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Are Real Devaluations Contractionary? Introduction

Are Real Devaluations Contractionary? IntroductionThe literature provides a rich debate of individual countries (See, Branson, 1986; Ghura and Thomas, 1993; Kamin and Rogers, 2000; Berument and Pasaogullari, 2003) and cross countries analysis on the relationship between the real exchange rate and output level with the application of different econometric techniques. However, inspite of these substantial number of studies conducted both for the developed and developing countries, the question whether real exchange rate devaluations put expansionary or contractionary effects on output is still not conclusive.
Until 1970s, the traditional wisdoms i.e. elasticities, absorption and Keynesian favors the expansionary hypothesis of real devaluations, were largely dominating. However, in recent years the “New Structuralist” economists (i.e. Edwards, 1989; Coock, 2004; Malender, 2009) strongly opposed the conventional theories by arguing that real devaluations can bring a decline in the output level through various aggregate demand and supply side channels. Whereas, the demand side channels of the contractionary hypothesis of real devaluations suggested by the New Structuralist theorists are: the income redistribution channel, interest rate channel, investment channel, external debt channel, real balance effect channel and tax channel etc. payday cash loans

The income redistribution channel is based on the assumption that as the marginal propensity to save (MPS) of the wage earners class is lower against the profit earner class hence devaluation will increase the prices in the export and import competing industries and reduce the real wages of the income earner group. This will raise the overall average propensity to save (APS) in an economy and result in the decrease of output. Similarly, the interest rate channel points towards the decline in the output through the decrease in consumption and investment when the devaluation swells the interest rate as a result of higher domestic prices and money supply. Likewise, the investment channel points to the decline in output, when the depreciation discourages the new investment in reaction of the costly imported capital goods. In the same way, the external debt channel is based on the argument that as most of the debt of the developing countries is dominated in dollars; hence the devaluation will decrease the net wealth and aggregate expenditure of both the private and government sectors which results in the reduction of the output. Moreover, the real balance effect channel refers to the decrease in output as a result of the decline in the real cash balances and net wealth of the people when devaluation rise the price level because of the increase in traded goods prices. Finally, their tax channel is based on the argument that as in developing countries the demand for imported goods is inelastic and its volume remains the same inspite of any rise in prices. This will increase the ad valorem trade taxes and redistribute the income from the private sector to the government sector. Hence all this will cause contraction in output via decrease in private consumption.

This post was written by , posted on April 30, 2014 Wednesday at 4:11 pm