Exchange rate management and stabilization policies in developing countries

Abstract

We outline three channels via which a devaluation has a direct contractionaly impact on the aggregate supply side of the economy: local currency costs of intermediate imports, wage indexing in the presence of food imports and reduced volume of real credit to firms. Contractionary effects via the supply side are more damaging than Krugman-Taylor effects via aggregate demand since a cut in aggregate supply leads to upward pressure on inflation while a cut in aggregate demand tends to abate inflation. Upward pressure on inflation may over time threaten the increase in competitiveness a nominal devaluation also intends to achieve. We also discuss the implications of a substantial foreign debt. We demonstrate that a successful devaluation raises the real (in terms of domestic goods) debt service burden, causing a Krugman-Taylor like contractionary effect on aggregate demand. We then analyse the effects of a preannounced slowdown of the rate of depreciation. Our results of course do not imply that a devaluation should never be considered. They do suggest, however, that a devaluation is likely to be an ineffective tool for demand management since it may cut aggregate supply as much or more in the short run.