Depreciation and the Dampening Effect of Income Changes

Abstract

EXCHANGE rate depreciation can be used by a country either to improve its balance of payments or to stimulate domestic employment and output. But there is a conflict between these two objectives. If expansion at home is allowed, the depreciation cannot be expected to result in the trade account improvement obtainable if domestic policies to stabilize output and employment were pursued. This article discusses the extent to which the income movements that are a consequence of devaluation conflict with the goal of improvement in the trade balance. analysis of devaluation was extended to incorporate income movements in the studies by Laursen and Metzler' and by Harberger.2 Subsequent criticisms and extensions have clarified many aspects of the problem,3 especially the money-illusion that was implicit in Harberger's analysis. Emphasis in their work has been placed upon the value that must be exceeded by the of elasticities of import demand in order to insure stability in the foreign exchange market. dominant conclusion that emerged was that this sum exceeds unity if employment and output are allowed to respond to the forces set in motion by depreciation. In this paper I assume that demand elasticities exceed the critical for exchange stability, so that depreciation becomes a feasible technique for improving the trade balance, and examine the nature and extent of the dampening effect of output and employment changes on the balance of payments. This is accomplished by investigating what I call the dampening coefficient associated with output changes. Consider the improvement in the trade account with variable outputs relative to the improvement if stabilization policies are pursued. This fraction subtracted from unity is an index of the extent to which income changes have reduced the improvement in the trade account. higher the value of this dampening coefficient, the greater the cost4 to the devaluing country of output changes. Two types of dampening coefficient must be distinguished. first relates to the comparison between (i) devaluation in which all countries' outputs vary as they will and (ii) devaluation in which all countries stabilize levels of output and employment, and is a measure of the comparative importance of effects5 and income effects. It is examined in the first section of this paper. second dampening coefficient is relevant to trade policy in the devaluing country. It measures the diminution in the gains in the trade account resulting from failure to control output in the depreciating country when some specific assumption is made as to stabilization policies abroad. That is, it is assumed that decisions in the devaluing country concerning stabilization policy do not influence other countries' stabilization policies. For simplicity, I assume, in the second section of this paper, that other countries decide not to permit any fall in employment. expressions for either dampening coefficient depend upon the period of time during which the of devaluation are considered. distinction made in this paper between the short-run and long-run of currency depreciation is based upon studies suggesting dif* This paper had its origin in my doctoral thesis submitted to M.I.T. in 1955-56. It has benefited from comments by Robert Solow and Lionel McKenzie. ' S. Laursen and L. Metzler, Flexible Exchange Rates and the Theory of Employment, this REVIEW, XXXII (November 1950). 'A. Harberger, Currency Depreciation, Income, and the Balance of Trade, Journal of Political Economy, LVm (February 1950). 'For example, cf. Spraos, Consumers' Behavior and the Conditions for Exchange Stability, Economica, xxII (May 1955); Pearce, A Note on Mr. Spraos' Paper, Economica, xxii (May 1955); H. Johnson, The Transfer Problem and Exchange Stability, Journal of Political Economy, Lxrv (June 1956). 4 Cost measured in sacrificed improvement in the trade account. 6 By price effects I mean the change in the trade balance resulting from the change in relative prices, neglecting the impact of changes in aggregate outputs.