Chapter 8 Exchange-Rate Management: Contractionary Devaluation and Real-Exchange-Rate Rules

1. Chapter 8Exchange-Rate Management: Contractionary Devaluation and Real-Exchange-Rate Rules © Pierre-Richard Agénor and Peter J. Montiel

2. Contractionary Devaluation. • Real-Exchange-Rate Targeting.

3. Contractionary Devaluation

4. Consider a small open economy that operates under a fixed-exchange-rate system. • “Dependent economy” framework in which traded and nontraded goods are produced using • homogeneous, intersectorally mobile labor; • sector-specific capital; • imported inputs. • Production costs may be affected by the need to finance working capital. • There are variety of mechanisms to determine the nominal wage. • Households hold money, capital, and foreign securities and issue debt to each other.

5. Effects on Aggregate Demand. • Consumption. • Investment. • Nominal Interest Rates. • Effects on Aggregate Supply. • Effects on the Nominal Wage. • Imported Inputs. • Effects Through Costs of Working Capital. • Empirical Evidence. • Before-After Approach. • Control Group Approach. • Econometric Models. • Macro-Simulation Studies.

6. Effects on Aggregate Demand • Demand curve facing the traded goods sector is given by the law of one price: PT = EPT*, PT: domestic-currency price of traded goods; E: nominal exchange rate; PT*: foreign-currency price of traded goods (unity).

7. Aggregate real demand for nontraded goods: dN = cN + IN + gN, cN: domestic consumption; IN: investment; gN: government demand.

8. Consumption • Consumption demand for nontraded goods: cN = cN(z, y - tax, i - a, a; ). z = PT/PN: real exchange rate (PN is domestic-currency price of nontraded goods); y - tax: real factor income received by households net of real taxes; a: real household financial wealth; i - a: real interest rate (i is domestic nominal interest rate and a expected inflation rate); : shift parameter to capture distributional effects on aggregate consumption. (1)

9. Effects of devaluation: Relative Price Effects: • Nominal devaluation causes changes in relative prices • This affects demand for domestically produced goods. • Total (foreign and domestic) demand for domestically produced traded goods is perfectly elastic and thus is not affected by relative price changes. • But total (domestic) demand for nontraded goods is affected by changes in relative prices. • Devaluation has a relative price effect on the demand for domestically produced goods through its effect on the demand for nontraded goods.

10. Real depreciation of the domestic currency (increase in relative price of traded to nontraded goods) increases demand for nontraded goods.

11. Real Income Effects: • Devaluations produce changes in real income that affect the demand for domestically produced goods. • Real-income changes can be decomposed into those resulting from changes in • relative prices at the initial level of output; • output at the new relative prices. • Price level: P = EP1 - , 0 <  < 1, : share of traded goods in consumption. (2) N

12. Real income: y = yNz - + yTz1 - , yN: production of nontraded goods; yT: production of traded goods. • Effect of a real devaluation on real income for a given level of output is ambiguous. • Differentiating (3) with respect to z: dy/dz = z-1(-)(yNz-+yTz1 - ). •  is share of traded goods in total output:  = zyT/(yN+zyT). (3) (4)

13. (4): impact effect on real income depends on whether traded goods have a higher share in consumption or in income. • Assume: • no expenditure on investment goods; • no public sector expenditure, so that cN = yN. • Then net effect on real income depends on whether consumption of traded goods is higher or lower than yT (whether there is a trade deficit or a trade surplus). • If there is a deficit, real income declines with a real devaluation. • Reason: goods whose relative price has increased have a higher weight in consumption than in income.

14. Demand for nontraded goods may increase because of a higher level of output of traded goods. • Production of traded goods increases as long as the price of its input does not rise by the full amount of the devaluation. • Whether the latter condition holds depends on the degree of wage indexation, the stance of inflationary expectations, and other factors.

15. Effects Through Imported Inputs: • Due to the presence of imported inputs, devaluation may cause negative effect on the demand for domestically produced goods. • Reason: imported inputs make it more likely that the real income effect of a devaluation is negative. • To obtain national income imported inputs must be subtracted from domestic output. • Thus real devaluation affects real income also through changes in the real value of imported inputs. Two opposing effects of a real devaluation on the real value of imported inputs: • Real devaluation increases relative price of imported inputs in terms of the basket of consumption; this increases real value of initial volume of imported inputs.

16. If the price of labor does not increase by the full amount of devaluation, relative price of imported inputs raises. • Then domestic producers have an incentive to substitute labor for imported inputs (reduce the volume of imported inputs). • Net effect depends on • degree of factor substitutability in production; • extent to which a devaluation is transmitted to wages. Assumptions: • Traded goods are produced with a fixed amount of specific capital and with labor.

17. Nontraded goods are produced with an imported input and labor according to a CES production function with elasticity of substitution . Lizondo and Montiel (1989): • (4) is modified in the presence of imported inputs by the inclusion of an additional term: z-JN[ - (1-)], JN: volume of imported intermediate goods used in the nontradable sector. • Net effect is ambiguous.

18. Net effect is more likely to be negative • lower the elasticity of substitution between imported inputs and primary factors; • higher the share of nontraded goods in the price index.

19. Income Redistribution Effects: • Devaluation is the redistribution of income from sectors with high propensity to spend on goods of this type to sectors with a lower propensity. Alexander (1952): • Redistribution of income may affect expenditure, and included it as one of the direct effects of devaluation on absorption. • Redistribution of income in two directions: • from wages to profits because of lags in the adjustment of wages to higher prices; • from the private to the public sector because of the existing structure of taxation.

20. Díaz Alejandro (1963); Krugman and Taylor (1978): • Only impact effect of a devaluation is to redistribute a given level of real income from wages to profits because of an increase in prices (with constant nominal wages). • This causes a reduction in the demand for domestic output if marginal propensity to spend on home goods is lower for profit recipients than for wage earners. Example of  other type of income redistribution effect between workers and owners of capital: • In a model with traded and nontraded goods, flexible wages, and sector-specific capital, a real devaluation • reduces real profits in the nontraded goods sector, • increases real profits in the traded goods sector, • has an ambiguous effect on real wages.

21. Cooper (1971): • Possibility of redistribution from the factors engaged in purely domestic industries to the factors engaged in export- and import-competing industries. • Although in some cases this may reduce demand, this may also induce a spending boom. • When all factors of production are mobile, redistribution of income may depend on technological considerations. • Example: in a Heckscher-Ohlin world, real wages and profits depend on factor intensities. • Real devaluation • increases real payments to factors used intensively by the traded goods sector; • reduces real payments to the other factor.

22. How important is the effect on the demand for domestic output of redistribution from wages to profits? Alexander (1952): • What is important is the marginal propensity to spend. • Even if profit recipients have a lower marginal propensity to consume, higher profits may stimulate investment. • Thus redistribution of income may result in increased absorption. Díaz Alejandro (1963): • Investment expenditure is more biased toward traded goods than consumption expenditure.

23. Since investment expenditure is undertaken by profit recipients, the demand for domestically produced goods declines. How important is the redistribution of income that will lead to a change in the pattern of aggregate expenditure? • No firm support for the hypothesis of redistribution against labor. Edwards (1989b): • In 15 out of 31 cases, there was no significant change in income distribution. • In 8 cases share of labor in GDP declined significantly. • In 7 cases, it increased significantly.

24. Effects Through Changes in Real Tax Revenue: • Effect of changes in real tax revenue operate through • demand for domestic output • private consumption expenditure or • private investment; • supply for domestic output. • Many governments in developing countries derive a substantial proportion of their revenues from import and export taxes. Krugman and Taylor (1978): • Nominal devaluation that succeeds in depreciating the real exchange rate will increase the real tax burden on the private sector. • Reason: real value of trade taxes increases.

25. This depends on the presence of ad valorem rather than specific taxes on foreign trade. Olivera-Tanzi effect: • When lags in tax collection or delays in adjusting the nominal value of specific taxes cause the real value of tax collections to fall during periods of rising prices. • If nominal devaluations increase inflation, the Olivera-Tanzi effect operates. • Since real tax burden falls, devaluation would exert an expansionary short-run effect on aggregate demand. Third channel works through discretionary tax changes: • Assume, other than trade taxes, all taxes are levied on households in lump-sum fashion.

26. Government's real tax receipts: Tr = Tr(z, , ), : parameter that captures the effects of discretionary taxes; : inflation rate. • First two terms in the function Tr(·) capture trade tax and Olivera-Tanzi effects. + - +

27. Government's budget constraint takes the form Tr(z, , )  gN z - + gTz1 -  + i*z1 - Fg – z1 -(Lg/E+Fg) gT and gN: government spending on traded and nontraded goods; i*: foreign nominal interest rate; Fg: net public external debt; Lg: stock of net government liabilities to the central bank. • Increase in Tr(·) must be offset somewhere else within government budget, since (7) must hold at all times. (7) . .

28. Effect of an increase in real trade taxes on aggregate demand will depend on the nature of this offset. • Example: If the offset takes the form of a reductionin , leaving Tr(·) unchanged, contractionary effect on aggregate demand disappears. • Nominal devaluation that results in a real depreciation may affect each of the entries on the right-hand side of Tr(·) identity. • External debt has been treated as if it were owed by the privatesector. • But most external debt has been owed by the public sector.

29. Implications of public external debt: • If the public sector is a net external debtor, a real devaluation increases real value of interest payments abroad. • Government can finance increased debt service payments by • increased taxation, • reduced spending, • increased borrowing from the central bank or from abroad. • Effects on aggregate demand depend on the mode of financing. • If the government increases discretionary taxes, the effects on aggregate demand would be contractionary.

30. Reason: private disposable income would fall. Reason: private disposable income would fall. • If government reduces spending on nontradedgoods, contractionary effects on aggregate demand may exceed those associated with tax financing. • If spending reductions fall on tradedgoods, the contractionary effects would be nil. • If government finances by borrowing either from the central bank or from abroad, contractionary effects fail to appear. • Devaluation would affect the real value of government expenditures on goods and services. • Total effect depends on the composition of government spending between traded and nontraded goods.

31. Example: reduction in discretionary taxes may ensue with corresponding expansionary effects on aggregate demand. • Effect of a devaluation on discretionary taxes depends on the monetary policy regime in effect. • This is captured by the last term on the right-hand side of identity (7). • If the central bank pegs the flow of credit to the government in nominalterms, the rise in prices that attends a nominal devaluation will reduce Lg/P. • This calls for an adjustment in the government budget, possibly through a discretionary tax increase. • If the flow Lg is adjusted to accommodate the price increase, no further changes in the budget will emanate from this source. . .

32. If real valuation gains on the central bank's stock of foreign exchange reserves are passed along to the government, Lg/P could increase. • Financing options would include an expansionary tax reduction. .

33. Wealth Effects: • Increase in wealth is expected to increase household consumption. • Thus, devaluation can affect the demand for domestic goods through its effects on real wealth. • Nominal wealth is taken to coincide with the nominal stock of money. Alexander (1952): • Devaluation would increase the price level and thus reduce the real stock of money. Two effects of this reduction: • Direct effect, when individuals reduce their expenditures to replenish their real money holdings to desired level.

34. Indirect effect, when individuals try to shift their portfolios from other assets into money, thus driving up domestic interest rate. • This contractionary effect on demand must be modified if the private sector holds other types of assets whose nominal value increases with a devaluation. • Assume that the private sector holds foreign-currency-denominated assets in an amount Fp. • Real wealth: a = (M/P) + (EFp/P) = z1 - [(M/E) + Fp).

35. Percentage change in real wealth from nominal devaluation: a = (1-)z - , : share of domestic money in private sector wealth and : devaluation rate. Implications: • If domestic money is the only asset,  = 1, devaluation has a negative effect on real wealth and on demand. • If the private sector also holds assets denominated in foreign currency, the result is ambiguous. ^ ^

36. Reason: although real value of domestic money declines, real value of foreign assets increases if domestic price level does not rise by the full amount of devaluation. • Thus, effect on the demand for domestic goods may be positive or negative. • It is more likely to be negative • higher ; • lower z; • higher . • Presence of private sector external debt reduces Fp. • This increases . • Thus it increases the likelihood that a devaluation will have a negative effect on real wealth. ^

37. Investment • Assume: capital stock in each sector consists of traded and nontraded goods combined in fixed proportions. • A unit of capital in the traded goods sector consists of N units of nontraded goods and T units of traded goods. • In the nontraded goods sector capital consists of N nontraded goods and T traded goods. • Prices of a unit of capital in the traded goods sector PKT and in the nontraded goods sector PKN: PKT = NPN+ TE, PKN = NPN+ TE. T T N N (10) T T (11) N N

38. Output in each sector is produced by using capital, labor, and imported inputs. • Marginal product of capital in the two sectors: mK = FK(/E; KT), mK = FK(/PN, z; KN), : nominal exchange rate. • In the In the short run, the capital stock is fixed. • By the first-order conditions for profit maximization, an increase in wage will reduce demand for labor. • Ensuing increase in the capital intensity of production will cause the marginal product of capital to fall. - - T T - - - N N

39. EmK/PKT T { ^ } - 1 KT = qT i +  - KT PNmK/PKN T { ^ } - 1 KN = qN i +  - KN • Similar effect results from an increase in z. • Assume: all relative prices are expected to remain at their post devaluation levels. • Sectoral net investment functions: Kh: rate of increase in the price of capital in sector h.

40. Net investment demand in each sector depends on the ratio of the marginal product of capital to the real interest rate. • Gross investment demand is the sum of net investment and replacement investment. • Depletion is assumed to take place at the uniform rate  > 0 in both sectors. • Combine (14) and (15) with replacement investment to yield the total investment demand for nontraded goods: IN = IN + IN = NKTKT + (NKT + NKN) + NKNKN. ^ ^ T N T T N N (16)

41. Branson (1986) and Buffie (1986b): • Since substantial portion of any new investment in developing countries consists of imported capital goods, real depreciation raises price of capital in terms of home goods. • This discourages new investment and exerts contractionary effect on aggregate demand. • This is valid only in the case of investment demand that originates in the nontraded goods sector. • In traded goods sector, real depreciation lowers real supply price of capital measured in terms of output. • Thus, this effect stimulates investment in this sector. • Thus, net effect on IN of changes in the supply price of capital is ambiguous.

42. Second channel through which devaluation affects the investment demand for nontraded goods operates through real profits. • Assume: firms operate on their factor demand curves. • Return to capital is its marginal product, which depends on • initial stock of capital; • product wage; • real exchange rate in the case of the nontraded goods sector. van Wijnbergen (1986), Branson (1986), and Risager (1988): • First two contrasted the case of fixed nominal wages with some degree of wage indexation.

43. Risager examined the effect on investment of holding the nominal wage constant over some fixed initial contract length and then restoring the initial real wage. • Result: devaluation may raise or lower the product wage on impact depending on the nature and degree of wage indexation. • With rigid nominal wages, the product wage would fall on impact, and investment would increase in the short run. • But with indexation, product wage could rise, thereby dampening investment.

44. With some nominal wage flexibility, nominal devaluation results in • reductionin the product wage in the traded goods sector; • increasein the product wage in the nontraded goods sector. • Investment would be stimulated in the former and discouraged in the latter, with ambiguous effects on IN. • Third channel: in the presence of imported inputs. • Marginal product of capital in the nontraded goods sector will be affected by a real devaluation through the higher real costs of such inputs. • Effect is unambiguously contractionary.

45. Reason: depressing effect on profits in the nontraded goods sector is not offset by positive effects on profits in the sector producing traded goods. • In the case of a real depreciation that lowers the product wage in the traded goods sector and raises it in the nontraded goods sector, all three effects • increase investment in the traded goods sector; • decrease it in the nontraded goods sector. • If these effects are sufficiently strong, IN must increase when capital is sector specific. • In this case, increase in investment demand in traded goods sector can be met only through new production. • It cannot be offset by negative grossinvestment in the nontraded goods sector.

46. Nominal Interest Rates • Increase in real interest rate reduces • private consumption of nontraded goods; • investment spending on nontraded goods by both the traded and nontraded goods sectors. • Distinguish between • current effect of an anticipated devaluation; • contemporaneous effect of a previously unanticipated devaluation.

47. Assumptions: • Domestic residents can hold financial assets in the form of money, domestic interest-bearing assets, and interest-bearing claims on foreigners. • Domestic interest-bearing assets take the form of loans extended by households to other entities in the private sector. • Portfolio adjustment is costless. • Effects of a devaluation on the nominal interest rate charged on these loans depend on • degree of capital mobility; • severity of portfolio adjustment costs. • Distinguish two cases based on whether domestic loans and foreign assets are perfect or imperfect substitutes.

48. - - + ( + ) + M + EFp h i, i* + a, y, ; x (17) = 0, P • If loans and foreign assets are imperfect substitutes, equilibrium in the loan market: h(·): real excess demand function for loans; i: nominal interest rate on loans; i* + a: nominal rate of return on foreign assets; i*: foreign nominal interest rate; a: expected rate of depreciation of domestic currency; y: real income; (M+EFp)/P: real household financial wealth; x: vector of additional variables.

49. Increase in i has a negative own-price effect on excess loan demand. • Increase in i* + a raises excess demand for loans as borrowers switch to domestic finance while lenders seek to place more of their funds in foreign assets. • Increase in y causes lenders to increase their demand for money, thereby increasing excess demand in the loan market. • Increase in (M+EFp)/P both reduces borrowers‘ need for outside financing and provides lenders with surplus funds. • This effect reduces excess demand in the loan market.

50. Effect of a devaluation on i at a given initial level of y and PN with a = 0: • Unanticipated devaluation: effect on i depends on the composition of household financial wealth. • Whether real excess demand for loans rises or falls depends on whether (M+EFp)/P increases or decreases. • Devaluation lowers real money stock but raises real value of foreign assets. • Former effect dominates if • large share of household financial wealth is devoted to cash balances; • traded goods have a large weight in private consumption.