1. Aggregate supply

Technology for the production of the home good is characterized by a separable, Cobb-Douglas function:

where Q_h denotes gross output, ${\overline{K}}_h$ the stock of capital (assumed constant), L_h labor, N_h the imported intermediate input, and and α_L and α_N the elasticities of output with respect to labor and intermediate inputs, respectively. Under the assumption of profit maximization and perfect competition, the following supply equation can be derived; ^9/

where ω denotes the nominal wage rate, $P_n=s{P}_n^{*},and\alpha ={\alpha }_L+{\alpha }_N<1$

The index of domestic consumer prices, P, is defined as a geometric average of the price of the home good, and the price of imported consumer goods, P_I: ^10/

where δ denotes the value share of the home good in final domestic consumption. The domestic currency price of imported consumer goods depends on the world price of imported goods, $P_I^{*}$, which is exogenously determined, and on a weighted average of the official and parallel exchange rates:

where σ denotes the proportion of imports carried through official channels. The coefficient a is related below to the rationing rule followed by the authorities in the official market for foreign exchange. ^11/

Labor contracts last, one period and are negotiated one period in advance, so that the wage rate is known by firms at the beginning of the period–that is, before output and home good prices are realized. Nominal wages adjust slowly to their equilibrium value, and are determined by:

where $\overline{\omega }$ denotes the equilibrium level of the nominal wage, and ψ is the speed of adjustment of the nominal wage to its market-clearing level. The market-clearing wage is derived from the labor-market equilibrium condition, with labor demand being derived from the first- order conditions for profit maximization. This yields ^12/

where ${\overline{L}}_s$ denotes the (exogenous) level of labor supply.

From the first-order conditions for profit maximization, the demand function for imported intermediate inputs can be derived as

Consider now the supply of exports. Since the economy being considered is that of a small country where the export price is fixed in the world market, the foreign demand for exports is infinitely elastic and the volume of exports is supply-determined. For simplicity, a production function identical, to (1) is assumed for the export good:

where the quantities ${\overline{K}}_x,L_x,N_x$ are appropriately defined. Following the same reasoning as above, the following supply equation can be obtained:

where P_x, the supply price of exports, is defined as

In equation (8), 0 < r_x < 1 measures the “ad valorem” rate of taxation of exports, and Φ denotes the proportion of undeclared exports. The above expression shows that the relevant supply price for producers of exported goods (in domestic currency terms) is an average of the price of smuggled exports, $b{P}_x^{*}$, weighted by the proportion of smuggled exports, Φ, and the after-tax price of official exports, $s(1-r_x)P_x^{*}$, weighted by the proportion of exports that are legally sold abroad, (1 - Φ). The behavior of Φ is explained below.

From (7′), the demand function for imported inputs by the export sector is given by

The officially recorded level of domestic output must exclude that part of the domestic production for exports that is illegally smuggled out. Thus, recorded real gross aggregate output at factor cost Z_g can be defined as

where P is used as the deflator. To obtain net aggregate output at factor cost, Z, real imports of intermediate goods must be subtracted from Z_g

2. Aggregate demand, Income and wealth

Total expenditure by the private sector, E_P, is given by

where A denotes total wealth of the private sector, Z_d real disposable income, and i_L the nominal interest rate in the informal credit market. Eπ₊₁ denotes the expected rate of inflation for period t+1, formed at t Equation (12) indicates that total private spending is a positive function of income and wealth, and a negative function of the real rate of interest–defined as the nominal interest rate in the informal credit market corrected for the expected change in consumer prices. Real disposable income, Z_d, is defined as

where γ denotes the income tax rate, L_P the stock of domestic bank credit held by the private sector, D_P the stock of deposits held by the private sector in the banking system, i_c the interest rate on bank loans, and i_d the interest rate on bank deposits. The first term in equation (13) represents after-tax factor income derived from legally recorded production activities. The second term represents income derived from the smuggling of exports–which is therefore not taxed–and is equal to illegal exports in foreign currency terms, $\mathrm{\Phi }{P}_X^{*}{Q}_X$ valued at the parallel exchange rate, b. Finally, the last two terms represent the implie it subs idles and taxes from the existence of Interest rate controls. ^13/

To understand how the last two expressions are derived, note that the existence of interest rate eel1ings imposes implicit taxes and subsidies on privane agents, as creditors and debtors with the banking system. In the general case i_L> i_c, so that, the interest rate ceiling provides an implicit subsidy to debtors equal to $(i_L-i_c)L_{-1}^P$

Similarly, if μ denotes the reserve requirement: on bank deposits, interest rate regulation imposes an implicit tax on creditors equal to $[(1-\mu )i_L-i_d]D_{-1}^P\mathrm{.}$ ^14/ The net effect depends therefore on $(i_L-i_c)L_{-1}^P-[(1-\mu )i_L-i_d]D_{-1}^P\mathrm{.}$. Since i_c will typically be greater than i_d, controls will provide a net implicit subsidy if agents are sufficiently indebted with respect to commercial banks, that is, if $L_{-1}^P/D_{-1}^P>\left[(1-\mu )i_L-i_d\right]/(i_L-i_c)\mathrm{.}$

The notion of a “financial repression tax” (or subsidy) provides a general way of formulating the impact of interest rate controls. As shown by Montiel (1991), an index of financial repression, p, can be formally defined as

where ρ measures the present value of the subsidy, per unit of bank credit, which is implied by the prevailing interest rate ceilings. When interest rate ceilings are not binding, i_c = i_L, and ρ = 0. As the curb loan interest rate rises relative to the controlled rate i_c, the constraints become more and more binding and ρ approaches unity. Equation (14) can be explicitly introduced in (10) by replacing (i_L - i_c) by ρi_L.^15/

The nominal value of agents’ financial wealth, A, is defined as the sum of holdings of domestic currency notes CC, bank deposits D^P, bank credit (which is a liability) L^P, and foreign exchange bF^P: ^16/

The budget constraint of the private sector, which determines flow changes in financial wealth, takes the form

where $i_{\underset{°}{l}}^{*}$ denotes the world interest rate. The first term in equation (16) represents the portion of disposable income that is not spent (domestic savings). The second and third terms measure interest income derived, respectively, from bank deposits and holdings of foreign-currency denominated assets. Interest payments on foreign assets are assumed to be repatriated through the parallel market, and are therefore valued at the unofficial exchange rate. The fourth term represents interest payments on bank credit. Finally, the last term captures valuation changes due to fluctuations in the parallel exchange rate.

Consider now the determination of the composition of households’ financial portfolio. Desired holdings of foreign currency-denominated assets are defined as

where $i_{\underset{°}{l}}$ denotes the perceived rate of return on foreign assets, defined as

where $E{\tilde{b}}_{+1}\equiv E\mathrm{\Delta }\log b_{+1}$denotes the (one-period ahead) expected rate of depreciation of the parallel exchange rate. Equation (18) indicates that a rise in the interest rate on curb market loans or bank deposits induces a fall in desired holdings of foreign assets, while a rise in the perceived interest rate on foreign interest-bearing assets (due to a rise in the world interest rate per se or to a higher expected rate of depreciation of the parallel market exchange rate) raises the desired proportion of interest-bearing financial wealth that households would like to hold in the form of foreign assets in their portfolios.

Desired holdings of bank deposits, which consist only of interest-bearing deposits, are given by

Equation (19) indicates that desired holdings of bank deposits rise as a proportion of interest-bearing financial wealth with an increase in the deposit rate or a fall in the interest rate on curb market loans or in the rate of return on foreign assets.

The demand for domestic currency notes reflects a pure transaction motive, and is given by

where the assumption φ₂ > φ₁ is taken to capture the view that illegal activities require a more intensive use of currency notes than legally recorded ones. ^17/

Finally, from the expenditure function (12), aggregate demand for the home good can be written as:

where G_h denotes exogenous real government spending on home goods.

3. The current account and the balance of payments

To derive the current account of the economy in the presence of fraudulent trade transactions, it is important to distinguish between reported trade flows, that is, officially measured transactions with the rest of the world, and unreported flows.

Given private expenditure as outlined above, the demand by the private sector for imported consumer goods can be determined as a constant share of total expenditure: ^18/

The government imports $P_I^{*}{G}_I$ of final goods, in foreign currency terms, and the central bank provides unlimited access for these imports. Producers also have unlimited access to the official foreign exchange market for imports of intermediate inputs. By contrast, the central bank satisfies only a portion a of total private sector demand for imported final goods.

Formally, the central bank sets the total amount of foreign currency sales in the official exchange market equal to a minimum quantity $P_I^{*}N+P_I^{*}{G}_I$–which corresponds to the demand by domestic producers for Imported inputs plus the demand for final imports by the public sector–plus a fraction a of private sector demand for consumer imports, given by equation (22). ^19/ Total sales of foreign exchange (expressed in foreign currency), F_S, are therefore equal to

The officially recorded current account, C, is equal to the value of recorded exports minus the value of recorded imports of final goods by the private sector and the government authorized by the central bank, plus imports of intermediate goods and interest income on net foreign assets of the public sector and the central bank. Measured in foreign currency terms, C is therefore given by

where Φ measures the fraction of exports that are smuggled out of the country, so that officially recorded exports amount only to $(1-\mathrm{\Phi })P_x^{*}{Q}_x$. Equation (24) also assumes, as previously mentioned, that interest income on foreign currency-denominated assets are repatriated through the parallel market for foreign exchange. ^20/ Note that since intermediate imports are not rationed and there is no under-invoicing by producers, their full value is recorded in the official trade statistics. Foreign exchange demand by the private sector for final imports not eligible for the official market, that $(1-\sigma )P_I^{*}{I}^P$ spills over to the parallel market.

The coefficient Φ is assumed to depend positively on the exchange rate ratio q = b/s. The particular functional form adopted here is given as

The function Φ(q,r_x) can be shown to satisfy the following properties:

The first two properties indicate that the higher the tax rate on exports, or the higher the premium, the higher will be the under-invoicing share. The magnitude of $\partial \mathrm{\Phi }/\partial q>0and\partial \mathrm{\Phi }/\partial r_x$ can in general be expected to be inversely related to the perceived implicit and explicit costs of engaging in illegal transactions and to the degree of enforcement of exchange restrictions. The third property indicates that there are rising costs to engaging in illegal activities (related perhaps to a higher probability of being detected). Finally, the fourth property indicates that when the premium is high enough, relative to the tax rate on exports, the under-invoicing share tends to unity. Note also that even if the premium (q - 1) is zero (that is, if b = s), the existence of an export tax still provides an incentive to fake invoices.

Consider now the capital account. Net private capital flows through the official foreign exchange market are prohibited, and public capital inflows are treated as exogenous. The capital account surplus is therefore equal to minus the change in net holdings of external assets of the public sector:

Using (24) and (26), the change in net foreign assets of the central bank–measured in foreign currency terms–is given by

The unreported current account, C, which determines the rate of change of the private stock of foreign currency-denominated assets, is in turn given by

4. Banks, budget deficits and the money supply

Bank assets consist of reserves held at the central bank, denoted RR and credit extended to households and producers, L_P. Their liabilities are the deposits held by the public, D_P, and credit received from the central bank, L_b. The balance sheet of the banking system is therefore given by:

Banks are assumed to hold no excess reserves. Given a required reserve ratio of /i, reserve holdings are given by

Reserves held at the central bank pay no interest, but credit extended to commercial banks by the monetary authorities carries an interest charge which, for convenience, is set equal to the interest rate which banks charge their customers for loans, i_c. Under these conditions, the zero-profit condition for the banking system is given by:

which determines the interest rate paid on bank deposits, i_d. The banks’ willingness to accept deposits is infinitely elastic, implying that the actual level of deposits held in the banking system is determined by the demand side, that is, the borrowers’ demand. Equation (31) fixes the relative price between the lending and deposit rates. Since μ > 0, in general i_d < i_c.

The central bank does not lend directly to households. Its balance sheet equates base money (defined as the sum of currency notes in circulation plus commercial bank reserves) to the sum of international reserves valued at the official exchange rate and the stock of domestic credit extended to the government and commercial banks minus the central bank’s net worth, denoted Ω:

where total domestic credit L, consists of credit to the private sector by commercial banks L_P, and credit to the public sector L_g and to banks by the central bank, L_b:

Changes in the central bank’s net worth are given by the difference between interest income on foreign reserves, lending to commercial banks and the government, and net transfers to the government budget, t_g: ^21/

The model’s dynamic specification is completed with a description of the behavior of the non-financial public sector. The government’s revenue sources consist of income taxes on the private sector, export taxes, income from holdings of foreign-currency denominated assets, and transfers from the central bank. It consumes both home and imported goods, and pays interest on its domestic debt. It borrows on external markets as well as from the central bank. Consequently, the government deficit, denoted D, can be written as follows:

The deficit is financed by borrowing either at home or abroad:

The model can be operated in several different modes, according to the deficit financing rule. In what follows, it will be assumed that government expenditure is exogenous and that a ceiling is imposed on foreign financing. Deficits are therefore financed by central bank credit --a typical situation in many developing countries. Equation (36) therefore determines the evolution of L_g.

Finally, the money supply can be defined as

5. The complete model

Table 1 in the Appendix provides a summary of the equations of the model. The basic innovations of the model are its detailed account of the macroeconomic effects of government restrictions and the treatment of expectations. Controls on interest rates and foreign exchange allocation lead to the emergence of informal credit and foreign currency markets, and these determine how various macro-economic shocks affect prices, output and portfolio decisions. The dynamics of the model arise essentially from forward-looking expectations and asset accumulation, in contrast with early macroeconomic models for developing countries which rely on partial adjustment and adaptive expectations mechanisms. This implies, for example, that unlike in earlier models, anticipated future shocks will have immediate effects, and the current effects of current shocks will in general depend on their expected duration.

In this setting, the central bank retains five instruments of policy --the level of controlled bank loan interest rates i_c, the required reserve ratio μ, the amount of credit it extends to the commercial banking system L^b, the proportion of private final imports satisfied in the official foreign exchange market σ, and the official exchange rate s. The fiscal authority determines the income tax rate r and the rate of taxation of exports, r^x, as well as the levels of spending on home and imported goods, G^h and G^I

1. A rise in government spending on home goods

Consider first a temporary (one-period only), fully anticipated increase by 10 percent in government spending on home goods G_h, financed by central bank credit. Figure 1 depicts deviations from baseline values for some key endogenous variables in the model: the real output of home goods, the domestic price level, total domestic credit (which is endogenous in the model), the stock of net foreign assets of the central bank, the informal interest rate, and the parallel exchange rate.

The anticipation of a future credit-financed increase in government spending on home goods has macroeconomic consequences before the shock itself actually occurs, as shown by the behavior of the variables between period t and t+4. The price of home goods rises prior to the policy change. Since the nominal wage is maintained at its baseline level, the real product wage unambiguously falls and this, in turn, stimulates domestic supply. This last effect is rather weak initially, but increases in the period preceding the implementation of the spending shock.

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Temporary Increase in Spending on Home Goods of 10 Percent

(Percentage deviations from baseline)

Citation: IMF Working Papers 1991, 018; 10.5089/9781451843576.001.A001

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These initial effects operate largely through the informal markets --the parallel exchange rate depreciates and the curb interest rate falls prior to implementation. The expected rate of return on foreign currency-denominated assets rises, as a result of an anticipated future depreciation of the parallel exchange rate associated with the forthcoming increase in the domestic money supply, due to the increase in credit-financed government spending. This gives agents the incentive to switch away from domestic assets and towards foreign currency assets before the shock occurs. As a consequence, the parallel rate depreciates. The rise in the premium induced by the increased demand for foreign exchange reduces the private sector’s demand for deposits, causing households to shift assets into the informal loan market, which leads to a fall in the curb market interest rate. These phenomena exert income and wealth effects which increase private demand prior to the implementation of the fiscal shock. The future expected rise in domestic prices reinforces the drop in the nominal interest rate, causing the real rate of interest to fall initially. In turn, the fall in the real rate further stimulates private expenditure, contributing to the anticipatory increase in the domestic price level.

The short-run reduction in the rate of interest in the informal loan market has two offsetting effects. On the one hand, it reduces the implicit subsidy provided by controls and decreases real disposable income. On the other, it magnifies the size of the decline in the real interest rate associated with expected inflation, as indicated above, and this stimulates private expenditure, offsetting in part the demand- reducing effect coming through disposable income. The net short-run effect through informal markets on private spending, operating trough both the premium and the informal loan rate, is expansionary prior to implementation of the spending shock.

Upon implementation, the rise in government spending is expansionary both directly and through its monetary effects. The increase in the money supply reinforces the direct expansionary impact of the fiscal shock, and operates again through the informal market for foreign exchange, that is, through a sharp increase in the premium. Although the curb interest rate falls when the policy is implemented, the real interest rate actually rises, because the removal of the fiscal stimulus in the next period produces an expected price decline, Thus the transitory nature of the shock diminishes its expansionary effect with forward-looking agents. After the shock is removed, the system returns to its initial equilibrium only gradually, since the monetary effects of the once-and-for-all credit infusion take time to dissipate through the balance of payments. Finally, smuggled exports increase the flow of foreign exchange channelled illegally in the economy, but this is more than offset by a rise in smuggled Imports, implying that the stock of foreign currency-denominated assets decreases over time. The portfolio implications of this tend to sustain the initial rise in the curb interest rate, keeping upward pressure on the premium and prolonging the return to the original equilibrium.

2. A rise in central bank credit to commercial banks

Consider now a fully anticipated, transitory increase by 10 percent in central bank credit to the commercial banks L^b, implemented in period t+5. Figure 2 shows deviations from baseline values for some of the key endogenous variables in the model.

Because the fiscal expansion considered previously was credit-financed, the outcome of this exercise resembles in many respects that of the fiscal policy experiment, except that the credit infusion is now removed after one period. As before, the anticipated increase in central bank credit generates output and price effects before the shock actually takes place. The anticipated rise in the premium leads to an immediate depreciation of the parallel exchange rate. This raises the domestic price of imported goods, and together with a wealth-induced expansion in aggregate demand, leads to an increase in the price level and to an output expansion in the home goods sector. Net foreign assets of the central bank fall, as a consequence of the higher level of domestic activity (which raises imports), and the increase in under-invoicing of exports (resulting from the higher premium). During the transition period (t t+4), output and prices rise, the parallel exchange rate depreciates continuously, and the curb interest rate falls for the same reasons as those indicated for the fiscal shock.

When the increase in central bank credit actually occurs (in period t+5), loans to the private sector by commercial banks expand. As a result, the demand for credit in the informal market falls, and the curb interest rate drops sharply (by about 7 percentage points). The reduction in the financial repression tax lowers the implicit subsidy provided by controls on interest rates, therefore reducing disposable income–since households are net debtors–and this has a negative effect on private spending. But the fall in the curb rate also reduces the real interest rate, which has a positive effect on private expenditure. The net effect is an expansion of private spending, which further stimulates output and raises prices.

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Temporary Increase in Central Bank Lending of 10 Percent

(Percentage deviations from baseline)

Citation: IMF Working Papers 1991, 018; 10.5089/9781451843576.001.A001

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The fall in the curb market interest rate gives agents the incentive to switch towards foreign currency-denominated assets, leading to a sharp spike in the premium. As the stock of foreign assets held by the private sector increases prior to period t+5, the undoing of the credit expansion leaves the private sector with a portfolio more heavily weighted toward foreign exchange than initially, and the parallel exchange rate appreciates beyond its initial level in the process of restoring portfolio equilibrium. The appreciation of the free exchange rate reduces the propensity to under-invoice exports, increases the flow of foreign exchange channelled through the official market, and reduces the rate of accumulation of foreign-currency denominated assets. Overall, therefore, the short- and long-term effects of a credit expansion are qualitatively quite similar to those resulting from an expansion of government expenditure on home goods described above.

3. An increase in bank loan interest rates

An alternative monetary policy tool frequently employed in developing countries is an increase in administered interest rates. This measure, which has been advocated by the McKinnon-Shaw school (see Fry, 1978), is intended to attract funds into the organized financial system, thereby making them available for lending to private agents. The effects of such a policy on aggregate economic activity are a priori indeterminate since, on the face of it, this policy would seem to increase the cost of credit while at the same time increasing credit availability.

Consider, then, a fully anticipated increase in the interest rate that banks charge on their loans to domestic agents (i_c) by one percentage point (equivalent to a 20 percent rise, in relative terms), implemented in period t+5 and left in place until period t+10. Figure 3 summarizes the results.

This measure affects economic activity through a number of channels. A key step in this transmission mechanism, however, is the portfolio reallocation to which this policy gives rise. An increase in the bank lending rate also raises (in the proportion 1/(1 - μ)) the interest rate paid on bank deposits. This rise in interest rates in formal financial markets causes individuals to attempt to move funds from both the informal loan market and from foreign-asset hoards into domestic deposits. As a result, the curb interest rate rises when the measure is implemented, and the free-market exchange rate appreciates, both on impact and, as is now familiar, when the measure first becomes anticipated. The magnitude of both effects depends on the degree of substitutability among these assets. As the parallel exchange rate appreciates, the domestic - currency value of financial wealth falls, to an extent that depends on the weight of foreign currency assets in private portfolios. The reduction in the nominal value of wealth causes a secondary reallocation of portfolios, since the demand for interest-bearing assets is linearly homogeneous in (non-currency) financial wealth. Because of this wealth effect, the demand for domestic deposits may, in net terms, rise or fall. In this model, the combination of fairly high substitution elasticities between domestic deposits and foreign exchange and an important share of foreign assets in private portfolios leads to a reduction in domestic bank deposits at the announcement period which persists even after the administered interest rates in the domestic financial system are raised.

This measure has contractionary effects on prices and output for a number of reasons. First, the appreciation of the parallel exchange rate reduces the real value of private wealth. Second, the exchange rate appreciation also reduces the producer price for domestic exports. Third, the implicit subsidy provided by controls on interest rates falls, as the proportional increase in the controlled interest rate exceeds that in the curb market. The increase in informal interest rate exerts direct contractionary effects on spending as well. Consequently, output and domestic prices fall when the measure is implemented.

It is worth noting that the anticipation of these effects brings the contractionary effect of this measure forward to the first period-that is, to the period in which the policy change is first announced. The reason is the combination of a negative wealth effect from the reduction in the premium and the fact that the anticipated price decrease in the fifth period raises the real interest rate in the fourth period, which reduces output and the price level in that period, which then affects price expectations and the real interest rate in the third period, and so on. The contractionary effects of the anticipated measure increase over time as the date of implementation approaches. However, in similar fashion, the anticipated reversal of the interest rate increase exerts an expansionary effect before it occurs. The increase in the bank lending rate is removed in the eleventh period, and thus the peak contraction occurs in periods six and seven.

The mechanisms through which an increase in bank lending and deposit rates could lead to a contractionary effect have not been thoroughly treated in the literature, in the sense that general equilibrium interactions have typically been neglected. ^28/ The model developed here highlights the importance of market linkages and wealth effects in the determination of macroeconomic outcomes. These results suggest that the short-run macroeconomic effects of McKinnon-Shaw financial liberalization policies may prove to be problematic.

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Increase in Bank Lending Rate of 1 Percentage Point

(Percentage deviations from baseline)

Citation: IMF Working Papers 1991, 018; 10.5089/9781451843576.001.A001

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4. Devaluation of the official exchange rate

This sub-section examines the short- and long-run effects of a devaluation of the official exchange rate --an issue which, in the past few years, has been the subject of renewed controversy in developing-country macroeconomics. ^29/ We consider a 10 percent devaluation which, as before, is announced in period t and implemented in period t+5, so that both the timing and the magnitude of the devaluation are known with certainty. Devaluation profits are retained by the central bank, rather than transferred to the government. As mentioned above, wages are assumed to adjust endogenously, with a coefficient of adjustment ψ = 0.8, to their new equilibrium level. Figure 4 summarizes the results of this experiment.

At the outset, it should be noted that in our model, a mechanism frequently cited through which devaluation may adversely affect real output, that is, automatic wage indexation to price level movements, is absent. Nevertheless, an official devaluation has indeed a contractionary effect on domestic real output at the announcement and implementation periods. It should also be emphasized that this is a net effect and thus a function of the model’s parameter values and initial conditions. Expansionary effects are also present (and indeed dominate in intervening periods), but are simply overwhelmed in this case.

The channels through which a devaluation of the official exchange rate affects real activity in our model are complex. The most important negative channel is through an increase in the real price of imported inputs, which functions as a negative supply shock. Second, the official devaluation directly increases the domestic price level (through its impact on the domestic price of imported goods), increasing thereby the demand for currency. Since monetary policy is unchanged, this causes households to shift funds out of deposits, curb market loans, and foreign currency assets. The result is a higher informal interest rate, and an appreciation of the parallel exchange rate. ^30/ The higher curb interest rate has a direct contractionary effect on private spending, as does the reduction in private real wealth brought about by a reduced domestic-currency value of foreign assets and a higher price level. Moreover, export production falls, because the increase in the demand price of exports is dampened by the appreciation in the parallel exchange rate, while the supply price of exports bears the full impact of the increase in the price of imported intermediate goods. On the other hand, the induced increase in the curb market rate raises the implicit financial repression subsidy and thus real private disposable income. This has a positive effect on the demand for home goods, as does the switch in expenditure due to (officially-measured) real exchange rate depreciation. At the same time, positive supply effects arise from a reduction in the real wage. In our model, however, these expansionary effects are overwhelmed by the contractionary effects outlined earlier.

Interestingly, the effects of an anticipation of an official devaluation are the reverse of those produced by the devaluation itself, that is, they are expansionary. Output rises in period t+4 because the anticipated price increase and parallel exchange rate appreciation in period t+4 combine to lower the real interest rate in period t+4. The anticipated appreciation of the unofficial exchange rate lowers the rate of return on foreign assets, causing individuals to shift into more lending through informal markets, thereby lowering the equilibrium curb market rate initially. Together with an expected price level increase, this lowers the real interest rate and increases domestic demand in period t+4. Because the induced price level change in this period is much smaller than the price level jump induced by the devaluation in period t+5, however, these effects become progressively weaker as one moves backward in timebefore the devaluation is implemented, and are overwhelmed at the announcement period by the negative wealth effects resulting from the appreciation of the unofficial exchange rate. These results help underline the importance of a proper account of dynamic features and expectational phenomena in assessing the macroeconomic consequences of devaluation, as emphasized by Buffie (1984), and Lizondo and Montiel (1989).

The official devaluation proves to be very effective in improving the current account in this model. The reason is clear–conventional expenditure-switching effects are here strongly reinforced by expenditure-reducing effects. In addition, the fall in the parallel market premium reduces the propensity to under-invoice sales abroad, resulting in a higher level of recorded exports. Because the resulting reserve inflow is only partially monetized and since other financial policies are unchanged, the real effects of the official devaluation are slow to dissipate.

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Devaluation of the Official Exchange Rate of 10 Percent

(Percentage deviations from baseline)

Citation: IMF Working Papers 1991, 018; 10.5089/9781451843576.001.A001

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