October 1976
*Contractionary Effects of Devalue..tion
by Paul Kr~en and Lance Taylor
l. Introduction
Tbe analysis of devaluation has occupied quite a few
econoIDists -- the subject is rivaled only by the consumption func-
tion and the demand for Doney as en exercise ground for !:lacro
theorists. But despite all this effort, the basic structure of the
theory has ch~~ged hardly at all since the classic article by A1ex-
ander (1952). Ne arLy al1 mode1s tell some variant of the folloving
story: The initial effect of devaluation is to raise the price of
foreign goods relative to home goods, creating excess demand for
domestic production. In response, home goods output, domestic
prices, or both go up. Real hoarding, by definition equal to the
balance of pa~~ents on current account, increases due to rising
income and/or demand for money.
Tbe emphasis in tellingthis story has changed over the years,
frem the money-less "Keynesian neutral" model of Heade (1951) to the
"monet.ary epp roach" of Dornbusch (1973) with its as sumpt í on of full
er:;p1oyment, but one basic assumption has always remained: 'I'heirnrnediate
Lmpac t Of devaluation is te create excess demand for horne goods. r·1ode1s
differ only in how the system reacts to the excess demando The possi-
bility that thp :-,ricer.ovemerrts caused by devaLuat.Lon will create
enQugh losers in real incor;::ete~s to reduce effective home goods de-
mand is a~ost always left out.
~~-------------------------------------------
2
This oversight persists, even though there is substantia1
empirical evidence suggesting that devaluation often reduces aggr2-
gate demand (vide Cooper (1971a)). Even a fev theorists 1ike
Hirschman (1949), Diaz-Alejandro (1963) and Cooper (1971b) have
suggested that í'alLí ng output and employment after devs.Luat Lon are
quite frequently to be -expected. These a8sertlons, however, have
had 1itt1e impact on thinking about exchange rates. Tbe possibi1ity
thet devaluation might be contractionary i8 general1y regarded as a
pe rvez-se, unimportant case.
Tne presumption that devaluation is expansionary is not
supported by firm empirical evidence. Why, then, is it so videly
accepted? Leftists have been knovn to suggest c1ass bias -- as ve
vill argue 1ater, devaluation does typical1y redistribute income
from vages to profits -- but this is too glib. "(le be Ld eve , instead, that
the ortbodox view of devaluation derives mucb of its 8t~ength from tbe
persuasive power of tbe simple, elegant mode1s in vhich it is presented.
Since skeptics bave rnostly relied on journalism or at best partial
equilibrium analysis, it is not surprising that theoretical discussion
i5 dominated by the belief that devaluation has an expansionary effe~t.l
As just hinted, neglecting the contractionary impacts of de-
valuation amounts to ignoring incorne effects, especially those trans-
ferring real purchasing pover toward economic actors vith high marginal
propensities to save. By redirecting income to high savers, devalua-
tion can create an excess of saving over planned investment ex ante,
and reductions in real output and imports ~ post. The three most
i~l~ortantcircumstfulces are the follo~ing:
I
3
(i) ~nen devaluation takes place with an existing trade deficit,
traded goods price increases immediately reduce real income at home
and increase it abroad, since foreign currency payrnents exceed re-
ceipts. Within the home country the value of "foreign savings" goes
up ex ante, aggregate demand goes down ex post, and imports fall along
with it. The larger the initial deficit, the greater the contractionary
outcome.
(ii) Even if foreign trade is initially in balance, devaluation
raises prices of traded goods relative to home goods, giving rise to
~ndfall profits in export and import-competing industries. If money
'\oIageslag the price increase and if the marginal propensity to save
fram profits is higher than froID '\oIages,ex ante national savings goes
up. The magnitude of the resulting contraction depends on the difference
bet'\oleensavings propensities of the two classes.
(iii) Finally, if there are ad valorem taxes on exports or imports,
devaluation redistributes income from the private s~ctor to the govern-
ment, '\oIhichhas a saving propensity of unity in the short run. Once
again, the final outcome is Teduction in aggregate demando
Casual empiricism suggests that all three circumstances pre-
vail in many countries, especially the less developed ones. In these
countries a deflationary impact from devaluation is more than a remate
possibility; it is close to a presumption. The purpose of this paper
is to sho'\olin a fo~al model ho'\ol devaluation can cause an economic con-
traction. The results '\oIillcome as no surprise to those con cerned with
policy in the underdeveloped world. But '\ole do hope that putting practical
economists; insights into a theoretically appealing frar.:evorkviii make
them accessible to the '\oIiderrange of the profession at large.
I
4
2. A Macroeconomic Model
In tbis section v e develop a simple Í':~{nes-raleckirrodeI of
en open economy with the following characteristics:
(i) There are two dis~inct sectors, en export sector producing
for tbeworld market and a bornegoods sector producing for domestic
demando
Prices of exports and imports are fixed in foreign currency;
,bome goods prices are determined by a markup on direct costs of labor
dU),dimportedinputs required to sustain prcduction (think of pe'tro.Leum
:.íp:8.Il oil-short country).
,(:tU) .Tbe vage_rate.is fixed in domestic currency.
,(iv)'I.n the short run, substitution responses of both exports and
imports to price changesare negligible. Export production is determined
,_by',avaih.blecapacity, vh í Le imports enter rithfixed coefficients Int.o
domest, i e demazid ,
';(v) 'Interest rates are kept constant by action of the n:onetary
~utho~ity, so,that ve need only consider income-expenciture ~elationships.
;AB~_umptions(i) - (v) are chosen for ane.Lyt.ice.Ico:wenience, but
tbey appear to correspond fairly vell to the stylized characteristics
-of m~~ partially industrialized countries. In tbese countries most
export earnings come f'r-om an agricultural or m í n í ng sector producing
for .•••.orld markets. Domestic industry hes oeen built up by import sub-
stitution vía protection, so that the remaining imports are nonco~petitive,
chiefly intermediate goods e.ndray¡meterials, ~or which little substi-
tution is possible in the short run.
The essu@ption of an accornnodatir~ lionetary policy is rrade
temporarily in order to allcw us to focus on the incor.:.eeffects of
5
devaluation. We vill return to monetery analysis in a later section.
We begin vith an eq~ation for the price af hame goods:
vbere ~'B¡m are input caefficients of labor arid imports respecti vely
into home goods, ~ is the vage rate, PM tbe home damestic price af
imports, and z a mar kup factor.
Prices of imports and exports are dete~ned by vorld prices,
taxes, and the exchange rate:
vhere e is the exchange rate of domestic currency for do11ars~ txand tM the rates of ad valorem tax on exports and imports, and Px '
PM the dollar prices of exports and imports on world markets. lJotice
that (1) - (3) imply that a chane;e in the exch9.nge rate changes traded
goods prices relative to the vege rate and the price of home goods, 8ut
does not affect the terms of trade.
Recipients of income may be divided into tvo classes: those vr.o
receive vages and those vho receive profits or rents. The nominal income
of each class is determined by the equations
(4)
(5)
I
6
Here H and X are outputs of home goods and e~~orts, ~ 13 the
input of labor per unit of exports.
For s1mpIicity of exposition, 1t viII ce ass~ed that a1l im-
ports are inputs loto home goods production, i.e., that there is no
direct final demand for imports. This implies that PH is the proper
deflator if ve varrt to measure real income of workers or capita1ists.
We viII assume separate consumption functions fcr the tvo groups, so
the dem.s.ndside of the model may be vritten
( G)
Rere,- M stands for real Lmpor-t s ,
r- i6 the interest-rate, which we assume to be held-fixed, I
is-real- investment,-and G is real government consumption.~1 For
convenieoce, define
i-:hent.ne exchange r at e- is held fixed, equations (4) - (7) make
up a- standard Keynesien open=economy modelo It is a simple matter te
compute multipliers on home goods production and inports. The multi-
plier effects of a change io government expenditure, for example, are
dR 1,dG = ñ
dJ-.1= ~rn:/DdG 1
7
Tbe mode L may a.Lso be r-ep r eserit.e d by e,n eLereent.eryKeyne s i an
cross , as in Figure l. Becaus e both wage an d profi t í nc ome are 1unc-
tions ofthe output of hCEe goods, the deMand for hODe gooes is a func-
tion of home gQods output, as represented by the l~ne LOLO in the
upper portion of the diagr&~. Equilibrium ~ay be determined by the
intersection witb a 45 degree line through the origino lmports can
then be read off from the schedule relating iMports to horne goods
production in the lower partion. An increase in government spending
of dG raises the demand schedule ta E1El.
So far this is familiar ground; tbe unfamiliar results appear
vben the exchange rate is allowed to change. The model excludes, by
assumption, substitution and monetary effects of devaluation, leaving
only income effects. The next section will examine just these.
3. Income Effects of Devaluation
Even when devaluation does not change a country's terms of
trade, it has a n~ber of other income effects. Unless the trade
account is initially bal~~ced, a devaluation changes the real income
of the country as a whole. Within the country it produces redistribu-
tion from workers to cepitalists, and from the private sector as a
vhole te the gevernrnent. These real income adjustments do not take
place independently--they interact, and there is no way to decompose
the impact ef a devaluation ínto separable cOT.ponents. In order to
study the different income effects of devaluation individually, it is
necessary to c ons í de r spec í aL cases in vh í cb on Lv one of them is operating.
That will be the p~ocedure followed in this section.
8
FIGlJ?2 1
//
,¿
E,
/
I tE, /' It tIe, / t tf/ f
/ I1ft
H
.••...- •...... _----_.-..
_.--------
fV'¡ = /"'l HV\ M ti
9
Devaluation from en ini tia1 trade Lrab e.Lan c e : Hi rs chman (194')) and
Cooper (197lb) have sbown -- though with little imp&ct C~ other theore-
tical .•.•.o~~ -- that deva1uation from an initia1 trade deficit reduces
real national income and may lead to a fall in agEregate d~~land. The
argument is straightforvard. Devaluation gives ~ith one hand, by
raising export prices, while taking away vith the other, by raising
import prices. If trade is balanced, and the terms of trade are not
changed, these price chenges offset each other. But if imports ex-
ceed exports, the net result is a reduction in real income within t~e
country.
The income loss can be quantified using the model of this
paper by considering a special case. Let YR = YW = y, eliminating
within-country distribution effects, and let tx = tM = G = O, eliminating
fiscal effects. After a good deal of manipulation ve can derive the
eIasticity of home goods output vith respect to the exchange rate (the
result is given as an elasticity because the econornic meaning of the
expression is clearer in that form):
dHde
eH = K .Ptf
In wcrds, output of home goods -- and hence total output, em-
pIoyment, and ireports -- viII rise or faII depending on whether trace
is i~itiaIIy i~ s~rp:~s cr deficit. Since countries which devalue are
usuaIIy i~ deficit at the time, there is contraction. Its rnagnitu¿e
for a given percentage devaluation is proportional to the ratio of the
I
10
deficit to home goods productinn.
The effect of trade iTbel~~ce is illustr~ted graphically in
Figure n. There is SOlZe level of i.mport s 11 at which tre.de vou l.d
, be balanced, and a level of horne goods output corresponding to it.
Devaluation causes the demand schedule EOEO to rotnte cloc}yise around
the point corresponding to that level of demand, to a ney schedule such
as ElEl' The effect when starting fr8m a trade deficit is to reduce
output and imports.
Distribut;onal effects: If money Yages are rigid in the short run,
-devaluation redistributes income from vag es to profi ts and rents. If,
"as is v í deLy believed, the rnar'g ine.L propensi ty to s ave out of profi ts
Ls larger than the mn.rginal propensi ty to s ave out of vag es , this ch ang e
in income shares Yill reduce aggregate demand and therefore ímports,
as pointed out by Diaz-Aleja..'1dro(1963). Fe again demonstrate by
considering a special case óf the modelo Suppose trade is initially
balanced, Pf< = P~1 , so there is no trade balance effect, and also
that t = t = G = O.X M 1,-re assume "YW >yR
• We can solve, once again,
for the elasticity of h~_e goods output Yith respect to the exchange
rate, Ybich after some substitutior.s becomes
<iRde
~ = __"Y~R~-__Y~~_T _H D
where y = y + yW R is total prívate income. Thus the elasticity of
v-':'::í?ut(and i:r.p,:,,"e' '.Ti t.h respect to devaluation is pr-opor'ti cna L to t.h e
difference in marginal propensities to consume, to the share of wages in
income, and to the share of imports in incone. It i3 also an increasing
I
l2
fucction of ~he ~kup. If cons~ption prcper.sities ~re ~Qual, de-
valuation has no short-run effect on output, employ¡;;entor trade,
but merely shifts income [roD wages to profits. The tr~ditional
leftist reluctance to deva.Lue may have sooething to do vi th this :'ac-:.
Fiscal effects of devaluation: Theoretical models of the be.Lance cf
payments ordinarily ignore the government budget, but the fiscal i~plica-
tions of devaluaticn may te of grea't practical importance. '!'bereare
a number of possibilities: if the goverDment bu¿get is no~ ~nitially
balanceo..-there is an income effect comparable to the incoTIe effect of
o.eveluation via the trade deficit; if there are progressive incoEe
taxes7 or higher taxes on profits than on wa.ges, the government claims
_.;, an increased share of income; finally, if there are ad velorem taxes
on exports or imports, higher traded Eoods prices vill redistribute
income to the government. One way of looking at this last point is
to say that the private sector pays Dore for ~ports than it earns from
exports, even though trade is balanced for the country as a whole~ so
ve get another version of the trade bal~~ce effect already discussed.
To illustrate how fiscal reactions can Dake a devaluation
deflationary, consider the case of an export t ax and a ssume \1 = O,
YR = YW = y •. Further as surae that both the trade accourrt and the
government budget are initially balanced, so that P~X = P*'1 andX-" M' Ylvl +
YR = ePXX + P~ - eP~~. Then we can solve for the result
dH ede E =
13
Tbe devaluetion elasticity ~s proportiocal to the tax rate 08 exports
and the share of iDports in iocome. Althougb the model assumes a
proportional tax function, what is relevant io general is the ~0rginal
rate, which IDay be very high. In one fairly COffiL.oncase, whe~e agri-
cultural exports must be sold to the state at fixed prices, the marginal
tax rate is one, so the fiscal drag from devaluation is quite strcng.
4. A Numerical Example
It seems worthwhile to provide a numerical example at this point,
for two reasons. First, ap effort to treat the general case of the
model analytically produces very complicated algebra. Second, ~~
example may help persuade the reader that the effects we have been
considering are in fact important, not merely curiousities.
To produce a computable model requires sorne, though not much,
specialization of the functional forms. Assume that workers and cap-
italists have proportional consumption functions with constant con-
sumption shares YW ~~d YR respectively. Then (6) may be written in
the special forro
(6' )
Tbe equations (1) - (7) then form a solvable system.
The ass~~ed values of parameters and exogenous variables are
given in 7able l. The numbers chosen are arbitrarj, thoueh they are
mee.nt to fal1 v it hí.n a "reasonable" range for semi-in¿i.l::;:.:-::'=-'::"~z~d
countries.
I
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14
Table 1: Assumed Values of Pe.::--8!:letersanu :::x:o¡;-enousVa~iRtlcs
~ 0.75 ••• 1
~ 0.25 ~ 1
"r.x 0.25 p* 1X
YW 1.0 1 20
YR 0.5 G 10
tx 0.5 X 15
tM 0.2 e 1.0
z. 0~4
Devaluation increases the value of e- .••hile leaving all of the
other parameters and exogenous vs.ri ab Le s unchanged. Suppose t.he currency
1s devalued by 25 percent. We can assess the effects by camputing the
values of some importent quantities far both e = 1.0 and e = 1.25.
The results are show~ in Table 11.
'l'nble11: Effects of a Devnlu;üione = 1.0 e = 1.25 % change
Nominal GDP 127.7 124.5 -2.5at factor costGDP at constant 127.7 119.8 -6.2pricesPrice of home 1.47 1.575 +7.1goodsCutput of 102.7 96.0 -6.5horie goodsTrade balance -10.7 -9.0 +15.9in dollarsTrade bal?-nce in -10.7 -11. 2 -4.7domestic money
I-~-
15
Before deva1uation the economy has a trade deficit of 8.4
percent of GDP -- 1arge, but by no me&ns unco~on. It exhibits all
of the f'eat.ures that ve have seen can raake a deva Luat ion deflatior;ary
initial deficit, differentia1 savings behavior, ad valorem taxes
on traded goods -- but nene to an unusual degree. When the currency
is devalued, tbere is a substantial deflation. Real GDP and the out-
put of home goods fall, while the trade balance i~proves in dollar
terros oecause i~ports decrease along with output. The loss in real
GDP of 7.9 might in practice be offset by some export responsiveness
to devaluation. However, even on our unrealistic assumption that the
import content of exports is nil, the relevant elasticity "ould have
to be close to two in the short run to restore GDP in initial prices
to its pre-devaluation level. In a semi-industrialized country, such
a responsive export industry is unlikely.
Finally, note that aggregate measures behave quite differently
in real and nominal terroso The fall in current price GDP is less
than half the fall in constant prices, while the trade balance actually
worsens when measured in domestic currency. The difference between
real and nominal movements has obvious importance for monetary analysis
of devaluation, to which '.lenow turno
16
5. Monetary Effects of Dev8luation
The analysis of pre'lious sections, with its purely Keynesian
approach, rnay seem dated and largely irrelevant to economists
accustorned to the "monetary approach" to the balance of pay-
ments. It might be argued that the incorne effects of devalua-
tion would be unimportant if the rnonetary authority, instead of
pegglng the interest rate, were to ~eep some monetary aggregate
constant. This ls a correct point in one respect: if a
monetary aggregate such as M.2 were n e.Ld..con st.arrt,the mul ti-
plier e.fi'ectsof impact changes in,real income would be dampened,
perhaps enough to make them insignificant. On the other
hand, devaluation. by raisingprices, increases the demand for
money at any given level of output and employrnent. If the nom-
inal' money stock is held constant. this will have a contraction-
ary effect on real output. Taking this into account, deval-
uation with money supply held ccnstant rnay be either more or
.Les.s contractionary than devaluation holding interest rates
constant.
To illustrate the contractionary effect on the monetary side,suppose we were to adopt an extreme quantity theory position ,
under which there is a strictly proportional relationship
between sorne monetary aggregate and income:
,.
I
(8)
where A is a monetary aggregate fixed in the short run.
Using equations (1) - (5) and (8), we can derive the result
dH . ede H
:::
which will always be negative. Thus a deflationary effect of
devaluation takes place in monetarist as well as Keynesian models.
Another numerical example may be in order. Suppose
that the initial state of the economy is the s~e as in the
last section, but that now, because the central bank holds
M2 (say) constant, nominal GDP does not ch ang e follo'Wing de-
valuation. The results of a 25 percent devaluation are displayed
in Table II!I
Table 111: Effects of Devaluation Holding Nominal IncomeConstant-
e == 1.0
Real GD~ 127.7
Output of 102.7home goods
lrade b~1ance -10.7in do11ars
~~~d9 ~~l~nce -10.7in do::-!.es-.:iccurrency
e == 1.25 % change
122.9 -).8
98.6 -4.0
-9.7 +9.3
-12.1 -13.1
18
In this case the contractio~ resulting from devaluation under
monetarist essumptions is less than under Keynesian assumptions, but
i8 still substantial.
All of this has as sume d that the rnonets..ryauthority really
can determine monetary aggregates, something vhich is not necessarily
so. In many countries open-mar~et operations are not available, and
the government must rely on its own deficit ano -- in rare instances
a balance of payments surplus to create nev monetary base. The identity
in the'absence of open-l!laI"ketoperations(and substitutes such as re-
discount and over dr-at't ) is base creation = government defici t + balance
of payments. Nov ve have already observed that devaluation ~ll often
increase government revenues through its effect on indirect taxes. 1tTe
have also'seen that devaluation can cause the trade deficit to vorsen
in domestic currency although it improves in dollars. So it is possible,
even likely, that devaluation will lead to a reduction in the rate of
grovth of the mone t.ary base -- an additional de í'Lat.Loner-yinfluence.
Thisresult is exactly the opposite of vhat comes out of orthodox
"monetary approach" models, like that of Johnson (1912).
6. Imp1ications for Policy
The purpose of this paper has been to argue that, in the short
ron at least, devaluation may not work the way ve usually assume; that
taken by itself it is quite likely to have the presumably ~~desirable
effects of shifting the income distribution against labor and reducing
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19
employment and output. í-tnatdoes this do to our reconmendations to
countries with balance of paywents proble~g? Should we abandon de-
valuation as a prescription because of its undesirable side effects?
The theorist's answer -- and he has a point -- would be that
the effects of devaluation on aegregate demand are irrelevant. Govern-
ments have other tools wi th vh í ch they can rianage demand , If t ney
don't like the demand effects of devaluation, let the!llcompensate
with fiscal or monetary policy, leaving devaluation to accorrp.li sb its
primary purpose of inducing substitution.
Practical men would answer that matters are not that simple.
Governments, especially in less-developed coun tri es , are not sufficiently
flexible to fine-tune their economies. Thus one cannot take it for
granted that devaluations will be accompanied by appropriate stabiliza-
tion measures, and one therefore cannot dismiss devaluation's demand
effects.
There is a reasonable argument which starts froID this point
and continues as follows:
(i) In the short run the balance of payments defici t is "st ruc tur a.l"
-- that is, both imports and exports are not very sensitive to price
changes for a given level of domestic output.
(ii) As a consequence, any favorable short-run effects of devalua-
tion on the trade balance come primarily through econorric contraction
rather than substitution.
Devaluation not only reduces output and employment, but re-
di str í 1"':'"':'0:" ; "'C',,:::e f ron labor to capital as well.
(iv) Thus devaluation is a costly cure, and a devaluation big enough
to reduce the balance of payments deficit substantially in the sho~t
1r-----~_7
20
run may be unacceptable. In such a case, the gove rnme nt shou Id be g
or borro", to meet the short-term deficit and ·••.ork tovar d eliminating
its structural difficulties by expansion of traded goods productio~
io the medium run.lI
The questioo is ho", one goes about correcting structural
problems. In economies ",hich are closely tied to the world market,
direct government investment is not likely to be too helpful. Govern-
ments can build and manage roads, daros, and even steel plants; but
there are fev countries vhere they can effectively produce ",igs, or
false teeth, or cosmetics, or peasant agricultural products; yet-these may be precisely the goods that the country has much chance of
exporting or substituting for imports. So a policy designed to expand
the capacity of the traded goods sector vill probably have to rely on
encouragement of private investment. This can be accomplished with
a variety of tools: subsidies, tariffs, preferential credit, m~tiple
exchenge rates. It can also be accowplished, vithout the microeconomic
distortions that these measures create, by devaluation, which increases
profitability in traded goods production. ?erhaps, then, one should
thiok of devaluation as a measure designed to rectify balance of pay-... 4/ments difficultles ln the medlum rather th~~ the short run.-
In challenging the established view of the effects of devaluation
on e.ggregate demand , then, this pap e.r does not deny its usefulness as
a policy tool. It is important, hovever, that policymakers be a"'are
of its contractionary effects. ;:orrIally,devaluation .is regarded as
an "expend.iture-switc:-:::-.¡::;"meas ur-e, \T:-::'c~ ~rC"Jl¿ be comb i ned víth an
offsetting "expendi ture-reducir..g" policy. wl1at ve nave seen í s that
21
devaluation itsel~ illayhave un éxpenditure reducing effect. A
stabilization plan ~hich, say, co~bines devaluation ~ith tax increases
may thus be piling deflation on deflation, arid the gove rnnent IT":E.y
find itself confronted ~ith a steeper decline in output than it ~anted.
Devaluation should in rnany cases be accompanied by measures to increase
demando
In any case, it is not the purpose of this paper to give policy
advice valid for all countries at all tiwes. The important point is
that devaluation may be deflationary, and one should be on tbe alert
for tbat possibility.
22
Footnotes
•• The autbors are at Hassachusetts Institute of Technology. He
are grateful to Rudiger Dombusch, Jagdish Bhagwati, EdffiarBacha and
members of tbe M.I.T. Trade and Development Workshop for corrments on
previous drafts.
11 Note the emphasis on theoreticel. Our friends from underdeveloped
countries mentioned in the preceding footnote rightly point out that
the contractionary ~pacts of currency depreciation have long be en recog-
nized by policy makers and their intellectual critics in the les s de-
veloped .••••orld. But informal statements, even of something that "eve ry-
body lrnows", are not enough. It is a fact of life, not confined to
economics, that practical insights usually becotne influential only aftcr
they have become embodied in formal theory; and that once an idea has
received persuasive theoretical treatment it will persist even in the
face of contradictory evidence, until another equally persuasive theory
comes along. "Practical men, who believe thef!lselves to be quite exernpt
from any intellectual influence, are usually the slaves of some defunct
economist".
~/ We abstract from stock changes. In practice, a good part of the
response to devaluation we are about to sketch would take place via
inventory adjustment. Again, the ~~failingly rnessy details are omitted
for simplici ty.
11 If one grants the proposition that in the short run there is
I
23
little that less-developed countries can or should do to reduce the
balance of payments deficit, one rnust al so grant ~~ i~portant corollarj
ebout the appropriate fiscal poliey yhen the external deficit is large.
With invest~ent lirnited by all the factors whieh develop~ent econo~ists
surn up under the rubric "absorptive capacity constraint", at full e:n-
ployrnent the governmei1t is forced to run a deficit to satisfy tbe identity
investment + balance of payments
= private saving + gover~ent current surplus
precisely because the foreign deficit 1s so large. Far frorn being
"inflationary finance", a government deficit in sucb circumstances
supports demand for home goods against unavoidable leakages of pur-
chasing power abroad through the trade gap.
!:...I The medium-term role of the exchange rate may be clarified by
the following example. Suppose a country were to experience a sudden
autonomous increase in wages and horne goods prices. This would lower
tbe profitability of investment in trsded goods production relative to
borne ~oods production, and would produce a gradually widening balance
of payments deficit. After four or five years the country might well
find itself wi t.h a large, "structural" external defici t, v i th internal
demand sustained by a corresponding tudget deficit. The proper policy
would have been to acco~~odatedomestic inflation by depreciation of
tbe currency at tbe outset, in which case the balance of payments
problem migbt never have arisen.
24
REFERENCES
Alexander, Sidney, S. (1952), "The Effects of Devaluation 00 a Trade
Balance", Interoational Monetary Fund, Staff papers, 2: 263-78.
Cooper, Ricbard N. (1971a), "Currency DevaLua.t í on in Developing Countries ,"
Essays in International Finance No. 86, Internationa.1 Finance Sec-
tion, Princeton University.
'CooEer, ,Richard. N, (1911b),' "Devaluation and Aggregate Demand in Aic.-
'Rece í.v.í-ng Countires," in J. N. Bhagwati et. al., Trade, Ba.lfulce
of'Payments and Grovth, Amsterdam: Nortb-Ho1land.
:..Di.az..,.A1eJandro,Carlos F. (1963), "A Note on the Impact of Devaluation
.end :the-Redistributive Effect," Journal of ?01itica1 Economy, 71:
'571-80.
.Dornbus ch , Rudiger, (1973), "Devaluation, Money, and Non-trad.ed Goods",
American Econornic Review, 63: 871-80.
Hirschman, Albert O. (1949), "Devaluation and the Trace Balance: A
Note, It Review of :C:conomics and Statistics, ll: 50-53.
Johnson, Harry G. (1972), "The Monet ar-y Approach to BeLance=of -Payments
Theory," Journal of Financia1 a!1d Quanti tati ve P-Jia1ysis, 1:
1555-1572.
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