The Dynamic Effect of Devaluation on the Balance of Payments of a Small Debt-Ridden Open Economy*

This paper derives a precise necessary and sufficient condition for devaluation to eventually improve the balance of payments in domestic currency, using assumptions more appropriate for a small open economy than those of Marshall-Lerner. It will be shown that, following devaluation, the balance of payments deteriorates over a short period before it gradually improves– the so-called J-curve effect The duration of this short period will be shown to depend on the magnitude of trade elasticities, lag-coefficients, unhedged foreign debt denominated in foreign currency, interest rate and current account deficit     

Die mittelfristigen Folgen der Wechselkurspolitik für Leistungsbilanz und Inflationsrate

Summary Nowadays it is uncontested that price elasticities of demand for exports and imports are high enough to secure an improvement of the current account of the balance of payments in the case of an exchange rate devaluation. Indeed it may take some time until the effects materialize and the primary effect may even run in the opposite direction. However, doubts arise about the favourable reaction of the current account if secondary price and wage effects are taken into consideration—what has been done more thoroughly in recent times.The present study deals with the medium term aspects of exchange rate changes in Austria. In order to quantify exchange rate effects on foreign trade and prices double weighted exchange rate indices and double weighted foreign trade price indices were computed and a simple econometric model was built. Behavioural equations for quantities and prices of exports and imports (as far as possible, disaggregated for raw materials, energy and manufactures), for domestic prices and wages were estimated. In addition to this model exchange rate effects on tourism were considered separately. In order to evaluate the consequences of the revaluation of the Austrian Schilling simulations were run under the assumption that in the period 1972 till 1976 Austria had kept constant the average exchange rate of the currencies of its main trading partners (competitors). The main results are as follows: If Austria had pursued a constant exchange rate policy in terms of the export weighted exchange rate index during the years 1972 to 1976 instead of actually revaluating the Schilling by 19 percent the volume of exports would have been higher by 1 billion Schilling (at 1970 prices) whereas the volume of imports would have been lower by 16 billions Schilling; measured in current prices exports and imports would have been higher by 59 billions and 60 billions, respectively, and the receipts from tourism would have grown faster by 12 billions. Therefore, the trade balance would have deteriorated by 1 billion and the current account would have improved by 11 billions. By 1976 consumer prices and wages would have reached a higher level (+7 3/4 percent and +5 1/4 percent, respectively). The results of this study are not in contradiction to those obtained in comparable work for other countries.There is some indication pointing to a further deterioration of the current account in the longer run: The revaluation caused profit squeeze which hits exporters as well as import competing domestic producers may weaken investment and the ability to maintain market shares. The revaluation could favour the sheltered sector of the economy in comparison to the exposed sector and shift the structure of the economy to the disadvantage of the current account.     

Does devaluation improve trade balance in small island economies? The case of Fiji

A number of countries, mostly small and island economies manage fixed exchange and often devalue it as a stabilisation strategy. The current paper investigates the effectiveness of devaluation in improving trade balance with reference to Fiji. A small island economy has limited exportable and hence highly depends on imports for both consumption and production purposes. A devaluation, therefore, inflates domestic price and appreciates the real exchange immediately by raising importable consumption and discouraging imports used in domestic production. The paper applies various econometric models for empirical investigation of its impact and transmission mechanism. Strong long-run relationship found between real exchange rate and trade balance explains that appreciation of currency has been responsible for the rising trade deficit in the economy. Moreover, the devaluation did not demonstrate J-curve phenomenon. The effect of devaluation strongly contributed to the domestic inflation has been while quite weak on stimulating aggregate demand.     

Input-output pricing in a Keynesian model as applied to Portugal

This paper develops a Keynesian model of the Portuguese economy in which the prices of the sectors of final demand are derived from input-output relationships. This model is used for short-run simulation analysis of the Portuguese economy through 1977. It is seen that Portugal cannot simply rely on world demand for its exports to improve its balance of payments and to generate an export-led recovery. Simulation of a policy package which includes a devaluation and fiscal restraint indicates that this policy will improve the external current account and raise domestic savings.     

EXCHANGE RATE PROBLEMS IN NATIONAL ACCOUNTING OF DEVELOPING COUNTRIES*

Developing countries which typically have import surpluses and inflationary pressures because of insufficient savings are prone to use indirect taxes on imports (Tm) and subsidization of exports (Sx) in order to prevent deterioration of the balance of trade. If these substitutes for devaluation are included in the net indirect tax component of product at current market prices (Ym) the import surplus is likely to be understated, and Ym upward biased. This distortion will be avoided if imports and exports are measured at effective exchange rates (ER), that is, at official rates (OR) plus Tm and Sx respectively, and if (Tm - Sx) is deducted from the net indirect tax component of Ym. Only in this manner become imports and exports consistent with the other uses and resources at market prices and can be articulated with them. At base-year prices the volume index of product at OR diverges from that of ER to the degree that the composition of imports and exports in regard to tax and subsidy rates computed ad valorem significantly changes. Such a case is similar to that of the price indexes of imports and exports moving in diverging proportions: the trade balance at base-year prices will differ from that at current prices. The resulting discrepancies in national accounts have led to proposals of deflating, for example, exports by the price index of imports. Suchlike approaches are incompatible with the principle of national accounting that prices are supposed already to measure substitution values. Deflating exports by import prices means reintroducing substitution values, as does, for example, deflation of incomes by a consumer price index. Correspondingly, since the trade balance at ER conceptually expresses the value of imports at domestic market prices as compared to the corresponding domestic market value of exports, and if at ER the trade balance diverges from that at OR, the former balance has an important meaning (as has the trade balance at base-year prices as compared to that at current prices) and the resulting discrepancy between the two measures should not be removed merely for the sake of accounting smoothness. In contrast to the market price approach, the measurement of product at base-year factor cost is indifferent to the measurement of the trade balance at ER and at OR. It is, therefore, proposed in countries in which part of import taxation and export subsidization substitutes for devaluation, to record imports and exports in the national accounts at effective exchange rates, and to correct the net indirect tax component of product correspondingly. Imports and exports at official exchange rates should be shown within the balance of payments, and the latter separately as a memorandum item.     

Pros and cons of official dollarization in Eastern Europe

The balance of payments barrier is the biggest obstacle to growth in Eastern Europe. This problem stems from the existence of individual national currencies which dynamically increases the risk associated with capital inflows. Capital inflow leads to both domestic growth and domestic currency real appreciation, reducing net exports to a level insufficient to service international debt obligations stemming from capital inflow. To avoid losses when capital flows are reversed, high domestic interest rates are required to stem capital outflow. Result is the decline of domestic economic activity. Adoption of foreign currency eliminates the need for net exports as the source of revenue needed to service debt obligation, hence it renders the balance of payments as an obstacle to sustained capital flows and economic growth irrelevant.     

Does devaluation improve the current account?

This paper incorporates the link between devaluation, foreign interest payments, and the current account into a fairly general macroeconomic model in which exchange rate changes influence aggregate demand through exports, imports, and expenditure as well as aggregate supply via the cost of imported factors of production. On the basis of available statistical estimates of the behavioral and structural parameters of the model, an attempt is made to assess the empirical importance of this link, among others, in a group of highly indebted industrial and developing countries. By and large, the empirical results indicate that high foreign debt and interest payments tend to reduce the short- to medium-run effect of devaluation on national income, especially in the LDCs, but make little difference to its generally positive effect on the current account.     

Trade prices and supply in the UK economy

Current account imbalances are a major source of instability in the world monetary and trading system. Measures to correct these imbalances have largely involved adjustments to exchange rates. In the international trade literature, when the current account is in deficit, the Marshall-Lerner condition is sufficient for a successful devaluation. However, this partial equilibrium condition — apart from being based on the assumption that supply elasticities are infinite — abstracts from how the domestic economy responds to the change in relative prices. In this paper we develop a model of price and output determination in an open economy with imperpectly competitive markets, and draw a distinction between goods which are exported and those which are supplied to the domestic market. This means that we have to determine jointly both export prices and the domestic price of house sales. We show that as long as there is no money illusion in the labour market a fall in the nominal exchange rate raises domestic and export prices proportionally and leaves trade volumes unaffected. However, shifts in domestic absorption relative to overseas demand — by changing relative prices — cause shifts in the relative supply of exports and domestically sold goods and affect the trade balance. Thus fiscal and monetary measures directed towards reducing domestic absorption are more likely to be successful in correcting current account imbalances than exchange rate depreciation.     

Contractionary devaluation in the southern cone: The case of Chile

This paper discusses the effects of a currency devaluation on output, employment and the trade balance in a small open economy (Chile). The structure of the foreign trade sector in terms of price elasticities, the sectoral differences in relative domestic value added intensities across exports and import competing industries and the degree of wage indexation, are the main determinants, in our model, of the impact of devaluation. A simulation carried out with a computable macro model for Chile, shows a currency devaluation to be contractionary in the short to medium run.     

Foreign capital and the contractionary impact of currency devaluation,with an application to Jamaica

This paper analyses the effects of currency devaluation in a small open economy host to foreign capital. Using a short-run macroeconomic model of the Krugman-Taylor (1978) type, it is shown that the presence of foreign capital provides devaluation with an additional contractionary mechanism, besides those already identified in the literature. The mechanism has its basis on the redistribution of income from wages to profits creasted by devaluation, which raises the foreign component of domestic income and tends to reduce GNP and GDP. The role of taxation policy in this context is examined. Finally, estimates of the relevant effects are offered for Jamaica, a small mineral exporter, showing that an expansionary effect of devaluation must rely on a relatively high value of the supply elasticity of non-mineral exports.     

Import-content of exports and J-curve effect

This article investigates how the response to devaluation of trade balance is affected, compared to J-curve hypothesis, by the presence of imported inputs in the production of exports. Using first the Almon lag technique and then the cointegration and the generalized impulse response function analysis, the J-curve effect is examined in two sectors of Turkish economy (manufacturing and mining), which use imported inputs at different rates. Based on the data covering the period from the first quarter of 1986 to the third quarter of 1998, our results indicate that in neither sector J-curve exists and that the violation of the J-curve effect is more severe in the sector with higher import content     

Is energy consumption sensitive to foreign capital inflows and currency devaluation in Pakistan?

This study investigates the relationship between foreign capital inflows and energy consumption by incorporating economic growth, exports and currency devaluation in energy demand function for the case of Pakistan. The long-run and short-run effects are examined via ARDL bounds testing procedure. Foreign capital inflows and currency devaluation (economic growth and exports) decrease (increase) energy consumption in long-run. The results confirm a feedback effect between foreign capital inflows and energy consumption. These findings would be helpful to policy makers in designing comprehensive economic and energy policies for utilizing foreign capital inflows as a tool for optimal use of energy sources to enhance economic development in long run.     

Trade flows,relative prices,and effective exchange rates: a VAR on Ethiopian data

The dynamic response of trade flows to price and effective exchange rate changes is examined via VAR using quarerly data from Ethiopia for the period 1973(i)–1985(iv). The results show one-way Granger-causality running from prices and exchange rates to imports and exports without significant feedback. Imports and exports exhibit similar response patterns to unexpected changes in relative prices and exchange rates. The responses of imports and exports are larger and the adjustment takes longer when relative prices rather than exchange rates caused a change in international prices. In the long-run, changes in prices account for a larger percentage of the forecast error variances in imports and exports than exchange rate changes. It is shown that devaluation may have an initial adverse effect on the trade balance.     

Exchange rate policy and trade balance: a cointegration analysis of the Argentine experience since 1962

Using multivariate cointegration tests for nonstationary data and vector error correction models, this article examines the determinants of trade balance (TB) for Argentina over the last forty to fifty years taking into account that the short-run impacts of currency depreciation on the TB behaviour may differ from the long-run effects. Our investigation confirms the existence of long-run relationships among TB, real exchange rate (RER) and foreign and domestic incomes for Argentina during different RER management policies. Based on the estimations, the Marshall-Lerner condition is checked and, by means of impulse response functions, we trace the effect of a one-time shock to the RER on the TB not finding support for a J-curve pattern in the short-run.     

The J-curve: evidence from commodity trade between US and China

In testing the short-run (J-curve effect) and the long-run effects of currency depreciation on the trade balance many researchers have used either trade data between one country and the rest of the world or between one country and another trading partner. Both groups are said to suffer from aggregation bias. To reduce the bias, in this article we consider trade data between one country (the US) and her trading partner (China) disaggregated by commodity. We use imports and exports of 88 industries (2-digit and 3-digit classifications) and cointegration analysis to show that the trade balance of at least 34 of the industries react favourably to real depreciation of the dollar. The J-curve effect is detected in 22 industries. Furthermore, most of these industries that are sensitive to currency depreciation are durable commodity groupings.     

Budgetdefizit und Leistungsbilanzsaldo-Replik

Summary In a previous article I explained the gradual deterioration of Austria's current balance in the seventies and its pronounced deficit in 1976 and 1977 within the framework of the relative absorption approach by reference to capacity utilization rates that were high compared to those of other countries. The high utilization rates in turn were the consequence of an expansive economic policy, in particular of an expansive fiscal policy. Guger-Wörgötter, on the other hand, interpret the deficit in the Austrian current balance as the result of weak foreign demand and view the budget deficit as an attempt to compensate for insufficient aggregate demand; they conclude that full employment policies should be continued disregarding the economic development abroad. The present paper presents additional evidence that the deficit in the current balance is attributable to the fact that Austria's economic policy maintained a higher rate of capacity utilization than abroad. Such a policy serves a useful purpose and can be financed by foreign currency reserves only in the case of a cyclical demand deficiency; in the long run, however, it can be sustained at best only under a regime of flexible exchange rates (continuing devaluation).     

货币替代理论研究述评

货币替代是开放经济中所特有的一种货币性扰动,它会对一国的经济金融形势产生严重影响,如货币政策的独立性和有效性受到影响、政府的财政税基遭到削弱、汇率波动频繁、国际收支失衡、减缓甚至阻碍该国货币的自由兑换进程等。随着中国经济高速增长以及人民币的强烈升值预期,我国出现了人民币正在逐步替代外币美元的反向货币替代现象,同样对我国经济造成了一系列的冲击。本文首先从货币替代的定义、形成机制、经济影响、防范风险的对策等方面对国外文献进行了理论综述;然后,分析了国内学者对货币替代理论的研究,特别研究了我国在目前背景下出现的反向货币替代现象;最后在对国内外货币替代理论文献综述的基础上,对将来的研究方向进行了展望。     

On the Transmission Mechanism of Monetary Constraints to the Real Side of the Economy

Contrary to the predictions of the theory underlying international finance, inflows of capital triggered by financial liberalisation have neither equalised real interest rates nor increased income growth in many emerging economies. We explain this puzzle by developing a model that combines the balance‐of‐payments constraint approach to economic growth with a less stringent version of the real interest rate parity hypothesis. The model’s foundations are based on robust empirical findings or well‐established macroeconomic models. We show that a perverse combination of income elasticities of demand for imports and exports generates slow income growth and high real interest rates. As domestic income grows and imports rise faster than exports, the real exchange rate is expected to depreciate in order to clear the balance of payments (or the foreign exchange rate market). An incipient capital outflow arises and interest rates increase. Faster adjustment in capital rather than in the goods market therefore generates a higher real interest rate differential between the domestic small open‐economy and the rest of the world. The long run analysis shows that a constant degree of risk aversion implies a positive equilibrium real interest rate differential that affects economic growth. A permanent increase in default risk driven by persistent current account imbalances thus impacts on long run growth. The model’s results are illustrated with evidence from the three major Latin America economies: Argentina, Brazil and Mexico.     

Corrupt Importers,Domestic Producers & Welfare: Role of Trade Policy

Stringent regulatory foreign exchange and trade policies create distortions and lead to mis‐invoicing of imports and exports. Such legally prescribed opportunistic behavior is alleged to be common in LDCs because of their lack of openness and restrictive policies. This paper focuses on the impact of various trade and currency policies like tariffs, quotas, different exchange rates, and devaluation and administrative policy instruments like monitoring and penalties on import mis‐invoicing under Cournot quantity competition. A framework is developed to analyze the impact of those policies on importers and domestic producers both under fixed and flexible exchange rate regimes.     

Currency devaluations,aggregate demand,and debt dynamics in economies with foreign currency liabilities

The article uses a post Kaleckian model to analyze how currency devaluations affect aggregate demand and capital accumulation in an economy with foreign currency liabilities in the short-run. In benchmark post Kaleckian open economy models, currency devaluations have two effects. First, they change international price competitiveness and thus affect net exports. Second, devaluations change income distribution and thereby affect consumption and investment demand. The overall effect on aggregate demand and investment is ambiguous and depends on parameter values. Existing models, however, disregard balance sheet effects that arise from foreign currency-denominated external debt. The article develops a novel post Kaleckian open economy model that introduces foreign currency-denominated external debt and balance sheet effects to examine the demand-effects of devaluations. Furthermore, the article models the dynamics of external and domestic corporate debt. It discusses how an economy may end up in a vicious cycle of foreign-currency indebtedness and derives the conditions under which indebtedness becomes stable or unstable. It shows that the existence of foreign currency-denominated debt means that contractionary devaluations are more likely, and that foreign interest rate hikes, and high illiquidity and risk premia compromise debt sustainability. Devaluations only stabilize debt ratios if they succeed in boosting domestic capital accumulation.