Optimal devaluations

Constantino Hevia and Juan Pablo Nicolini

No 4926, Policy Research Working Paper Series from The World Bank

Abstract: According to the conventional wisdom, when an economy enters a recession and nominal prices adjust slowly, the monetary authority should devalue the domestic currency to make the recession less severe. The reason is that a devaluation of the currency lowers the relative price of non-tradable goods, and this reduces the necessary adjustment in output relative to the case in which the exchange rate remains constant. This paper uses a simple small open economy model with sticky prices to characterize optimal fiscal and monetary policy in response to productivity and terms of trade shocks. Contrary to the conventional wisdom, in this framework optimal exchange rate policy cannot be characterized just by the cyclical properties of output. The source of the shock matters: while recessions induced by a drop in the price of exportable goods call for a devaluation of the currency, those induced by a drop in productivity in the non-tradable sector require a revaluation.

Keywords: Economic Theory&Research; Debt Markets; Emerging Markets; Currencies and Exchange Rates; Economic Stabilization (search for similar items in EconPapers)
Date: 2009-05-01
New Economics Papers: this item is included in nep-cba, nep-ifn, nep-mac, nep-mon and nep-opm
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (3)

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Related works:
Journal Article: Optimal Devaluations (2013)
Working Paper: Optimal devaluations (2013)
Working Paper: Optimal Devaluations (2011)
Working Paper: Optimal Devaluations (2004)
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Persistent link: https://EconPapers.repec.org/RePEc:wbk:wbrwps:4926

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