Exchange Depreciation, Financial Policy, and the Domestic Price Level

Abstract

T HE PRESENT PAPER constitutes the first part of a study designed to show the order of magnitude of the increases in domestic prices that will result, on specified assumptions regarding the relevant foreign trade elasticities and propensities, from exchange depreciation accompanied by appropriate financial policies. Exchange devaluation may be used to improve the balance of payments or to permit a relaxation of import restrictions. Only the former use is considered here, the latter being reserved for consideration in a later paper. It is assumed here that exchange depreciation is accompanied by a financial policy that leaves unchanged the level of aggregate employment. For the type of depreciation examined, such a policy is taken to be compatible with the maintenance of stability in the prices of home trade goods, although the prices of import and export goods will rise. Several hypothetical cases are defined by assigning sets of numerical values to the relevant coefficients (Table 1); and illustrations are given of the price effects that will result in these cases from (1) an exchange depreciation of 10 per cent and (2) a depreciation leading to an improvement in the balance of trade equivalent to 5 per cent of national output (Table 2). For some of these cases, the extent to which the price level may be expected to rise after adjustments have been made to indirect taxes for the purpose of restoring budgetary equilibrium is indicated (Table 8). Finally, the effect on the price level of a defined tendency for wage rates to rise in response to, though to lesser extent than, increases in the cost of living is illustrated (Table 9). In general, it appears that, if an appropriate financial policy is pursued, and if a wage-price spiral can be prevented, price increases are likely to be fairly moderate relative to the improvement achieved in the balance of trade, although considerable differences exist in this respect between different cases.