Devaluation, Fiscal Deficits, and the Real Exchange Rate

Abstract

This article examines the use of fiscal policies to sustain the effects of a nominal devaluation on the real exchange rate. It is shown that the magnitude of the change in the real exchange rate depends not only on the size of the devaluation and the degree of fiscal adjustment but also on the means by which the fiscal deficit is reduced. The change in the nominal exchange rate necessary to maintain the depreciation of the real exchange rate will depend on whether the fiscal deficit is eliminated by increasing taxes or by reducing government expenditures on traded and nontraded goods. The required depreciation of the domestic currency will be larger if the fiscal deficit is reduced by increasing taxes than it will be if the deficit is cut by lowering government expenditures. Further, the depreciation would be smaller if the cuts in expenditure fell on traded rather than nontraded goods. This result implies that the authorities must ensure consistency between exchange rate action and policies to reduce fiscal imbalances in order to achieve a desired level of the real exchange rate necessary to attain balance of payments equilibrium. The real exchange rate represents a key relative price in the economy and policies to change it are often the centerpiece of adjustment programs designed to improve international competitiveness and shift resources toward the production of tradable goods. Consequently, it is critical for policymakers to have some idea of the magnitude and time path of the likely response of the real exchange rate to nominal exchange rate action. It is a well-accepted proposition, however, that a nominal devaluation will only have a transitory effect on the real exchange rate. In the long run domestic wages and prices will rise by the full amount of the devaluation and the real exchange rate will return to its original level. To alter the real exchange rate on a permanent basis, therefore, devaluation has to be supplemented by policies that restrain the increase in domestic factor costs that results from a devaluation. Generally speaking, the effects of a devaluation on the real exchange rate can