaneously with thedevaluation of the exchange rate. However,it may be of interest to investigate whetherat least part of the decreases in output maybe explained solely as a directresult of thedevaluation.This note shows that the apparent para-dox of a devaluation leading to an improve-ment in the trade balance and a decreaseindomesticoutput can be explained by a redis-tributive effect caused by the devaluation.This redistributiveeffect is likely to precedethe initial, or relative, price effect. Evenelasticity optimists do not expect priceelasticities to be very high in the short runand rely on such devices as short-termcap-ital movements to fill the gap between the

577


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578 CARLOS F. DIAZ ALEJANDROtime a devaluation takes place and the timewhen the balance of trade will respond fa-vorably to the change in relative prices in-duced by the devaluation. In many casesthe redistributive effect may be a morepowerful and speedy mechanism in fillingthis gap.It is well known that a devaluation mayhave a redistributiveeffect,4 but the impor-tance and timing of it has received littleemphasisin the literature. I suspect that thetheoretical point raised here may prove im-portant in any attempt to fit the empiricalanalysis of recent devaluations in semi-in-dustrializedeconomies into accepteddevalu-ation theories and models.

IIFor the purposes of this note it will besufficient to examine the relatively simplecase of a small country facedwith a perfectlyelasticdemand for its exportsand a perfectlyelastic supply of its imports, both in termsof foreign currency units. Let us originallyconsider three goods: importables (M), ex-portables (X), and the homegood (H), whichdoes not enter into international trade. Be-cause we have assumed that the terms oftrade for our country are set exogenously,it is legitimate to lump exportablesand im-portables into a single Hicksian compositegood,' which we may call the foreign good,(F).Severalassumptions regardingthe domes-tic supply schedules could be made. To em-4One of S. S. Alexander's direct effects of de-

valuation was the redistributive effect. See his Ef-fects of a Devaluation on a Trade Balance, Inter-national Monetary Fund Staff Papers, II (1951-52),263-79; see also J. Spraos, Stability in a ClosedEconomy and in the Foreign Exchange Market, andthe Redistributive Effect of Price Changes, Reviewof Economic Studies, XXIV (1956-57), 161-76. Apioneering but unpublished 1948 paper by J. J.Polak (prepared in consultation with I. S. Friedman,W. R. Gardner, J. Marquez, and Felipe Pazos), De-preciation To Meet a Situation of Overinvestment,outlined not only the absorption approach but a re-distributive effect as well. E. M. Bernstein refers tothe Polak paper and to the redistributive effect inhis article, Strategic Factors in Balance of Pay-ments Adjustment, International Monetary FundStaff Papers, V (1956), 159.

phasize the redistributive effect it will beassumed that the domestic supply schedulefor the output of F is perfectly elastic fordownward movements of output and per-fectly inelastic for increases in output, atleast in the short run. Assume that thesupply schedule for H is perfectly elastic.The supply schedules are both perfectlyelasticwith respectto downwardmovementsof prices due to the rigidity of money wagerates (an assumption which will be intro-duced below).Thus, decreases n the demandfor H will result in a lower level of outputand higherunemployment,but no change inthe price of H. The domestic price of F willbe solely determined by its foreignprice andthe exchangerate. These assumptionsimplythat there are idle resourceswhich even inthe short run can be put to work produc-tively in the H-industry, althoughthis is notpossible in the case of the F-industry be-cause of the nature of its production func-tion. If some elasticity were allowed to thedomestic production of F with respect toincreasesin its price, a decreasein domesticoutput following a devaluation would be-come less likely.Our country can be divided into two so-cial classes: wage earners and capitalists.Each class will be assumed to be composedof individuals of identical tastes, who con-sume both H and F and save part of theirincome. Total money wages and profits willbe determined by the total output produceddomestically and by the money wage rate,assumedto be the samein both H- and F-in-dustries and constant, at least in the shortrun.Under these assumptions we can now

I See J. R. Hicks, Value and Capital (2d ed. Ox-ford: Clarendon Press, 1946). A collection of phys-ical things can always be treated as if they weredivisible into units of a single commodity so long astheir relative prices can be assumed to be unchanged,in the particular problem in hand (p. 33). The tra-ditional use in the literature of two-good models in-cluding only imports and exports has led to an ex-aggerated emphasis on the analysis of the impact ofdevaluation on the terms of trade, while neglectingthe more basic relations between the price of thehome good and the domestic prices of imports andexports.


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IMPACT OF DEVALUATION AND REDISTRIBUTIVE EFFECT 579show that following a devaluation the bal-ance of trade may improve while total do-mestic output falls. To simplify the analysis,we shall deal only with the impact effect ofdevaluation without working out the fullsolution of the model.Let

F8= total initiallocal production f FF= initialconsumption f F by capitalistsFw= initialconsumption f F by workersmfc= marginalpropensityof capitalists oconsumeF

m = marginalpropensityof workers o con-sumeF

mh, = marginalpropensityof capitalists oconsumeHmhw = marginalpropensityof workers o con-sumeHso = 1-mh-MfcsW = -mhw-mfwEhf = cross-elasticityof demandfor H withrespect o the priceof F, includingonlythepuresubstitution ffect.Forthesakeof simplicity,this substitutioneffect isassumed o be the samefor workers ndcapitalists.

It will be assumedthat by an appropriatechoice of units we originally set all pricesequal to one and that the rest of the worldadjusts passively to the changes in the bal-ance of trade of our small country.Devaluation will raise the price of F indomestic currency,pf, in proportion to theincrease in the price of foreign currency.Thus, the impact effect of devaluation willresult in an increase of the real income ofcapitalistsof (F8 - Fc)dpfand a decreaseinthe real income of workers by the amountFW,,df, ince the money wage rate is un-changed.The impact of the devaluation on domes-tic output will be examined first. As thedomestic output of F is being assumed per-fectly inelastic with respect to increases inpj, the result depends on changes in thedomestic output of H, which is in turn de-

termined by the level of domestic demand.As a result of devaluation, the change indemand for H will be given by the followingexpression, which includes the real-incomeeffect for capitalists and workers, plus thepure substitution effect arising from thechange in the price of the foreign good:

dH = [mh,(Fj, - F,)- mhFW (1)+ HEhf]dpf

If we assume trade is initially balanced,then F. -F0 = F, so that (1) can be sim-plified to:dH = [(M-h m h)F. + HEhf]dpf. (2)The pure substitution effect in (2), HEhf,will switch expenditures away from F andinto H, thus inducing a higher level of out-put in the H-industry. However, this effectmay be offset if mhW is sufficiently argerthan Mh,. The condition mh,> Mh, is likelyto be met in many countries, as the capital-ists will tend to have an expenditurepattern

(consumptionplus investment) more biasedtoward imports than workers and are likelyto save a higherproportionof their income.It should be noted that the m's are to beinterpretedas marginal propensities to con-sume and invest. Capitalists carry out theinvestment of the economy, which in manycountries has a higher F component, bothaverage and marginal, than consumptionspending.Furthermore, especially in the short run,Ehf could be small for many semi-indus-trialized countries, so that the conditionsMhw > Mh, and I (mh, - MhnA)FwI > HEhfcan be realized, yielding a decrease in thelevel of domestic output following a devalu-ation.It remains to be shown that expression(2) can yield a negative result while the bal-ance of trade improves.The balanceof tradeis equal to the difference between the do-mestic supplyof F and its domestic demand.Since the supply of F is fixed, improvementin the balance of trade will follow so long asthere is a decrease in the domestic demand


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580 CARLOS F. DIAZ ALEJANDROfor F. The impact income effect of the de-valuation on the demand for F will be:

[mfc(Fa Fc) - mfwFwldpf (3)The pure substitution effect will simplybe the negative of the pure substitutioneffect on the demand forH, or - HEhf *dpf,8so that the total impact effectof devaluationon the demand for F is:

dF = [mfc(F8 Fc) - mfwFw (4)-HEAf]dpj.

Equation (4) can be made directly com-parable with (2) by using the relationss, + mf, + Mic= 1 and sw+ mfw + Mhw=1.This yields the followingalternative expres-sion:dF = [(F, - F, - Fw) - (Sc + mhc)(F.

-F0) + (Sw + mhw)Fw - HEhf]dpf .If we assume initially balanced trade, weobtain for the impact effect of devaluationon the demandfor F:

dF = [(sm - SC)Fw+ (mhw - mhc)Fw (6)- HEhf]dpf.

Comparing equations (6) and (2), it canbe seen that the last two terms in the squarebrackets are the same, but with oppositesign. Thus, if these were the only two termsin the expression for the impact effect ofdevaluation on the demand for F it wouldfollow that the output of home goods will6 The pure-substitution effect between F andsavings is neglected to keep the argument simple.7 A deficit in the balance of trade at the time ofdevaluation will tend to make eq. (5) negative,therefore contributing to an improvement in thetrade balance. It will also tend to make eq. (1) nega-tive, making a decrease in home output more likely.

increase only when the demand for F de-creases (and thus the balance of trade im-proves), and vice versa. But the term (s,- s,)F, in equation (6), which does notappear in expression (2), is almost certainto be negative, thus making it possible, andfor many semi-industrializedcountries likely(especially n the shortrun), that the balanceof trade will improve as a result of devalua-tion while home output falls.Equations (6) and (2) also show the pos-sibility of another interesting result. If Ehfand (sw - s,) are sufficiently small, and(mah - mnh) has a high positive value, adevaluationwould lead to a worsening f thetrade balance and a fall in domestic output.The redistributive effect of devaluation, inother words, introduces a new potentialsourceof instability in the foreign exchangemarket.8The results obtained here depend im-portantly on having low values for Ehf andthe elasticity of supply of the F-industry.More generally, the greater the ability of acountry to substitute one good for anotherin its consumption and investment and thegreaterits capacity to transformin produc-tion, the more likely will be an improvementin both the balance of trade and in homeproduction following a devaluation.The other key assumption made was theconstancy of money wage rates. This leadsunambiguouslyto an increase n total moneyprofits in the F-industry. However, totalmoney profits in the H-industry will fallwhen equation (2) yields a negative result.Thereforethe net effecton total money (andreal) profits will depend on the full multi-plier effects of the devaluation on the H-in-dustry. But the profit share in the nationalproduct will necessarily improve as a resultof devaluation even after these full effects.

8 This point was stressed by J. Spraos, op. cit.

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