Inflationary Effects of Exchange Rate Changes: The Case of the ASEAN Countries, 1973–79

Abstract

This paper addresses the question: Are cur rency depreciations inflationary (and hence revaluations deflationary)? In answering the question it also assesses the commonly held view in developing countries (for example, by the structuralist school in Latin America) that the inflationary effects nullify the price advantages that the dev aluation is designed to give the country's product in the foreign and domestic mar ket (Cooper 1971, p. 492). This topic has acquired added significance in the gen eralized floating period because a major component of the movement of effective (import-weighted) exchange rate of developing countries during this period is due to third-country exchange rate changes that are exogenous to developing countries.1 Although several authors (for example, Cooper 1971; Connolly and Taylor 1976; Krueger 1978) have dwelt on this question using the experience from the Brett on Woods period of adjustably-pegged exchange rates, the sole study during the generalized floating period is that of Bautista (1980). The present paper examines the experience of the five ASEAN countries during the floating period. Although the basic mechanisms by which changes in exchange rates are transmitted to domestic prices are independent of exchange rate regimes, several factors (for example, non-linearity between small vs. large changes, expectations, and asym metries) could make the response of domes tic prices to exchange rate changes different under the different exchange rate regimes. These factors are discussed below. Theor etical arguments2 and the available empiri cal findings of studies during the Bretton Woods period are summarized. It is also shown that theoretically it is easier to justify a one-shot price increase after a devaluation rather than a higher rate of inflation. Various alternative specifications of the price equation are also discussed. It is argued that, when dealing with developing countries, the monetarist specification is preferable to the expectations-augmented Phillips Curve one. These equations are then estimated for the five ASEAN member countries by using the OLS technique and quarterly data from 1973 (IV)-1979(11).