Devaluation, Capital Formation, and the Current Account

This paper re-examines the effects of devaluation and a rise in the rate of devaluation on capital formation and the current account in an optimizing monetary model of a small open economy with endogenous labor, investment with adjustment costs, and perfect capital mobility. It is shown that devaluation leads to capital accumulation and a current-account deficit in the long run and during the adjustment process, whereas a rise in the rate of devaluation has an ambiguous impact on capital formation and the current account depending on the relationship between consumption and real balances in the utility function. If consumption and real balances are separable or complements, then a rise in the rate of devaluation produces capital decumulation and a current-account surplus in the long run as well as on the transition path. These results stand in sharp contrast with Calvo (1981). JEL Classification Numbers: F41