1. The Sample

Table 1 contains the list of the 20 devaluation episodes analyzed in this paper. The choice of countries in the sample was basically determined by data availability; only those major devaluation episodes for which data on (most) of the variables of interest were available were incorporated into the analysis. All these countries devalued their currencies by at least 15% after having maintained a fixed (official) exchange rate with respect to the U.S. dollar for two or more years. Thirteen of them implemented a stepwise devaluation, where after the nominal exchange rate adjustment they attempted to once again fix the parity (Panel A of Table 1). Many of them did not succeed and experienced recurrent devaluations. Seven of the countries adopted a crawling exchange rate after devaluing (Panel B). This table also contains data on the amount of each nominal devaluation measured as the percentage change of the official exchange rate with respect to the U.S. dollar. It is interesting to note that all of these devaluations were followed by some kind of predetermined regime (either fixed or passive crawl) and not by a freely floating nominal rate, as most theoretical models of exchange rate collapse have assumed (Krugman, 1979; Flood and Garber 1984; Obstfeld 1986). In the model we developed below we take this important stylized fact into account and deal with exchange rate crisis where the official exchange rate is fixed at a new (higher) level after the devaluation.

Table 1.

Devaluation Crises in Selected Developing Countries: Rate of Devaluation (percentage) ^1/

(Percentage of Devaluation)

Source: International Financial Statistics.

^1/Devaluation of the official rate with respect to the U.S. dollar. In the case of multiple rates the IFS reports the “most common” of them.

Table 1.

Devaluation Crises in Selected Developing Countries: Rate of Devaluation (percentage) ^1/

(Percentage of Devaluation)

Country	Year of Devaluation Crisis	Year of Devaluation	One Year After Devaluation	Two Years After	Three Years After
A. Stepwise Devaluations
Colombia	1962	34.3	0.0	0.0	50.0
Colombia	1965	50.0	0.0	16.7	7.1
Costa Rica	1974	28.8	0.0	0.0	0.0
Cyprus	1967	16.6	0.0	0.0	0.0
Guyana	1967	15.9	0.9	0.6	0.2
India	1966	58.6	-0.3	1.0	-0.9
Israel	1962	66.6	0.0	0.0	0.0
Israel	1967	16.6	0.0	0.0	0.0
Israel	1971	20.0	0.0	0.0	7.1
Nicaragua	1979	43.0	0.0	0.0	0.0
Pakistan	1972	130.1	-10.2	0.0	0.0
Sri Lanka	1967	24.1	0.0	0.5	0.0
Yugoslavia	1965	66.6	0.0	0.0	0.0
B. Devaluations Followed by Crawling Peg
Chile	1982	88.2	19.2	46.5	43.3
Colombia	1967	16.7	7.1	5.7	6.9
Kenya	1981	35.9	23.7	8.4	14.3
Korea	1980	36.3	6.1	6.9	6.2
Mexico	1976	59.6	13.9	-0.0	0.3
Mexico	1982	267.8	49.1	33.7	93.0
Pakistan	1982	29.6	5.1	13.7	4.0

Source: International Financial Statistics.

^1/Devaluation of the official rate with respect to the U.S. dollar. In the case of multiple rates the IFS reports the “most common” of them.

View Table

Table 1.

Devaluation Crises in Selected Developing Countries: Rate of Devaluation (percentage) ^1/

(Percentage of Devaluation)

Country	Year of Devaluation Crisis	Year of Devaluation	One Year After Devaluation	Two Years After	Three Years After
A. Stepwise Devaluations
Colombia	1962	34.3	0.0	0.0	50.0
Colombia	1965	50.0	0.0	16.7	7.1
Costa Rica	1974	28.8	0.0	0.0	0.0
Cyprus	1967	16.6	0.0	0.0	0.0
Guyana	1967	15.9	0.9	0.6	0.2
India	1966	58.6	-0.3	1.0	-0.9
Israel	1962	66.6	0.0	0.0	0.0
Israel	1967	16.6	0.0	0.0	0.0
Israel	1971	20.0	0.0	0.0	7.1
Nicaragua	1979	43.0	0.0	0.0	0.0
Pakistan	1972	130.1	-10.2	0.0	0.0
Sri Lanka	1967	24.1	0.0	0.5	0.0
Yugoslavia	1965	66.6	0.0	0.0	0.0
B. Devaluations Followed by Crawling Peg
Chile	1982	88.2	19.2	46.5	43.3
Colombia	1967	16.7	7.1	5.7	6.9
Kenya	1981	35.9	23.7	8.4	14.3
Korea	1980	36.3	6.1	6.9	6.2
Mexico	1976	59.6	13.9	-0.0	0.3
Mexico	1982	267.8	49.1	33.7	93.0
Pakistan	1982	29.6	5.1	13.7	4.0

Source: International Financial Statistics.

^1/Devaluation of the official rate with respect to the U.S. dollar. In the case of multiple rates the IFS reports the “most common” of them.

The data in Table 1 refer to the official exchange rate. Many of these countries, however, had an active parallel market during the period surrounding the devaluations. In subsection II.5 below we discuss the behavior of the parallel market exchange rate. The existence of this parallel market is another important stylized fact not captured by traditional models, but explicitly incorporated in our unified model.

2. Fiscal and Credit Policies and Devaluation Crises

Table 2 summarizes the behavior of domestic credit and fiscal policies for the period immediately preceding the 20 devaluation crises. In addition, data for a control group of countries that maintained a fixed rate for 10 or more years are also presented. ^3/ The following indicators can be found in this table: (1) rate of growth of domestic credit (Panel A); (2) rate of growth of domestic credit to the public sector (Panel B); (3) percentage of credit received by the public sector as proportion of total domestic credit (Panel C); (4) fiscal deficit as proportion of GDP (Panel D); and (5) growth of domestic credit to the public sector as a proportion of GNP. All these indicators have been constructed using data from the International Financial Statistics. For the devaluing countries these indicators are reported for 3 years, 2 years, and 1 year prior to the devaluation as well as for the year of the devaluation. While Panel A deals with monetary (or domestic credit) policy, the rest of the panels take us beyond the monetary realm and into the fiscal side of the economy. Indeed, these panels provide four different ways of looking at fiscal pressures.

Table 2.

Indicators of Macroeconomic Policy In Devaluing Countries During Year of Devaluation and 3 Years Preceding Devaluation: Comparison to Control Group of Fixers

Source: See text.

Table 2.

Indicators of Macroeconomic Policy In Devaluing Countries During Year of Devaluation and 3 Years Preceding Devaluation: Comparison to Control Group of Fixers

	Three Years Prior to Devaluation	Two Years Prior to Devaluation	One Year Prior to Devaluation	Year of Devaluation	Control Group
A. Annual Rate of Growth of Domestic Credit (Percentage)
First Quartile	11.9	13.8	12.3	15.7	14.4
Median	22.1	16.8	17.8	22.9	17.4
Third Quartile	34.8	39.9	30.1	40.6	29.9
Mean	23.5	22.8	21.2	35.4	19.3
B. Annual Rate of Growth of Domestic Credit to Public Sector (Percentage)
First Quartile	7.8	0	0	11.2	0
Median	24.4	14.8	10.2	31.0	22.7
Third Quartile	66.5	51.4	33.9	69.2	33.2
Mean	43.1	28.3	29.8	58.9	5.7
C. Ratio of Domestic Credit to Public Sector to Total Domestic Credit (Ratio x 100)
First Quartile	11.3	12.0	12.5	7.8	0
Median	26.0	24.7	24.7	25.5	11.4
Third Quartile	46.5	45.6	46.0	49.1	27.9
Mean	27.6	27.1	28.1	27.3	14.0
D. Fiscal Deficit as Percentage of GDP (Percentage)
First Quartile	0.00	0.13	0	0.01	0.7
Median	3.30	0.84	1.34	3.66	1.6
Third Quartile	5.89	5.85	5.90	6.49	2.7
Mean	3.5	3.1	2.3	3.15	1.9
E. Growth of Credit to Public Sector as Proportion of GNP (Percentage)
First Quartile	0.7	0.09	-0.5	1.3	0.03
Median	1.7	1.09	1.1	2.7	0.76
Third Quartile	3.9	2.6	2.9	5.3	1.6
Mean	2.4	1.5	1.5	3.9	.75

Source: See text.

View Table

Table 2.

Indicators of Macroeconomic Policy In Devaluing Countries During Year of Devaluation and 3 Years Preceding Devaluation: Comparison to Control Group of Fixers

	Three Years Prior to Devaluation	Two Years Prior to Devaluation	One Year Prior to Devaluation	Year of Devaluation	Control Group
A. Annual Rate of Growth of Domestic Credit (Percentage)
First Quartile	11.9	13.8	12.3	15.7	14.4
Median	22.1	16.8	17.8	22.9	17.4
Third Quartile	34.8	39.9	30.1	40.6	29.9
Mean	23.5	22.8	21.2	35.4	19.3
B. Annual Rate of Growth of Domestic Credit to Public Sector (Percentage)
First Quartile	7.8	0	0	11.2	0
Median	24.4	14.8	10.2	31.0	22.7
Third Quartile	66.5	51.4	33.9	69.2	33.2
Mean	43.1	28.3	29.8	58.9	5.7
C. Ratio of Domestic Credit to Public Sector to Total Domestic Credit (Ratio x 100)
First Quartile	11.3	12.0	12.5	7.8	0
Median	26.0	24.7	24.7	25.5	11.4
Third Quartile	46.5	45.6	46.0	49.1	27.9
Mean	27.6	27.1	28.1	27.3	14.0
D. Fiscal Deficit as Percentage of GDP (Percentage)
First Quartile	0.00	0.13	0	0.01	0.7
Median	3.30	0.84	1.34	3.66	1.6
Third Quartile	5.89	5.85	5.90	6.49	2.7
Mean	3.5	3.1	2.3	3.15	1.9
E. Growth of Credit to Public Sector as Proportion of GNP (Percentage)
First Quartile	0.7	0.09	-0.5	1.3	0.03
Median	1.7	1.09	1.1	2.7	0.76
Third Quartile	3.9	2.6	2.9	5.3	1.6
Mean	2.4	1.5	1.5	3.9	.75

Source: See text.

A number of revealing facts emerge from this table. First, macro-economic- -and in particular fiscal—policies became increasingly expansive in the devaluing countries immediately preceding the year of the devaluation. Second, the devaluing countries as a group behaved quite differently than the control group of fixers. This is particularly clear for the fiscal policy indicators. For example, during the year prior to the crisis half of the devaluing countries allocated one quarter or more of total domestic credit to the public sector; the median for the control group countries, on the other hand, was only slightly more than 10 percent. Formal χ² tests indicate that the probability of these policy indicators for the devaluing countries coming from the same population as the control group is very low. ^4/ This strong empirical evidence suggests a third feature that any model that attempts to capture the dynamics of crisis and stabilization should possess, i.e., it should have a well developed fiscal side.

3. Terms of Trade and Devaluation Crises

Of course, balance of payments difficulties are not always the result of inconsistent domestic macroeconomic policies; historically, exogenous shocks have sometimes been the sources of serious external imbalances. In our sample there is a wide variety of experience. While in some episodes the terms of trade did not change in the period preceding the exchange rate collapse, in others there was a substantial change. In six of the sixteen episodes for which there are data there was a significant worsening in the terms of trade before the devaluation (see Appendix, Table A.1). ^5/ Existing models of exchange rate collapse, however, have ignored the possibility of terms of trade shocks being the generating cause of devaluations. This possibility is explicitly taken up in our model.

4. Real Exchange Rates. The External Sector and Devaluations

In the vast majority of our 20 devaluation episodes the external sector experienced a serious deterioration in the period leading to the crisis. In 16 out of the 20 episodes the ratio of net foreign assets to money experienced a steep decline during this two year period (see Appendix, Table A.2). This, of course, is in accord with the traditional models of exchange rate crises developed by Krugman (1979) and others, where the devaluation takes place when the level of international reserves hits a lower threshold. ^6/ Also, in 14 of the 20 episodes the current account ratio experienced a worsening in the two years before the crisis. In fact, in some of these episodes the current account to GDP ratio reached remarkable levels. In Kenya and Israel 1971 the deficit was approximately equal to one-fourth of GDP! An important characteristic of these devaluation episodes is the tendency, present in most countries, for the ratio of net foreign assets to return to its pre-crisis level following the devaluation. This suggests that countries have a well-established desired level of reserves to which they seek to return. This characteristic, which has been ignored in the literature, is explicitly incorporated in our model.

Regarding real exchange rates, in 15 out of the 19 countries with relevant data the bilateral real exchange rate (RER) experienced a real appreciation in the three years prior to the devaluation; in 13 out of the 19 cases there also was a real appreciation of the multilateral RER during the period immediately preceding the crisis. The average real appreciation during the 3 years preceding the devaluation crisis was almost 9.2 percent, while the real multilateral appreciation was 9.0% (see Appendix, Table A.3). ^7/ These real appreciations were the result of domestic rates of inflation that increasingly exceeded the world rate of inflation. A set of χ² tests, in fact, indicate that as the crisis date approached the rate of CPI inflation in the devaluing countries became more distinct from that of the fixed rate control group. This evidence is particularly important for determining our modelling strategy. What these data suggest is that devaluation decisions are based on the behavior of (at least) two indicators: foreign reserves and the real exchange rates. It is possible to think of some devaluations as undertaken in order to improve a country’s competitive position rather than because reserves have disappeared (Indonesia in 1978 comes to mind). This means that, contrary to the traditional literature, a model that attempts to capture the stylized facts surrounding crises in the LDCs should explicitly incorporate nontradable goods and, thus, the possibility of domestic inflation exceeding world inflation.

A particularly interesting feature of these data is that in many episodes the authorities postponed the implementation of the adjustment measures, even after it had become evident that the economy was facing a severe macroeconomic disequilibrium. Moreover, in a number of cases in its effort to postpone the adjustment the government resorted to exchange and capital controls (Edwards 1989a).

5. Devaluation Crises and Black Market Premia

We could obtain information on the black market rate for foreign exchange for most of the countries in our sample. These data are, in fact, extremely suggestive, showing a marked increase in the premium in the period leading to the exchange rate collapse. In all but one of the episodes the black market premium was higher one month before the devaluation than 3 years prior to the devaluation (see Appendix, Table A.4). It is interesting to note that in every country immediately following the devaluation the parallel market premium experienced a sudden downward jump. This type of behavior is, in fact, consistent with perfect foresight models of the type developed by Lizondo (1987a) and Kiguel and Lizondo (1986). In the model we developed below we also incorporate this feature of the parallel market behavior.

6. Devaluation Crises and Real Wages

Critics of orthodox stabilization programs have argued that devaluations result in important reductions in real wages. ^8/ In order to analyze this issue we collected data on the evolution of real wages in the manufacturing sector in the period surrounding our devaluation crises (see Appendix, Table A.5). Since these data have not been corrected by productivity gains, they should be analyzed with care. These figures show no clearcut behavior of real manufacturing wages in the period surrounding the devaluation crises. In only 8 out of 18 episodes for which there are data, real wages increased in the period preceding the crisis. In all of these eight cases real wages dropped after the devaluation. In the other 10 episodes for which there are data, real wages did not decline after the crisis. Thus, the popular belief that all devaluations are followed by a wage reduction is not sustained by our data.

7. Summary

The data discussed in this section provide a fairly clearcut pattern regarding the stylized facts surrounding a large number of devaluation crises in the developing countries. These facts—which we believe an adequate model of devaluation crises should capture—can be briefly summarized as follows:

a. Historically the vast majority of devaluation crises have been preceded by loose and inconsistent macroeconomic policies. In particular, the evidence shows that fiscal policy in the devaluing countries as a group was significantly more expansive than in a control group of fixers.

b. In a nontrivial number of episodes we detected a significant worsening in the international terms of trade immediately before the crisis. This suggests that historically some collapses may have been caused by exogenous external shocks.

c. In the period preceding the devaluations we observed (a) a significant real exchange rate appreciation; (b) the depletion of the stock of international reserves; (c) a deterioration of the current account deficit and; (d) a decline in the ratio of net foreign assets to money.

d. Devaluation crises have been preceded by very steep increases in the black market premium. Moreover, the evidence shows that immediately following the devaluation the premium experienced a significant decline.

e. Regarding real wages, the evidence is less clear. There are some indications, however, that in some countries real wages followed an inverted U path. They increased in the years preceding the crisis, and dropped in the years that followed.

1. Supply

We consider a small open economy which produces exportables (X), importables (Z), and nontraded goods (H) using sector-specific capital and homogeneous labor. ^9/ Labor is available in fixed supply, and all prices are flexible; full employment prevails continuously. The labor market equilibrium condition is:

where w is the real wage measured in terms of importables, ρ is the domestic price of exportables in terms of importables (i.e., the external terms of trade), and e is the real exchange rate, defined as the ratio of the domestic price of importables to that of nontraded goods; $\mathrm{e}=\mathrm{s}{\mathrm{P}}_{\mathrm{z}}^{*}/{\mathrm{P}}_{\mathrm{N}}$, where s is the predetermined nominal exchange rate applicable to commercial transactions and ${\mathrm{P}}_{\mathrm{z}}^{*}$ is the world price of importables. L_i is the demand for labor in sector i, and L_i 0. Equation (1) implies a relationship between ρ, e, and the equilibrium real wage:

Since each sector employs only one variable factor, conventional sectoral supply functions that relate output in each sector to the two relative prices ρ and e can be derived.

Consequently, an improvement in the terms of trade increases output of exportables while reducing that of importables and nontraded goods. A real exchange rate depreciation, on the other hand, increases output of importables and exportables while reducing that of nontraded goods.

2. Demand

3. Equilibrium

Since the economy in question is small, domestic-currency prices of exportables and importables are governed by the law of one price:

As we abstract from world inflation and assume that the exchange rate for current account transactions is fixed, the domestic currency prices of X and Z are constant.

Equilibrium in the nontradable goods market is given by:

y^N = c^N + g^N

Using (3), (5b), (6), (7) and (8), this becomes

This equation can be solved for the real exchange rate that clears the market for nontradable goods. To do so, it is convenient to assume that the initial equilibrium is characterized by trade balance equilibrium. In this case, it can be shown that y₂ = 0. ^12/ The solution for e is given by:

with the following expressions for the partial derivatives:

e₁ = [y^N - (l-θ)e^θc₁y₁] / ɸ 0; e₂ = -1/ɸ < 0;

e₃ = (l/θ)e^θc₁ / ɸ 0; e₄ = -(l-θ)ec₂ / ɸ < 0,

The model is solved by combining equation (18) with equations (9) and (10) to yield a system of two differential equations in m and v. To do so, notice first that, since F and P_z are both exogenous, and since we will be considering only discrete changes in these variables, the definition of v implies that $\hat{\mathrm{d}}=\hat{\mathrm{v}}$. Making use of this property, equation (9) can be written as:

Similarly, substituting (18) in (10) produces:

where all derivatives are evaluated at $\dot{\mathrm{m}}=\dot{\mathrm{v}}=0$. ^13/

The equilibrium defined by $\dot{\mathrm{m}}=\dot{\mathrm{v}}=0$ can be shown to be saddle-point stable. The determinant of the system consisting of the linearized versions of (19) and (20) is given by:

so the roots are indeed of opposite sign. The phase diagram for this system is depicted in Figure 1. The equations $\dot{\mathrm{m}}=0$ and $\dot{\mathrm{v}}=0$ trace out a pair of loci in m-v space with slopes given by:

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Steady State Equilibrium

Citation: IMF Working Papers 1989, 011; 10.5089/9781451925845.001.A001

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The signs of the arrows are derived from the partial derivatives in (18) and (20), and the saddle path SS through the equilibrium point A must have a positive slope. ^14/ Thus, along stable paths the real money supply and the premium in the dual exchange market will tend to move in the same direction.

1. The Role of Devaluation

A steady-state configuration such as A in Figure 1 is characterized by $\dot{\mathrm{m}}=0$. By differentiating equation (14), this can be shown to imply that b = -def. However, this condition is not sufficient to ensure that a point like A will be sustainable. Assuming that the authorities are unwilling to permit their stock of foreign exchange reserves to fall outside some prescribed range of values, equation (15) suggests that nonzero values of def are not sustainable, since such values of def must eventually drive the stock of international reserves held by the Central Bank (R/s) to its upper or lower bounds. Sustainability of a fixed nominal official parity thus requires def = 0 in steady state.

Although a balanced government budget is a necessary condition for sustainability in our model, not all paths that satisfy the steady-state condition def - 0 are feasible. This condition will indeed guarantee convergence of (R/s), but not necessarily to a value which lies inside the authorities’ preferred range. For a given time path of the fiscal variables, the role of a nominal devaluation in this model is to alter the steady-state value of (R/s). To see this, suppose that a devaluation of the official rate takes place at time t⁰, at which the economy may or may not be in steady state, but at which time the condition def = 0 is fulfilled. From (14), (16b), and the fact that a nominal devaluation does not alter the steady-state value of m(m*), we have

(recall that ${\mathrm{P}}_{\mathrm{z}}^{*}$ is constant). From (15) and (22) and since d(def(u))/ds = 0, we have that a nominal devaluation will affect the stock of international reserves as follows:

That is, since the path of the fiscal deficit is unaltered, and since capital gains on reserves are not monetized, the original real money supply can be restored only by running cumulative trade surpluses—in other words, by reserve accumulation. It follows that, in the case of a public spending shock, a path rendered infeasible by reserve inadequacy may be sustainable if the eventual fiscal adjustment is accompanied by a sufficiently large devaluation of the official rate. The reason for this is that such a devaluation will reduce the cumulative loss of reserves during the transition to the new steady state. A similar analysis applies to the case of a terms of trade shock. We now examine the effects of fiscal and terms-of-trade shocks under adjustment-cum-devaluation.

2. Fiscal Shocks and Devaluation Crises

The effects of an increase in government spending on nontraded goods are depicted in Figure 2. An increase in g_N shifts the $\dot{\mathrm{m}}=0$ locus to the right, by:

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Effects of an Expansionary Fiscal Shock

Citation: IMF Working Papers 1989, 011; 10.5089/9781451925845.001.A001

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The $\dot{\mathrm{v}}=0$ locus is undisturbed. If the increase in government spending were perceived to be permanent, the dual rate would depreciate on impact by an amount such as to place the new short-run equilibrium at a point directly above A on the saddle path S′S′, from then on, the new steady state B would be approached.

Whether such a path is feasible, however, depends on how the increase in spending is financed. Notice that, since t has been held constant in (20), tax financing has implicitly been ruled out. The alternatives are a reduction in spending on importables or central bank financing. We will examine the case in which the latter option is initially chosen, consistent with the pre-devaluation stylized facts presented in Section II. ^15/

Since we are explicitly examining a devaluation crisis, at the moment that government spending increases the private sector is assumed to know not only that adjustment will eventually be necessary (i.e., that the spending increase is temporary), but also that the eventual adjustment in spending will be accompanied by an official devaluation. Since the eventual official devaluation is assumed to be anticipated at the time of the initial shock, the exchange rate in the dual market cannot jump when the official exchange rate is actually devalued. Recalling that $\mathrm{v}=\mathrm{dF}/\mathrm{s}{\mathrm{P}}_{\mathrm{z}}^{*}$ and $\mathrm{m}=\mathrm{M}/\mathrm{s}{\mathrm{P}}_{\mathrm{z}}^{*}$, this means that at the instant of devaluation, ν and m must decrease in inverse proportion to the change in s. Thus, at the moment the devaluation takes place the economy must move inward along a ray from the origin such as OR in Figure 2. From a point such as D, at the instant of adjustment the economy jumps to E. The point E must be on SS, which governs the economy’s post-adjustment trajectory. The location of D, on the other hand, is determined by the condition that DE/EO = Δs/s, i.e., by the size of the devaluation. To see how the position of D is determined, suppose ΔS/S takes on some known value, say π. Consider the family of rays from the origin of which OR is a member. Each such ray will contain a point such as E where the ray intersects SS and a point like D with the property DE/EO = π. The set of all such points D traces out a locus LL located above SS and with slope given by:

Notice that there will be one such locus for each rate of devaluation π. If it is known that the fiscal expansion will last for t periods and that its termination will coincide with a π percent official devaluation, then the location of the point D will be determined by the intersection of the locus LL and a path such as CD which takes exactly t periods to reach LL from some initial point C. The point C must lie directly above A and above the saddle path S′S′—which passes through the supposed long-run equilibrium B—as well as below LL. The reason for this is that from points below S′S′ or above LL there are no continuous trajectories that would take the economy to LL. In the case under discussion, therefore, the dual rate will depreciate on impact, causing v to jump to point C. From this point, v will continue to depreciate, and at least temporarily, m will rise. Notice that the dual rate depreciates continuously and eventually must do so at an increasing rate (since v/m rises as the economy approaches D and, from equation (19), an increase in this ratio increases $\hat{\mathrm{v}}$) in anticipation of the eventual devaluation, which is consistent with the stylized facts presented in Section II. At the moment of adjustment the economy jumps from D to E along OR, then gradually returns to A along SS. We can now analyze the behavior of other key macro variables under the adjustment-cum-devaluation path CDEA.

To examine the nature of reserve behavior, use equations (3), (5a), (6), (7), and (8) in the trade balance equation (13). The result is:

The sign of b₁ assumes that the term in square brackets is positive, which will be the case if the substitution effects of a real devaluation on household demand for importables exceed wealth effects.

Using equations (18) and (24), and noticing that m+v rises continuously along the range CD, we can show that the trade balance moves into deficit on impact and the deficit increases over time until adjustment is undertaken, at which point a surplus must emerge (point E in Figure 2). Similarly, the price level jumps on impact and continues to rise in the period leading up to the devaluation. Thus the pre-devaluation period is characterized by a high and rising premium in the dual market, a trade deficit, and inflation, all of which were common features in the sample of devaluation episodes described in Section II.

Notice that, given that the price level rises continuously during the predevaluation period, the real exchange rate simultaneously appreciates. Since there have been no changes in the determinants of the equilibrium real exchange rate, this real appreciation represents a misalignment situation. By equation (2), the real wage in terms of tradables rises. Moreover, if the share of tradables in the consumption bundle is sufficiently large, the real wage measured in terms of the consumption bundle will also rise in the period leading up to the devaluation. Under this assumption, the devaluation of the official rate results in a sharp decrease in the real wage which causes it to fall below its pre-shock level. This is followed by a gradual increase in the real wage until its original level is restored. Finally, as can be shown from equations (6), (7), and (8), the same condition (a large value of θ) ensures that private real consumption also rises over this period. ^17/

3. Devaluation Postponement and Macroeconomic Adjustment

We now examine how the dynamics of adjustment are affected by postponing the eventual measures. Consider first a postponement of adjustment which holds constant the size of the devaluation. We can show that as the fiscal expansion is prolonged, the point C in Figure 2 moves closer to the saddle path S′S′—i.e., the initial depreciation in the dual rate is dampened. ^18/ Moreover, since the ratio v/m is smaller at points below C, the initial rate of depreciation of the dual rate is also smaller in this case. However, since paths that begin below C must intersect LL to the northeast of D, the peak values of both ν and m, as well as of v+m, in this case exceed those in the case of more rapid adjustment. The larger peak value of v+m (reached just prior to adjustment) means that the increase in the domestic price level—and thus the eventual degree of real exchange rate misalignment—is larger the longer adjustment is postponed. It follows from the arguments presented above that peak deviations of the current account, the real wage, and real consumption from their steady-state values are also larger the more that adjustment is postponed.

Moreover, postponing adjustment also diminishes the steady-state stock of foreign-exchange resources. To see this, use (14) and (15) to write:

where s₀ and s₁ denote the pre- and post-devaluation official exchange rate. Since m and ${\mathrm{P}}_{\mathrm{z}}^{*}$ are unchanging across steady states, for a given value of s₀/s₁, the larger the cumulative fiscal deficit (which depends only on how long devaluation is postponed), the smaller must R/s₁ be.

If the authorities pursue a reserve target, the consequences of postponement are more dramatic. As can be verified from equation (25), for a given value of R/s₁, an increase in t requires a reduction in s₀/s₁—i.e., a larger official devaluation. Thus, in the presence of a reserve target, postponing adjustment implies a larger eventual official devaluation. To see the consequences of this for the economy’s dynamic behavior, return to Figure 2. An increase in π causes the locus LL to shift upward and become steeper. Holding the duration of the fiscal expansion constant, this would in itself increase the initial value of C and the peak values of both v and v+m (at the point D). Thus an increase in the size of the eventual official devaluation increases the peak deviation of macroeconomic variables at the instant just preceding adjustment from their steady-state values. Moreover, since the ray OR rotates counterclockwise in this case, the point E moves to the southeast along SS. This implies that the peak post-adjustment deviations of v, v+m and the other macroeconomic variables from their steady-state values is also increased by a larger official devaluation.

Putting together the longer duration of the fiscal expansion and the larger official devaluation that it implies, the following picture emerges:

a. Since the longer fiscal expansion tends to lower the initial value of v (i…, the point C) while the larger official devaluation tends to raise it, the impact effects on ν of postponing adjustment in the presence of a reserve target are ambiguous.

b. Over time, however, the longer adjustment is postponed, the larger the cumulative deviations of the macroeconomic variables of interest from their steady-state values.

c. When adjustment is finally undertaken, these variables will tend to overshoot their steady-state values (i.e., the economy will be at E, rather than at A), and the degree of overshooting will be magnified by postponing the adjustment.

d. Finally, since postponement requires a larger official devaluation in the presence of a reserve target the legacy of postponement will be a higher steady-state price level.

4. Terms-of Trade Shocks and Devaluation Crises

The analysis of an adverse (permanent) terms of trade shock is slightly more complicated, since in this case both the $\dot{\mathrm{v}}=0$ and $\dot{\mathrm{m}}=0$ loci are affected. ^19/ The shift in $\dot{\mathrm{v}}=0$ is given by:

while that in $\dot{\mathrm{m}}=0$ is:

Since both loci shift to the left, in the new steady state m will unambiguously fall, but v may either increase or decrease. The reduction in real income attendant upon the terms of trade deterioration causes domestic agents to seek to shift their portfolios away from money and into foreign currency, thus increasing v. On the other hand, the reduction in real income reduces saving, and to restore saving to its steady state level of zero, wealth must fall. This is partly brought about through a reduction in v, leaving the net change in v ambiguous. In Figure 3, we illustrate the case in which the portfolio-composition effect on v dominates the wealth effect, so that v is higher in the new steady state at B. The steady state at B is in principle viable, since in this exercise no fiscal deficit exists at that point to generate continuous reserve depletion.

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Effects of an Adverse Terms of Trade Shock

Citation: IMF Working Papers 1989, 011; 10.5089/9781451925845.001.A001

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In the absence of devaluation, the economy would jump to a point such as F on the new saddle path S’S’ and gradually converge to B. This path is characterized by trade deficits and reserve depletion. Given a reserve target, the authorities may instead prefer a path which involves an official devaluation. However, unlike in the previous section, the size of the required official devaluation is unaffected by its timing. This can be verified from equation (25), recalling that in this case the fiscal deficit remains at zero during the entire transition path between steady states. Since the second term on the right hand side of (25) drops out, the reserve target will determine the size of the official devaluation, but the final reserve outcome will be independent of when the devaluation takes place. On the other hand, as will be shown below, the timing of adjustment (in the form of the official devaluation) again matters in determining the paths followed by the main macroeconomic variables.

Suppose, for concreteness, that the authorities choose the magnitude of the official devaluation such as to preserve the original level of reserves measured in terms of foreign currency. Then, if the terms of trade deterioration is accompanied by an immediate official devaluation of (m₀-m₁)/m₀ percent (Figure 3), the economy will immediately move from the original steady state at A to the new one at B, without undergoing an intervening sequence of trade deficits. If the exchange rate adjustment is postponed, however, again m and v must contract along a ray from the origin at the instant of devaluation, from a point such as D on the ray OR₁, to a point such as E on the new saddle path S′S′. For this to be possible, the initial jump in v must be to a point above this saddle path, and since this implies a sequence of trade deficits (because m is falling), it must be offset by eventual surpluses—i.e., the post-devaluation point must be located to the southwest of B along S′S′. The implied transition path is CDEB, with an initial depreciation of the dual rate. ^20/ This is followed by gradual appreciation and then by an accelerating depreciation.

The behavior of the remaining macroeconomic variables that concern us over the range CD of the adjustment path cannot be determined unambiguously, since the terms of trade deterioration and the depreciation in the dual market have conflicting effects on the real exchange rate and therefore on variables such as the price level, the real wage, and real consumption. However, at the moment of devaluation, the real exchange rate undergoes a step depreciation, accompanied by a reduction in the real wage and real consumption, this again assuming a sufficiently large share of tradables in the consumption bundle. As the trade balance goes into surplus with a depreciating dual rate over the final segment EB, real exchange rate appreciation is accompanied by a rising real wage and rising real consumption.

In the event that devaluation is further postponed, the ray OR will rotate counterclockwise, to OR₂, say, as the point D moves along the locus LL (derived as in the previous section). In this case, the initial depreciation must be to a point between F and C, such as G, and the economy will follow the more prolonged adjustment trajectory GHIB. ^21/ Thus the pre-devaluation period is characterized by trade deficits and increasing premiums in the dual exchange market which increase at an accelerating rate (since v/m rises).

The effects of postponing adjustment on the deviations of macrovariables from their steady-state values is quite different in the present case from the case of a temporary fiscal expansion. Since LL has a positive slope, the peak values reached by both v and v+m in the period leading up to the official devaluation are smaller when the devaluation is postponed. Thus the peak deviation of the macrovariables from their steady-state values during this period is diminished when adjustment is postponed, in contract to what is observed under a temporary fiscal expansion. However, at the point H the cumulative reserve loss exceeds that at D (notice that m is smaller), so that larger cumulative trade surpluses are needed in the post-adjustment period. Thus the point I is to the southwest of E on S′S′ in Figure 3, and the post-adjustment deviations of macrovariables from their steady-state values are magnified, as in the previous section.

In the case of a permanent terms of trade shock, in which “adjustment” consists of an official devaluation designed to meet a reserve target, we therefore conclude that:

a. Postponement of adjustment mutes the impact effect of the shock on macroeconomic variables.

b. Similarly, with the exception of foreign exchange reserves and the money supply, the cumulative deviation of macrovariables from their steady-state values prior to adjustment is smaller when adjustment is postponed.

c. However, as in the case of a temporary fiscal expansion, postponement magnifies post-adjustment overshooting.

d. In this case, postponement does not affect the steady-state values of domestic nominal variables.