The Real Exchange Rate and the Output Response in Four Transition Economies: A Panel Data Study

Aleda Mitchell and Eric Pentecost

Chapter 5 in Exchange Rate Policies, Prices and Supply-Side Response, 2001, pp 68-77 from Palgrave Macmillan

Abstract: Abstract The relationship between the real exchange rate and the level of output is an important and controversial issue for developing and transitional economies. The traditional literature suggests that a real exchange rate depreciation will lead to a rise in the demand for domestic output as the gain in competitiveness improves the trade balance, assuming that the sum of the import and export elasticities of demand exceed unity.1 On the other hand, there are several theoretical reasons why, contrary to the traditional view, devaluation can be contractionary and generate a decline in economic activity. First, nominal devaluations can result in some contractionary pressures on aggregate demand, which could more than offset the traditional expenditure-switching effect. For example, a devaluation will raise the price level, generating a negative real balance effect (Alexander, 1952), which will in turn lower aggregate demand and output. Another channel through which devaluation can lower aggregate demand relates to its effect on income distribution. A devaluation can redistribute income from groups with a low marginal propensity to save to groups with a high marginal propensity to save, resulting in a decline in demand and output (see Krugman and Taylor, 1978). Furthermore, if the price elasticites of imports and export are sufficiently low, the trade balance expressed in domestic currency may worsen, generating a recessionary effect. Second, in addition to these demand-side effects there are a number of supply-side channels through which devaluation can be contractionary.

Keywords: Real Exchange Rate; Money Supply; Trade Balance; Domestic Currency; Exchange Rate Policy (search for similar items in EconPapers)
Date: 2001
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DOI: 10.1057/9780230554535_5

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