Chronicle of Large Currency Devaluations: Re-Examining the Effects on Output

Abstract

The impact of large currency devaluations on output, as measured by the real gross domestic product, continues to be an elusive question in the empirical macroeconomic literature. This paper aims at reexamining and providing new empirical evidence on this relationship, by using a sample covering 109 emerging market and developing economies for the period 1960-2006. In contrast with the existing empirical literature, we examine not just the impact of large nominal currency devaluations on output growth, as has been customary in the literature, but also provide estimates of how devaluationary episodes affect output trend. By doing so, we find that the devaluation-output relationship is not robust across regions and time, and that the persistence of devaluations matters. In particular, one-time devaluations induce output trend gains at ten year horizons, while successive devaluationary episodes have no impact whatsoever. A policy implication is that poorly executed devaluations induce no long-run output gains. Finally, the role of the external sector in explaining the heterogeneity of the results is examined. We find that real imports rather than exports do most of the adjustment, thus suggesting a strong expenditureswitching effect and, possibly, the emergence of export financing constraints at the time of devaluations. This last aspect highlights the need to avoid a credit crunch at the time of large currency devaluations as it might wipe out all the beneficial gains that devaluations may have on exports and, ultimately, on output.