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Are Real Devaluations Contractionary? Contractionary Effects

In contrast, the supply side channels through which real depreciation put contractionary effects on output are: the higher cost of imported inputs channel, higher wage costs channel, higher cost of working capital channel and foreign exporters as a price taker in the domestic economy channel etc. Whereas, the higher cost of imported inputs channel shows the contractionary effects of devaluation on output through the reduction in the firms demand for imported inputs. Second, the higher wage costs channel refers to the decrease in the output level because of the curtailment in the firms supply when the workers demand for higher wages, as a result of depreciation. Third, the higher cost of working capital channel is based on the argument that depreciation increases the price level and leads to the reduction of real volume of credit via higher money supply. This increase the interest rate and results in the higher cost of working capital and lesser production in the economy. Finally, the foreign exporters as price taker channel shows that as the foreign exporters face an upward sloping marginal cost curve and a horizontal marginal revenue curve so their foreign supply of goods is determined by the intersection of marginal revenue and marginal cost curves. Hence, when devaluation occurs the price receive by a foreign producer in terms of his own currency will decrease. As a result the foreign producer will reduce the output supply in the domestic economy leads to a leftward movement in the aggregate supply curve. direct lenders payday loans
Like the theoretical controversies, no common consensus also exists among the empirical economists about the relationship between the real depreciations and output level. The literature shows four types of empirical approaches: the control group approach, the before and after approach, the macro-simulation approach and the econometric approach. Whereas, the control group approach is based on the separation of the effects of devaluations from other factors on the output. Similarly, the before and after approach analyzes the economic performance of a country before and after the devaluation. Likewise, the macro-simulation approach uses simulation models for examining the relationship between the exchange rate and the output. However, the econometric approach applied by various studies e.g. Sheehey, Upadhyaya and Bahmani-Oskooee and Miteza etc. uses the econometric methods to the time series data for finding the impact of devaluations on output. All the above discussions show that the relationship between the real exchange rate and output depends on the macroeconomic policies (i.e. monetary and fiscal) of each country and cannot be generalized. These large disagreements in the literature become a source of motivation for testing this contractionary hypothesis of real devaluations for Pakistan. A study like this for a developing country Pakistan can be interesting because the country has unique experiences of exchange rate systems, frequent devaluations and higher inflation periods.

This post was written by , posted on May 2, 2014 Friday at 5:13 pm