CONTRACTIONARY EFFECTS OF DEVAlUATION

by

Paul Krugman and Lance Tay101'

Number 191 Octobcr, 1976

I

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

11

FIGC~~ Ir

'7/

//

/,/1/

/ I/,,"115° H

~)~I~.~--------------~)

//

/

M .• --

M ,1:: aMt{ rr

M

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

-- --------------------------------------------

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

I

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.

25

Meade, James E. (1951), ~he Theory of Internationa1 ~cono~ic Polic~f,1:

The Balance of Pa~ents. (Oxford, Oxford Cniversity Press).