The Exchange Rate as an Instrument of Policy in a Developing Country

Quite often an economist, after examining persistent balance of payments deficits (loss of reserves) of a country, will conclude that that country’s exchange rate is “out of line” and must be changed. One issue to be raised here is why not simply say that the country’s credit policy is out of line, and concentrate on monetary and credit policy to solve the balance of payments problem? This question is important, because, politically, devaluation may be an unpopular tool—in which case, good reasons should be adduced in its favor.

Abstract

Quite often an economist, after examining persistent balance of payments deficits (loss of reserves) of a country, will conclude that that country’s exchange rate is “out of line” and must be changed. One issue to be raised here is why not simply say that the country’s credit policy is out of line, and concentrate on monetary and credit policy to solve the balance of payments problem? This question is important, because, politically, devaluation may be an unpopular tool—in which case, good reasons should be adduced in its favor.

Quite often an economist, after examining persistent balance of payments deficits (loss of reserves) of a country, will conclude that that country’s exchange rate is “out of line” and must be changed. One issue to be raised here is why not simply say that the country’s credit policy is out of line, and concentrate on monetary and credit policy to solve the balance of payments problem? This question is important, because, politically, devaluation may be an unpopular tool—in which case, good reasons should be adduced in its favor.

This paper is also concerned with the real effects of exchange rate changes. It is argued, using an essentially monetarist framework, that in a situation in which (1) a devaluation is allowed to be an effective tax on real money balances, (2) the country is a price taker in world markets, (3) domestic producers use imported inputs in conjunction with domestic inputs, (4) there are significant costs of moving nonlabor factor resources from one sector to another during some “short-run period,” a devaluation will have short-run balance of payments and relative price effects. This in turn will induce wealth effects that will have long-run consequences for the structure of the economy. These conclusions will hold even if (5) there is no money illusion among wage earners. Because of comparative advantage, different structures with respect to output and techniques may have different consequences for the growth of the economy.

We are primarily concerned with a less developed country (LDC) without monopoly or monopsony power in international markets. By this, it is implied that the prices of its exports and imports in terms of foreign currencies are to be taken as given and that changes in the LDC’s share in both world trade and the world’s money supply do not induce any perceptible adjustment on the part of the rest of the world—for there is no significant effect on any other country’s trade share and money. In the concluding remarks, the implications of relaxing these assumptions are discussed. It is also assumed that the country has only a rudimentary capital market. Thus, internal finance in the Gurley-Shaw sense tends to dominate investment financing, and the only financial assets that the public can hold are those created by the domestic banking system.

I. The Effects of Devaluation—The Monetary Approach

As a result of recent theoretical research on the monetary approach to the balance of payments (e.g., Dornbusch (1973 a), (1973 b); Johnson (1972); Mundell (1971); Mussa (1974)), our understanding of the transmission process and policy mix involved in devaluation has been improved. The monetarists hypothesize that devaluation is a monetary weapon and that it exerts its influence through the real balance effect. The basic monetary mechanism can be stated, in conventional terms, as follows. With a devaluation in a small country starting from long-run stock equilibrium,1 the price of traded goods rises by the full percentage of the devaluation. Since the prices of traded goods enter into the domestic price level, the latter price level also rises. This means that the real value of cash balances declines, inducing, given the demand for real balances, an excess flow demand for cash balances matched by an excess flow supply of real goods. This excess supply of goods implies two things. First, as long as the marginal propensity to spend on all goods is positive, the prices of nontraded goods must fall relative to the prices of traded goods. This is so because, by assumption, the extra traded goods released by domestic purchasers will be bought in foreign markets, while the excess supply of nontraded goods forces their prices down. Second, the excess flow supply of domestically produced goods induces an improvement in the balance of payments, given the initial nominal stock of money. This is the intersection of the absorption approach to devaluation and the real balance effect of monetary theory. The decline in real cash balances, which reduces domestic absorption relative to domestic real income and output, implies increased hoarding. With a zero rate of domestic credit expansion by the monetary authorities, this desired accumulation of cash balances produces a balance of payments surplus that continues until actual and desired cash balances are equal.

Thus, once individuals have acquired their desired holdings of real cash balances, the balance of payments surplus vanishes. The amount of reserves accumulated is therefore a finite amount. This amount will be influenced by the money multiplier relating changes in high-powered money to changes in total money supply.2 The lower this multiplier, the greater the total reserves accumulated during the transition from one long-run equilibrium to another following a devaluation. Once equilibrium is restored, the old relative prices will be restored (to be precise, they will be restored if the old equilibrium was unique and stable), but the domestic price level is higher, and the domestic money supply is greater, than before.

Certain important implications of this analysis enable us to analyze and to appreciate the role of devaluation and its relation to credit contraction. These would help us in stating when a devaluation should be used instead of a monetary squeeze that has the same balance of payments effects as the devaluation. There are two general points about the monetary effects at this stage. First, given the rate of devaluation, there exists a rate of expansion of the domestic component of the monetary base that will wipe out any short-run balance of payments effect of the devaluation. Conversely, if it is desired to expand the domestic component of the monetary base, starting from long-run equilibrium, there is a rate of devaluation that will prevent this credit expansion from having any balance of payments effect. Second, devaluation is tantamount to a lump-sum tax on cash balances. What the foregoing two points suggest is that showing that a country has a balance of payments deficit is not sufficient to demonstrate that devaluation is necessary, because a balance of payments deficit can be seen as the reflection of an excess supply of money.3 The solution may be a tax on cash balances, or a reduction of the nominal quantity of money, given the real demand for money. In a nongrowing economy, there are solutions to this problem that do not involve devaluation, such as an explicit tax on cash balances, or increasing bank reserve requirements.

In a growing economy, there are even greater possibilities that do not involve devaluation. All that a balance of payments deficit implies in such an economy is that the rate of increase of the domestic component of the monetary base is too high, relative to the rate of growth of demand for money, given the money multiplier. All that is needed is to reduce the rate of growth of the domestic component of the monetary base.

All of this is helpful in looking for clear criteria by which to demarcate those balance of payments deficits that are to be cured by devaluation-cum-monetary management and those that are to be cured by monetary management alone. For clarity of thought, the case for devaluation must be sought on grounds that are much broader than the mere existence of a deficit. Moreover, this discussion implies that devaluation may be wanted even if there is no intention to accumulate foreign reserves or even if there is no attempt to wipe out a deficit, if devaluation can be shown to have desirable consequences in addition to purely monetary effects.4

As an obiter dictum, it is possible to show that the monetary approach can be considered only a special case of the absorption approach.5

II. The Pure Monetary Adjustment Case—Devaluation Versus Monetary Contraction

If there is a situation of short-run flow equilibrium with a balance of payments deficit, then the nominal stock (and/or rate of growth) of money is too large, relative to the nominal demand (and/or rate of demand growth) for that stock. If devaluation is used, then there is an attempt to raise the nominal demand, while if monetary policy is used, there is an attempt to reduce the money supply. A way to look at the issue of monetary policy versus devaluation is simply to ask under what conditions should a government decide to increase the nominal demand for the existing stock rather than simply to reduce the nominal stock? The monetary approach would seem to imply the following rule of thumb. Use devaluation (increase the demand for the nominal stock) when it is harder and more costly, as explained later, to reduce the nominal stock of money to meet the demand for that stock than to raise nominal demand to meet the supply. There is, of course, a third choice: reduce supply and increase demand until they meet somewhere in between the initial starting points.

From the viewpoint of devaluation as a pure monetary adjustment tool, it is possible to give a qualitative answer as to the conditions under which some devaluation is particularly helpful in the adjustment process. The answer is implicit in the monetary approach to devaluation. For expositional convenience, define Ms as nominal money stock, Md as desired nominal balances, and g as the rate of growth of real output. In general, we hypothesize that the case for devaluation to augment money demand will be stronger, the greater is Ms − Md and the lower is g.

The reason why the size of the disequilibrium (i.e., MsMd) at the time that the decision is taken is important is simply that there may be technical difficulties in adjusting the rate of growth of money supply downward.6 This is especially true when the change required is a significant absolute decline in the money stock at given prices. In this situation, monetary policy would proceed by raising bank reserve requirements and/or by reducing the domestic component of the monetary base. If there are no technical difficulties in this area, then there is no clear-cut case for devaluation. But a presumption exists that the greater the MsMd, ceteris paribus, the greater the case for devaluation.

The case for g is also obvious. The greater is g, the more rapidly will Md be increasing, so that adjusting Ms may be sufficient, given the technical difficulty of doing so. Ceteris paribus, therefore, the case for devaluation is stronger, the smaller is g.7

But there are other considerations. However high the rate of growth, there might be a sizable period during which Md is rising toward Ms even if Ms is held constant. During this period, the economy is allowed to absorb more than its output and to either run down its reserves or increase the rate of foreign borrowing by the monetary authorities. One could consider the maximum amount of reserve loss and/or borrowing that the authorities are willing to permit during the adjustment period to bring MsMD to zero. This amount would depend on the ratio r/ρ, where r is the opportunity cost of reserves lost (when foreign exchange reserves are positive) and the cost of borrowing funds (when foreign exchange reserves are zero or less), and where ρ is the marginal rate of time preference of domestic spenders. The greater is r/ρ, the smaller the reserve loss, or borrowing, that will be required.

What we can say is illustrated in Figure 1. On the ordinate is money, and on the abscissa, time. At time t = 0, Ms is Ms(0) and Md is Md(0). The disequilibrium is Ms(0) − Md(0). At the price level prevailing at time t = 0, the path of money demand is shown by the curve M′. For instance, if real money demand is a constant fraction of real income and income growth is a constant g, then, assuming the price level to be unchanged throughout, the curve M′ is described by the equation Md(t) = Md(0)egt. Suppose that the authorities can hold the money supply constant during the adjustment period,8 that is, they are able to institute policies that will have this effect, and that this is the best that they can do from the standpoint of money supply adjustment. Then the path of money supply is given by Ms(0)M′′′. The area Md(0)Ms(0)C is the approximate loss of foreign exchange reserves during the adjustment period. Let this area be Ra. Suppose that the maximum amount of reserve loss plus foreign borrowing that the authorities are willing to permit during the adjustment is Rd. Suppose now that Ra > Rd; then there is some rate of devaluation that will shift the M′ curve up to, say, M′′ in Figure 1, such that the area Ms(0)AB is equal to Rd. The greater the rate of growth of real output, the steeper is the M′′ curve. The more the authorities can contract money supply during the adjustment period, the more negatively sloped is the M′′′ curve (it has zero slope in Figure 1). The greater the reserve loss that the authorities are willing to tolerate, the greater is Rd. In each of these instances, the smaller is the probability that devaluation is needed.9

The foregoing approach implies that a devaluation as a pure monetary adjustment tool may be reversed after the adjustment process is completed. Thus, in Figure 1, if the country devalues, raising M′ to M′′, then at tm or a little thereafter it can reverse the devaluation and use traditional monetary policy instruments from then on.

III. Devaluation as a Tax on the Private Sector

It can be shown that a devaluation (up to a point) is the open economy analogue of a once and for all tax on inflation in a closed economy. Imagine a situation in which the government sells securities to the central bank, and, instead of receiving domestic currency, it requests foreign exchange to incur payments abroad. The government can then devalue and, through the real balance effect, replenish the foreign reserves of the country. Devaluation becomes a lump-sum once and for all tax on the private sector to finance government spending. The tax is not permanent, because once individuals attain their long-run desired money balances, they cease to accumulate real balances.

Looked at in this way, devaluation can be used as a technique to augment capital accumulation in the public sector, where this sector engages in production and where capital goods are imported. Where there are idle domestic resources, say, because domestic resource rentals are sticky in real terms, such an accumulation of capital may permit the economy to attain higher employment and output levels than before.

Even if the government does not import goods from abroad but borrows from the central bank, receiving the loans in domestic currency, the devaluation allows the government the opportunity to effect the “inflation tax” without loss of foreign exchange reserves by the central bank.

The preceding discussion is important in appreciating the differences between a closed and an open economy. In an open economy, the effectiveness of the inflation tax is diminished; rapid money expansion generates balance of payments deficits and loss of reserves. What is open to the authorities is inflationary credit creation-cum-devaluation, not simply inflationary credit creation.

The transfer of resources from the private sector to the government sector through this mechanism is not sufficient to ensure increased output and employment (given unemployed resources). For this result to ensue, at least one of the following conditions must prevail: (1) the government must be more productive in its use of the resources transferred; (2) the loss of wealth implied by the tax must induce less contraction of the capital stock in the private sector than the increase in the capital stock induced in the government sector; (3) the government must employ its capital stock in areas that are labor intensive relative to the average labor intensity of all productive activities in the economy; and (4) the government must employ its resources in areas in which the economy has a comparative advantage.

Even if none of these conditions hold, the foregoing underlines an important point that will be explored later. Even for a once and for all devaluation, the conditions necessary for no permanent real effect on the economy—adverse or favorable—are stringent indeed. The wealth effects of the short-run flow equilibrium situation can leave permanent real effects on the economy. For the moment, it is clear that if a single devaluation is used as a device to transfer real resources to the government, the presumption is that while there is some rate of devaluation that will produce long-run real effects on the economy, there is no a priori reason for the real effects to be positive (i.e., to increase output and employment).

IV. The Exchange Rate and the Structure of the Economy over Time

The monetary approach to devaluation agrees with the older approaches that when the devaluation results in an effective tax on real cash balances, in the short-run flow equilibrium after the devaluation, the prices of traded goods rise relative to the prices of nontraded goods. The essence of this section is to show that in the conditions prevailing in the LDCs this conclusion is important in understanding the effect of exchange rate changes on the structure of these economies.

Consider a single devaluation for an LDC. The prices of traded goods immediately rise by the same percentage as the devaluation, and the prices of nontraded goods remain the same as before or rise by less than the devaluation, given the money stock. Since the domestic price level is a weighted average of these two price levels, it rises less than the devaluation but more than the price of nontraded goods. This is the real balance effect in operation. Since we are assuming that there is no money illusion on the part of workers, let us assume that the money wage rate rises instantly by the full amount of the rise in domestic price level. Let us differentiate two groups in our LDC economy: wage earners and capitalists (or residual income earners). Wage earners, by assumption, avoid being taxed by the devaluation. Thus, there is no wealth effect.

Now consider the capitalists, that is, owners of “firms” who receive noncontractual income, or accounting profit, or residual income. Suppose that there are “high” costs of shifting productive resources or altering techniques of production, so that over some short-run period owners of firms are unable to transfer their assets from one activity to another, or to alter their techniques of production. This is the Marshallian assumption. Since the prices of traded goods rise by the same percentage as the devaluation and the wage rate rises by less than that, profit earners in the traded goods sector(s) earn economic rents during the short-run period of adjustment after the devaluation. The opposite holds for profit earners in nontraded goods sector(s); they make losses (or, rents hitherto earned are reduced) during the period of adjustment, since the money wage rate rises by more than the price of nontraded goods. It is clear that there exists a rate of devaluation such that the sum of the economic rents earned and the sum of the losses incurred are significant, relative to the sum of residual incomes.

But this is not all. Owners of “firms” in their production processes will be using several factors, some of which are imported and some of which are produced locally. The effect of the devaluation is to induce greater losses (or smaller economic rents) for those owners whose use of foreign factors of production is relatively intensive than for those whose use of domestic factors is relatively intensive.

For expositional convenience, let N represent domestic factors (land, labor, etc.) and K, foreign factors. The matrix that follows presents two kinds of classification of all goods that are produced in the economy. The first is in terms of whether or not the goods are traded; the second is in terms of whether their N/K ratios are higher or lower than average.

Thus, there are four sectors: X1, X2, X3, and X4, as shown in the matrix. Assuming zero rents before the devaluation, in the adjustment period that follows, residual income earners in the X1 sector unambiguously receive economic rents, while those in the X4 sector unambiguously make losses. For the X2 and X3 sectors, we are not sure; we conjecture that our results will not be significantly affected by assuming that the residual income earners in X2 and X3 neither receive economic rents nor incur economic losses during the adjustment period.

What has been implied so far is that there exists a rate of devaluation that would make the economic rents accumulated in X1 and the economic losses incurred in X4 significant, relative to residual incomes in those sectors. There is a once and for all expansion in X1 and a once and for all contraction in X4, as a result. If the X1 sector is at least as important as the X4 sector in terms of value added, or at least in terms of N employed, the effect of all this is to induce a once and for all increase in the N/K ratio of the economy. The implicit assumption, of course, is that in both X1 and X4 productive assets desired by residual income earners vary positively with wealth.

The preceding implication is more important than would at first be imagined. One could argue that the rate of devaluation that would produce wealth effects significant enough to raise the overall N/K ratio, assuming that other conditions were favorable, is so great as to be out of the question in most countries. But we have shown that devaluation is, to producers, like a wealth tax. The tax is negative for producers in X1 and positive for producers in X4. Similarly, for all producers the wealth tax is lower, the higher the N/K ratio. If, therefore, there is some chance of devaluation in the future, producers benefit by being in X1 and not in X4, and by using production techniques with sufficiently high N/K ratios. The risk of exchange rate changes affects the present value of expected future receipts from investment in different sectors, and the present value of using different production techniques. An expected series of exchange rate changes (with respect to direction but not to timing) will, therefore, affect the pattern of investment. A series of such devaluations (revaluations) can be used to alter the structure of the economy toward X1(X4) and to alter techniques, such as to raise (lower) N/K in all sectors. By altering the expected profitability of investing in certain sectors and of using different techniques, the threat, or possibility, of exchange rate changes in conjunction with the short-run wealth effects caused by actual devaluations, can be used to alter the long-run expansion path of the economy. A given exchange rate change can be made to have long-run effects, and the exchange rate instrument can also be made to alter the structure of the economy over time.10

V. Concluding Remarks

There will be no attempt to summarize the analysis but only to pinpoint the thrust of the paper. The fundamental point made is that we must understand clearly why we want to use the exchange rate: (a) as an instrument of monetary adjustment; (b) as a device to tax (subsidize) the private sector and to subsidize (tax) asset accumulation in the public sector; (c) as an instrument to impose a once and for all wealth tax on some producers in the private sector and to give a once and for all subsidy to some others; and/or (d) as an instrument to induce long-run shifts of resources from some sectors to others.

For reasons of simplicity, it has been assumed that we are dealing with an economy with no monopoly or monopsony power. But even if the economy concerned has some monopolistic power over its exports and some monopsonistic power over its imports, the conclusions will not be seriously changed. In general, the analysis will be affected as follows. The prices of the country’s traded goods will rise (fall) by less than the exchange rate change following a devaluation (revaluation). This would be so because with a devaluation, for example, the foreign prices of the traded goods will fall when the country reduces its demand for them. As a result, to attain any given tax on cash balances, that is, to effect any given increase in the domestic price level (with a devaluation), the rate of the devaluation will have to be greater than it would if the country had no monopsonistic or monopolistic power.11

A situation that is encountered is one in which the country is experiencing balance of payments pressure and/or undesirable urban unemployment plus rural underemployment, combined with a low rate of growth of real output and a rather high rate of growth of the money stock (relative to the growth of the demand for money). In such a case, it may be that the structure of the economy is distorted from the point of view of long-run comparative advantage. Now there are many possible directions in which the economy may have been distorted, and the reasons for this distortion are usually numerous. This means that there are many other ways of dealing with the distortions, apart from using the exchange rate. For instance, the distortions may have been due to tariff and other trade policies, wage and price controls, or simply differential tax incentives to invest in different sectors. Removing these distorting factors is obviously a more direct approach to the problem. But, in general, if past policies have led to a distortion of the economy toward nontraded goods that are relatively intensive in their use of foreign factors of production, that is, X4-type goods (including here goods produced behind prohibitive tariff walls), the analysis in the paper suggests that exchange rate depreciation can be part of a policy package to restore a more efficient economic structure. With this latter structure, a higher growth rate and better balance of payments performance are expected.

Wages may not instantly adjust upward when there is a devaluation. This means that a devaluation may, by distributing income away from workers and toward capitalists or residual income earners, allow employment to be augmented within some short-run period before increased wages catch up with the devaluation. Governments often find that they have instituted plans that, once they take hold, will result in increased employment and real output at current real wage rates. But in the meanwhile, the level of unemployment may be higher than desirable. A devaluation can then be used as a short-run tool to exploit the stickiness of wages and to raise employment, allowing the government a breathing spell before its development program results in an increase in real demand for labor.

To end with a general note of caution: the real effects of exchange rate changes would seem to be an area where much work must be done. For instance, even within the monetary approach, the current literature is unclear as to (1) how long the adjustment process lasts, (2) the nature of the wealth effects, if any, that occur during the adjustment period, and (3) the influence of these effects on the real variables of the economy. The solution to these problems may differ for different types of economies. Of course, it may still be true that whatever real effects result from exchange rate changes could have been achieved more efficiently by other means. Moreover, one cannot overemphasize what is currently generally accepted—that is, there cannot be even short-run real effects of devaluation unless some nominal variable, such as money supply, wage rate, or the price of some commodity, is held constant or does not adjust instantly to its predevaluation real value in terms of domestic prices. This paper has been concerned, in particular, with the real effects of exchange rate depreciation when changes in the domestic component of the monetary base do not neutralize the tax effect of devaluation, and when the foreign prices of traded goods are given. One can draw no conclusions as to the short-run real effects of devaluation until one makes explicit assumptions as to the behavior of nominal variables. It is a corollary of this basic point that to say that the exchange rate is “out of line” is not at all a meaningful statement; for one could just as well have said that some other nominal variable or set of nominal variables is “out of line.” Finally, the argument has been presented that under conditions actually prevailing in the LDCs (in particular, their importation of a significant fraction of their producer goods and the significant costs of shifting resources between sectors) the short-run real effects will tend, if the devaluation is large, to have wealth effects that in turn have permanent real effects on the economy. The devaluation will result in a positive wealth tax on residual income earners (profit earners) in sectors producing nontraded goods and utilizing techniques that are relatively intensive in their use of foreign factors of production, while it will result in a wealth subsidy to residual income earners (profit earners) in sectors producing traded goods and utilizing techniques that are relatively intensive in their use of domestic factors of production.

REFERENCES

  • Dornbusch, Rudiger (1973 a), “Currency Depreciation, Hoarding, and Relative Prices,” Journal of Political Economy, Vol. 81 (July/August 1973), pp. 893915.

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  • Dornbusch, Rudiger (1973 b), “Devaluation, Money, and Nontraded Goods,” American Economic Review, Vol. 63 (December 1973), pp. 87180.

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*

Mr. Johnson, economist in the Stabilization Policies Division of the Exchange and Trade Relations Department, received his doctorate from the University of California, Los Angeles. He has been a member of the faculty of Fourah Bay College, University of Sierra Leone, and a visiting faculty member of the University of Michigan. His technical writings deal mainly with the economic problems of less developed countries.

1

In long-run stock equilibrium, no one is trying to add to or subtract from his existing holdings of real balances, and the balance of payments is in equilibrium (that is, there is no net loss or gain in the flow of foreign reserves).

2

This point is not usually brought out explicitly in the monetary models.

3

If there is significant price and wage rigidity, the cost-price and relative-price structures of the economy may have become distorted as a result of prolonged inflationary pressures. Relative prices of commodities, for instance, no longer represent relative marginal social costs, even in the absence of external economies and diseconomies and of increasing returns. The structure of production no longer reflects long-run comparative advantage, given tastes, techniques, resource endowment, and world prices. Given monetary policy, a devaluation, in this case, can correct some of this distortion, as elaborated later.

4

We are not talking here about devaluation merely to augment a country’s share of world reserves when there is no balance of payments problem. We are concerned here with a country that finds itself, for various historical reasons, with a structure of production and techniques that is not consistent with efficient allocation of resources. The exchange rate is one tool that can be used to alter the structure of the economy and indeed can help to raise world real income, by better allocation of world resources. This is discussed further in the text.

5

We know, given real income, that real absorption must decline for the price of domestic goods to fall relative to the price of traded goods in the short-run flow equilibrium after the devaluation. The monetarists made this clear, but it was implicit in the absorption approach. If so, then the essence of the monetary approach is the implicit assertion that real absorption will decline if, and only if, real money balances decline after the devaluation. Suppose that A is real absorption; Y is real income; DH is net real dishoarding; ms and mD are the stocks of real money balances actually held and demanded, respectively; k is the desired ratio of money to income; and j3 is the coefficient of adjustment of actual to desired real balances. Then we have the following relationships in the short run:

A=Y+DH(1)
DH=β(msmd)=βmsβkY(2)
from equations (1) and (2)
A=(1βk)Y+βms(3)

Equation (1) says that real absorption is equal to real income (or disposable income, as the case might be) plus net real dishoarding. Equation (2) gives net dishoarding. Equation (3) then gives what may be called the implicit fundamental monetarist relation. Since Y and k are both constant in the monetarist models, and, by implication, β, as well, it follows that real absorption will decline if, and only if, ms declines. Given Ms (the nominal quantity of money), this of course implies that the general price level, P, must rise.

6

The technical difficulties arise because rapid downward adjustments of the money supply may affect not only aggregate demand for real goods but also supply (i.e., real output) because of distributive effects, and these effects may be inconsistent with government objectives. Some enterprises depend heavily on bank credit for their working capital requirements. This is often true for government (public) enterprises and numerous small and medium-sized firms in the so-called modern sector, especially those without significant access to world money markets. Trying to adjust the growth of the money supply downward, by, for instance, higher bank reserve requirements, tends to affect such enterprises relatively more than it does, say, large international firms as a result of the short-run adjustment costs imposed by bank credit restrictions. In addition, the government itself may suffer adversely from such money supply restraint. Thus, the government’s reduced ability to borrow from the central bank in an attempt to reduce the rate of growth of the domestic component of high-powered money may have short-run favorable effects on prices and the balance of payments; but the government may feel that the long-run effects on growth are rather detrimental.

7

It is implicitly assumed throughout this analysis that the interest rate is held constant. Nevertheless, raising the rate of interest is an alternative way to increase the demand for money at given price and income levels, when money is defined to include some interest-bearing assets, such as time and savings deposits in financial institutions. In this regard, where the elasticity of money demand with respect to the rate of interest is “large,” variation of deposit rates becomes a policy with effects that are similar to those of exchange rate variation.

8

With a balance of payments deficit, the money supply will tend to decline unless the monetary authorities replace the reserves lost with domestically created high-powered money. Thus, throughout the adjustment period, with reserve loss the ratio of net foreign assets to net domestic assets of the banking system will be falling.

9

For instance, in the simple example where Ms is held constant during the adjustment period and Md(t) = Md(0)egt,

Ra=0tn(Ms(0)Md(0)egt)dt=Ms(0)tnMd(0)g(egtn1)(1)

We can obtain tn by setting Ms(0)=Md(0)egtn and solving for tn to get

tn=log(Ms(0)/Md(0))g(2)

Now using equations (1) and (2), we can set Rd=Ms(0)tmM¯d(0)g(egtm1)

substitute tm=log(Ms(0)/M¯d(0))g

simplify to get

Rd=Ms(0)g[log(Ms(0)M¯d(0))1]+M¯d(0)g(3)

and solve for M¯d(0) by substituting for all the other parameters, in equation (3). In Figure 1, M¯d(0) is point A. Then

M¯d(0)Md(0)Md(0)=P˙(4)

is the desired rate of increase of domestic price level, that is, the rate of tax on cash balances, at time t = 0. Finally, we have

e˙=P˙αF(5)

as the desired rate of devaluation, ė, where αF is the share of traded goods in the price-index basket.

10

Not too long ago, Professor Stolper (1972) tried to show that, in the sort of economy with which we are concerned, a devaluation can have favorable internal effects. In particular, he stressed the proposition that a devaluation will have the desirable effect of shifting the internal terms of trade in favor of agriculture and against urban consumers, and, generally, in favor of domestic producers and against importers. The monetary approach casts doubt on this sort of relative price approach because it does not properly explain why the relative price changes came about and because the relative price changes induced by a devaluation will not generally persist in the new long-run equilibrium. Here we have tried to reformulate the Stolper-type approach so as to correctly incorporate the fundamental point that a devaluation is a monetary weapon and, thus, the real balance effect is important in the transmission process. As a result, we have stressed the wealth effects produced by the short-run changes in relative prices.

11

Moreover, in a country with such power, αF in footnote 9 will generally be smaller than for a small country with no such power. This implies that ė will be greater for any given desired .