Expectations and the Dynamics of Devaluation

Abstract

The traditional treatments of devaluation consist of the elasticities and absorption approaches. The first of these focuses on the relative price effect and assigns a central role to the price elasticities of demand.1 By lowering the relative price of domestic goods, a devaluation will have an expansionary effect domestically, and provided the MarshallLerner condition holds, this will be accompanied by an improvement in the balance of trade (payments). The absorption approach on the other hand, emphasizes the relationship of real expenditure to real income and shows that a devaluation will improve the balance of trade if and only if it increases the difference between income and expenditure.2 Recently, an extensive literature has been evolving, reassessing these traditional effects. Most of this follows the so-called monetary approach to devaluation.3 This itself has several aspects. First, it emphasizes the role of real wealth. It is observed that given the stock of financial assets in nominal terms, a devaluation will lower real wealth, thereby lowering consumption demand, and providing an offsetting contractionary effect to the traditional relative price effect. Secondly, it pays particular attention to how the change in foreign reserves resulting from a devaluation will lead to a change in the domestic money supply, thereby creating a dynamic adjustment process. As a consequence it becomes necessary to distinguish between the short-run and long-run effects of a devaluation, rather than treating it statically, as in the traditional model. In this paper, we focus on one further aspect which has thus far been ignored in devaluation analysis, but which nevertheless is important. This concerns the role of expectations of the devaluation, which impinge on the economy through the domestic interest rate.4 Indeed, devaluations often take place precisely in economic circumstances in which it is not unreasonable for the public to anticipate their occurrence. To the extent this is so, expectations may generate an outflow of capital which at least in the short run may offset the desired effects of the devaluation. We shall analyze the influence of expectations on the effects of a devaluation by using a simple monetary model. There are two critical aspects to the expectation of the devaluation which need to be considered. One concerns the timing; the other the magnitude (and direction). Except for a few brief comments in Section 6 below, we assume that individuals forming these expectations have perfect information with respect to the precise date of the devaluation. In this case the devaluation will induce an impulse into the system, which we show will have an important impact on its dynamic adjustment. We assume that individuals may or may not have perfect information with respect to the magnitude of the devaluation; if they do, then this hypothesis corresponds to a world of perfect myopic foresight, extensively studied by economists in flexible exchange rate and other contexts. The remainder of the paper proceeds as follows. In Section 2 we describe in formal terms the devaluation and the expectational hypothesis we are adopting. The following section discusses the implications of interest rate parity for the behaviour of the domestic bond price and interest rate in response to an anticipated movement in the exchange rate.