Devaluation in low-inflation economies

Miguel A. Kiguel and Nita Ghei

No 1224, Policy Research Working Paper Series from The World Bank

Abstract: In the current period of devaluation pessimism, devaluation is often seen as an instrument to accommodate inflation instead of one to change the real exchange rate and support external balance. The authors argue that such pessimism has in some cases gone too far. The real exchange rate is an endogenous variable, and whether devaluation can change the real exchange rate depends on other factors. But devaluation is not always evil, say the authors, and in some cases it can improve macroeconomic performance. It is most effective if it corrects an initial situation where the currency is clearly overvalued. In low-inflation countries, devaluation is less likely to destabilize prices because there is less indexing. The authors examine the effect of maxi-devaluation in low-inflation countries on the real exchange rate, inflation, and growth. They use a sample of 33 maxi-devaluations (20 percent or larger) in economies that had low inflation before the devaluation and where the exchange rate had remained fixed for at least three years before the devaluation. Not surprisingly, most of these episodes occurred in the 1950s and 1960s, when fixed exchange rates and inflation were the norm. The results indicate room for devaluation optimism. The authors find that devaluation is more effective in low-inflation economies where devaluation is a sporadic event - typically, effecting a real depreciation twice as large as that in inflationary economies. In low-inflation countries, a 50-percent devaluation typically succeeds in depreciating the real exchange rate by about 30 percent in the long run, without leading to a permanent increase in inflation. The authors also find that growth and exports increase after devaluation. Other findings include the following. Countries determined to maintain price stability after devaluation can do so. In countries with low inflation that have not devalued for three years, a maxi-devaluation is not likely to move the economy into high inflation. Under most of the most likely scenarios, inflation will increase around 3 percentage points (or 35 percent of the original rate of inflation). Under the best scenarios, there is an increase in inflation the year before and the year of devaluation, but inflation then falls to a level slightly higher than the level before devaluation. Devaluation has a favorable impact on exports. The shift to a more flexible exchange-rate regime was not associated with complete loss of control of inflation. In most cases, inflation went up slightly - and in only a few cases (Ecuador, Israel, Mexico, and Zaire) dramatically.But the movement toward greater exchange-rate flexibility was not associated with complete loss of control of inflation. In Pakistan and Rwanda, inflation fell, and in most countries it averaged less than 20 percent.

Keywords: Environmental Economics&Policies; Economic Stabilization; Economic Theory&Research; Macroeconomic Management; Fiscal&Monetary Policy (search for similar items in EconPapers)
Date: 1993-11-30
References: View complete reference list from CitEc
Citations: View citations in EconPapers (4)

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