Currency Devaluations And Implications Of The Correspondence Principle

Are devaluations contractionary? Do devaluations ensure improvement in the balance of payments? These questions have attracted much attention in recent years, since during that time, macro-economists have developed models involving intermediate imports. In such a framework, the exchange rate has both expansionary demand-side and contractionary supply-side effects. A number of studies, both theoretical and empirical, have explored the relative size of the competing effects that follow from devaluations. However, most of the studies involve very limited or specialized models. For example, most studies deal with a specific form of the production function, and dynamic analysis of exchange rate devaluation is almost always absent. As a result, very few studies shed any light on the relationship between stability of the model and the likelihood of contractionary devaluation. Furthermore, except for one, none of the studies has examined devaluation's effects under different tax system. In this thesis, we extend those models which have imposed the bare minimum of restrictions on the production relationship, and which pay explicit attention to dynamics. The whole thesis can be viewed as two main essays. In the fIrst main essay (Chapters 3 and 4) we focus on the likelihood of contractionary devaluation in a model with a general production function involving imported inputs. In this essay the inconsistencies in BuffIe (International Economic Review 1986) are corrected. Furthermore, some sensitivity tests are also performed in this essay. These stem from the alternative specifIcations of wage flexibility, inflationary expectations, the definition of the money demand function, and alternative degrees of capital mobility. In the second main essay (Chapter 5) a sensitivity analysis of an improved version of the Lai and Chang model (Journal of Macroeconomics 1989) is presented. In this essay we have investigated how the supply-side effects of taxes and exchange rates interact (when the tax systems is not fully indexed) to complicate the effects of devaluation. In our fIrst essay we noticed that regardless of alternative specifIcations of wage flexibility and of inflationary expectations the strong BuffIe's results do not hold in general. BuffIe derived the result that if the system is locally stable then devaluation cannot both contract employment and worsen the balance of payments of the country. Furthermore, if labour and the imported inputs are gross substitutes then devaluation both increases employment and improves the balance of payments (given stability). However, when we assume that the aggregate demand function for goods is negatively sloped in the price/output plane then it is seen that in stable economies all the results derived by Buffie hold true. In this same essay we found that in case of perfect capital mobility the employment effect of devaluation largely depends upon the alternative specifications of the wage flexibility and of inflationary expectations. It is seen that if workers have perfect foresight then devaluation has an ambiguous effect on employment, expansionary when workers have static expectations, and neutral when the real wage is sticky at each point in time.