Developing countries have often resorted to devaluations to reduce large external imbalances, correct perceived “overvaluations” of the real exchange rate, increase international competitiveness, and promote export growth. The 50 percent devaluation in early 1994 by the CFA franc zone countries stands out as an example of such a policy. However, a devaluation can accomplish these tasks only if, in the first place, it translates into a real devaluation and, second, if trade flows respond to relative prices in a significant and predictable manner.
With regard to the response of the real exchange rate to a nominal devaluation, the empirical literature appears to agree that, indeed, in most devaluation episodes the real exchange rate responds significantly to the nominal exchange rate shock, at least in the short run. As for the impact of real exchange rate changes on trade flows, an older empirical literature on trade commonly found evidence that relative prices play a significant role in the determination of trade flows. However, some of the recent studies that have taken into account the time-series properties of these variables have arrived at a very different conclusion, namely, that no systematic relationship between trade balances and relative prices is discernible from the data.
This paper re-examines the role of relative prices in affecting trade and therefore, implicitly, the effectiveness of devaluation policies, in light of the recent time-series literature that deals with variables that have unit roots and no well-defined limiting distributions. Several empirical regularities emerge. First, the analysis suggests that, in accordance with standard microeconomic theory, income and relative prices are, more often than not, both necessary and sufficient to pin down steady-state trade flows. However, the “traditional” specifications appear to fare better when modeling developing country demand for imports than when applied to industrial country demand for developing country exports. This finding may suggest that a fruitful area to investigate is trade among developing countries. Second, for the majority of cases, relative prices are found to be a significant determinant of the demand for imports and exports. Third, although relative prices have a predictable and systematic impact on trade, price elasticities tend to be low, in most instances well below unity. This result suggests that large relative price swings are required to have an appreciable impact on trade patterns. Finally, industrial country income elasticities are well above their developing country Asian and Latin American counterparts, suggesting that in a scenario of balanced growth the developing country trade balance should improve. However, this result does not hold for Africa, most likely because of the high primary commodity content of African exports.