Testing the Monetary Approach to Devaluation in Developing Countries

Abstract

The monetary approach to the balance of payments suggests that surpluses and deficits are essentially adjustment phenomena which serve to equilibrate the money stock in existence to the quantity demanded in an open economy. An increase in the domestic money supply via increased domestic credit creation, by either central or private banks, leads to larger deficits which, in turn, deplete the excess supply of money. A devaluation, however, raises domestic prices and as a result increases the demand for money, thereby leading to a temporary improvement in the balance of payments. 1 The purpose of this paper is to test the monetary approach to devaluation from a sample of 18 independent devaluations that took place in developing countries during the 1959-70 period and, at the same time, to indicate the conditions under which devaluation is successful in improving the balance of payments. In the process, the paper sheds light on two important related issues: first, the degree to which devaluation is inflationary per se, and second, the extent to which devaluation changes the price of traded goods relative to nontraded ones. Part I sets out a simple monetary model appropriate for empirical testing of the monetary approach, Part II summarizes the results of the empirical tests, and Part III focuses upon the impact of devaluation upon the terms of trade and domestic prices. The concluding section discusses Richard Cooper's (1971) test of the monetary approach and attempts to assess the weaknesses and strengths of the monetary framework.