Does Devaluation Make Sense in the Least Developed Countries?

Abstract

The exchange rate is a controversial instrument of economic policy, especially in developing countries. Even in cases where currency overvaluation is clearly a major cause of an acute balance of payments crisis, the governments of developing countries are frequently reluctant to devalue, apparently for three main reasons: (a) they doubt that export production, import demand, and domestic expenditures are very responsive to a change in the exchange rate (elasticity pessimism); (b) they fear the potentially disruptive side effects of devaluation on inflation, employment, and output growth as well as on real wages and income distribution; and (c) they want to avoid political risk.' The focus of the present study is on the effects of devaluation in the deficit-prone least developed countries where a large part of the population barely survives on a subsistence wage. To be wholly successful, devaluation generally requires a reduction of real wages to encourage the expansion of exports and of import substitution without a contraction of national income. Hence our lead question: Is devaluation an appropriate method of economic stabilization in the least developed countries where a decrease of real wages or earnings could result in severe economic hardship or even starvation? More specifically, the aim of our study is twofold: (1) to investigate the short-to-medium-term effects of devaluation on macroeconomic performance in the least developed countries, subject to the condition that real wages or earnings