Devaluation Crises and the Macroeconomic Consequences of Postponed Adjustment in Developing Countries

A small analytical model is developed to explore the relationship between the dynamics of macroeconomic adjustment and the timing of the implementation of an adjustment program featuring a nominal devaluation. The effects of postponing adjustment depend on the source of the original shock. For fiscal expansion, postponement implies a larger eventual devaluation and greater deviations of macroeconomic variables from their steady-state values. For adverse terms of trade shocks, postponement does not affect the size of the eventual devaluation but does magnify the degree of postdevaluation overshooting by key macroeconomic variables.

Abstract

A small analytical model is developed to explore the relationship between the dynamics of macroeconomic adjustment and the timing of the implementation of an adjustment program featuring a nominal devaluation. The effects of postponing adjustment depend on the source of the original shock. For fiscal expansion, postponement implies a larger eventual devaluation and greater deviations of macroeconomic variables from their steady-state values. For adverse terms of trade shocks, postponement does not affect the size of the eventual devaluation but does magnify the degree of postdevaluation overshooting by key macroeconomic variables.

AN IMPORTANT issue in the design of stabilization programs is the timing of different policies. In particular, determining the consequences of alternatives in timing devaluations has for a long time concerned policymakers in the developing countries. Despite this policy interest, the literature on stabilization and devaluation has not analyzed this issue in detail. The purpose of this paper is to develop a generalequilibrium dynamic model to explore the relationship between the dynamics of macroeconomic adjustment and the timing of the implementation of a stabilization program that includes a nominal devaluation as its principal component.1 In particular, we explore the effects of postponing adjustment on the cumulative deviations of key macroeconomic variables from their steady-state values and on the degree of overshooting of these values following the implementation of adjustment measures.

The model is derived from well-articulated microeconomic foundations and distinguishes between equilibrium and disequilibrium movements in real exchange rates. We investigate the characteristics of two different types of exchange rate crises: those provoked by inconsistent fiscal policies and those generated by exogenous terms of trade shocks. A central aspect of the discussion is determining conditions under which a nominal devaluation will be required to render the adjustment process effective. This is an important policy issue because the role of devaluation has for some time been at the center of controversies surrounding so-called orthodox adjustment programs (see, for example, Buira (1983)). An important innovation of our analysis is that it relates the timing of adjustment to the size of the (corrective) devaluation and, thereby, to the path of several key macroeconomic variables during the disequilibrium process and the adjustment period.

In developing the model we make a special effort to capture the more important stylized facts associated with balance of payments crises, devaluations, and stabilization programs. We start in Section I with a brief exposition of those facts. In Section II we present the model, and in Section III we illustrate how the model works. Here we concentrate on two possible causes of devaluation crises: fiscal shocks and exogenous shocks to the international terms of trade. The central part of this section deals with the consequences of postponing adjustment and devaluation. Finally, Section IV contains concluding remarks, including some thoughts regarding directions for future research.

I. Macroeconomic Policy, Real Exchange Rates, and Devaluation Crises: The Stylized Facts

In this section we briefly analyze the circumstances preceding 20 major devaluation crises in 16 developing countries. Our main interest is to provide a simple “list” of the most salient stylized facts that, we believe, should be captured by a unified model that deals with devaluation crises and macroeconomic adjustment processes. We focus both on policy-induced disturbances—shocks to domestic credit as well as fiscal policy—and on external shocks in the form of terms of trade changes. We then analyze the behavior of the following endogenous variables: (1) real exchange rates, (2) the current account, (3) the monetary system’s foreign asset position, (4) the black market premium, and (5) real wages.

The Sample

Table 1 contains the list of the 20 devaluation episodes analyzed in this paper. The choice of episodes in the sample was 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. In each of these episodes, the countries involved devalued their currencies by at least 15 percent after having maintained a fixed (official) exchange rate with respect to the U.S. dollar for two or more years. Thirteen of the episodes involved stepwise devaluation, whereby after the nominal exchange rate adjustment the country attempted once again to fix the parity (panel A of Table 1). Many of these countries did not succeed and experienced recurrent devaluations. In seven of the episodes a crawling exchange rate was adopted 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 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 develop below, we take this important stylized fact into account and deal with exchange rate crises where the official exchange rate is fixed at a new (higher) level after the devaluation.

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 the subsection on devaluation crises and black market premiums (below), we discuss the behavior of the parallel market exchange rate. The existence of this parallel market is another important stylized fact that is not captured by traditional models but is explicitly incorporated in our unified model.

Table 1.

Devaluation Crises in Selected Developing Countries: Rate of Devaluation

(Percentage of devaluation)

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Source: International Monetary Fund, International Financial Statistics (IFS), various years.Note: 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.

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 ten or more years are also presented.2 The following indicators can be found in this table: (1) the annual rate of growth of domestic credit (panel A); (2) the annual rate of growth of domestic credit to the public sector (panel B); (3) the percentage of credit received by the public sector as a proportion of total domestic credit (panel C); (4) the fiscal deficit as a proportion of gross domestic product (GDP) (panel D); and (5) growth of domestic credit to the public sector as a proportion of GDP. All these indicators have been constructed using data from various issues of the International Monetary Fund’s International Financial Statistics as well as several IFS tapes. For the devaluing countries these indicators are reported for three years, two years, and one year before the devaluation as well as for the year of the devaluation. Although panel A deals with monetary (or domestic credit) policy, the rest of the panels go 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 Three Years Preceding Devaluation: Comparison with Control Group of Fixers

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Source: See the text.
Table 3.

Macroeconomic Data in Period Preceding Devaluation for 20 Devaluation Episodes

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Sources: IFS, Picks Currency Yearbook, and International Labour Office.

Year before devaluation (index = 100).

Colombia devalued in 1965; this explains the evolution of its real exchange rate index before 1967.

Several revealing facts emerge from Table 2. First, macroeconomic— 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 before 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, in contrast, was only slightly more than 10 percent. Formal x2 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.3 This strong empirical evidence suggests a third feature that any model attempting to capture the dynamics of crisis and stabilization should possess: it should have a well-developed fiscal side.

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. Although 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 6 of the 16 episodes for which there are data, there was a significant worsening in the terms of trade before the devaluation (see columns A in Table 3).4 Existing models of exchange rate collapse, however, have ignored the possibility that terms of trade shocks may be the generating cause of devaluations. This possibility is explicitly taken up in our model.

Real Exchange Rates, the External Sector, and Devaluations

In the vast majority of the 20 devaluation episodes the external sector experienced a serious deterioration in the period leading up to the crisis. In 16 of the 20 episodes, the ratio of net foreign assets to money experienced a steep decline during this two-year period (see Edwards and Montiel (1989) for the data). This, of course, is in accord with the traditional models of exchange rate crises developed by Krugman (1979) and others, in which the devaluation takes place when the level of international reserves hits a lower threshold.5 Also, in 14 of the 20 episodes the current account ratio experienced a worsening in the two years before the crisis. In some of these episodes the ratio of the current account to GDP reached remarkable levels: in Kenya in 1981 and in Israel in 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 money to return to its precrisis level after 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.

As regards real exchange rates, in 15 of the 19 episodes for which relevant data exist, the bilateral real exchange rate experienced a real appreciation in the three years prior to the devaluation; 13 of the 19 cases also exhibited a real appreciation of the multilateral real exchange rate during the period immediately preceding the crisis. The average real appreciation during the three years before the devaluation crisis was almost 9.2 percent, whereas the real multilateral appreciation was 9.0 percent (see columns B in Table 3).6 These real appreciations were the result of domestic rates of inflation that increasingly exceeded the world rate. A set of x2 tests indicates that, as the crisis date approached, the rate of consumer price inflation in the devaluing countries became more distinct from that of the fixed-rate control group. This evidence is particularly important for determining our modeling strategy. What these data suggest is that devaluation decisions are based on the behavior of (at least) two indicators: foreign reserves and 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 exchange rate crises in the developing countries 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 adjustment measures, even after it had become evident that the economy was facing a severe macroeconomic disequilibrium. Moreover, in its effort to postpone the adjustment, the government in several cases resorted to exchange and capital controls (Edwards 1989a).

Devaluation Crises and Black Market Premiums

We could obtain information on the black market rate for foreign exchange for most of the countries in the sample. These data are extremely suggestive, showing a marked increase in the premium in the period leading up to the exchange rate collapse. In 13 of 18 episodes the black market premium one month before the devaluation was higher than it was nine months before the devaluation (see columns C in Table 3). It is interesting that in every country immediately after the devaluation the parallel market premium experienced a sudden downward jump (see Edwards and Montiel (1989)). This type of behavior is consistent with perfect foresight models of the type developed by Lizondo (1987a) and Kiguel and Lizondo (1986). In the model developed below, we also incorporate this feature of parallel market behavior.

Devaluation Crises and Real Wages

Critics of “orthodox” stabilization programs have argued that devaluations cause important reductions in real wages (see, for example, Pastor (1987)). To analyze this issue we collected data on the evolution of real wages in the manufacturing sector in the period surrounding the 20 devaluation crises (see columns D in Table 3). Because these data have not been corrected by productivity gains, they should be interpreted with care. These figures show that real manufacturing wages increased in 13 of the 18 episodes for which there are data in the period preceding the devaluation crises. In only 7 of these 18 episodes, however, did real wages register significant (greater than 5 percent) increases. In all of the latter cases, real wages dropped after the devaluation (Edwards and Montiel (1989)). 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.

Summary

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

  • 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.

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

  • In the period preceding the devaluations we observed (1) a significant real exchange rate appreciation; (2) the depletion of the stock of international reserves; (3) a deterioration of the current account deficit; and (4) a decline in the ratio of net foreign assets to money.

  • 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.

  • For real wages, the evidence is less clear. In some countries, however, real wages may have followed an inverted-U path. They increased in the years preceding the crisis and dropped in the years that followed.

II. The Model

In this section we develop a model of a typical developing country that is designed to trace the dynamic response of certain key macroeconomic variables to a variety of shocks that eventually culminate in a devaluation episode. The model is able to generate dynamic responses that mimic quite closely the stylized facts described above. It turns out that, for a given shock that eventually results in adjustment with devaluation, the primary determinants of the path followed by domestic macroeconomic variables are the nature of the eventual macroeconomic adjustment to the shock and the magnitude of the associated devaluation.

Supply

We consider a small open economy that produces exportables (X), importables (Z), and nontraded goods (N) using sector-specific capital and homogeneous labor.7 Labor is available in fixed supply, and all prices are flexible; full employment prevails continuously. The labor market equilibrium condition is

Lx(w/ρ)+Lz(w)+LN(we)=L(1)

where w is the real wage measured in terms of importables; ρ is the domestic price of exportables in terms of importables (that is, the external terms of trade); e is the real exchange rate, defined as the ratio of the domestic price of importables to that of nontraded goods (e=sPz*/PN, where s is the predetermined nominal exchange rate applicable to commercial transactions and PZ* is the world price of importables); and Li is the demand for labor in sector i (where Li<0). Equation (1) implies a relation between ρ, e, and the equilibrium real wage:

w=w(ρ,e)(2)

where

w1=(Lxw/ρ2)/(Lx/ρ+L2+LNe)>0
w2=(LNw)/(Lx/ρ+Lz+LNe)<0

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

yx=yx(ρ,e);y1x>0,y2x>0yz=yz(ρ,e);y1z<0,y1z>0yN=yN(ρ,e);y1N<0,y2N<0(3)

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

Demand

We consider demand on the part of the private sector (households) and the public sector (government and central bank) in this subsection.

Household Sector

We assume that households consume only importables and nontradable goods. To simplify the analysis, we suppose that households’ utility functions are Cobb-Douglas. This implies constant expenditure shares (denoted θ for importables and 1 - θ for nontradable goods) and permits us to write an “exact” price index P:

P=PzθPN1θ=Pzeθ1,(4)

where Pz and PN are the domestic-currency prices of importables of nontradables. With c denoting real consumption measured in units of the consumption bundle with price P, the household demand functions for importables and nontradable goods can be written as

cz=θPc/Pz=θeθ1c(5a)
cN=(1θ)Pc/PN=(1θ)eθc.(5b)

Real household consumption, in turn, is taken to depend on real disposable factor income and real financial wealth:

c=c(yt,a),c1>0,c2>0,(6)

where y is real factor income, t is real (lump-sum) taxes, and a is real financial wealth, all measured in terms of the consumption bundle. Real taxes on households are taken to be exogenous.

Real factor income can be expressed as the product of the relative price of imports measured in terms of the consumption bundle and real factor income measured in terms of importables:

y=e1θ(ρyx+yZ+e1yN)=y(ρ,e).(7)

From equation (7) it follows that an improvement in the terms of trade increases real factor income, whereas a real exchange depreciation has an ambiguous effect on this variable.8

Household financial wealth consists of domestic money and foreign exchange. The economy is assumed to operate under a dual nominal exchange rate system, consisting of a predetermined official exchange rate for current transactions and a freely fluctuating rate that governs transactions in foreign exchange among private citizens.9 Consequently, changes in the desired stock of foreign money will result in changes in the freely floating rate without accompanying capital flows. In that sense the stock of foreign exchange in private hands at any one time reflects past central bank intervention in the dual exchange market; that is, the stock of privately held foreign exchange is exogenous when measured in foreign currency units. Letting M denote the stock of money, F the foreign-currency value of the stock of foreign exchange held by the private sector, and d the dual exchange rate, real household financial wealth is a = (M +dF)/P, which can be conveniently written as

a=e1θ(m+v),(8)

where m = MIPZ and v =dF/Pz. Finally, we assume that households continuously maintain their financial portfolios in the desired composition, which is specified in conventional fashion as a function of the nominal rate of return on the money substitute and of income:

mv=m(d^,y),m1<0,m2>0,(9)

where d^ is the expected rate of depreciation of the dual exchange rate, which under the assumption of perfect foresight is equal to the actual rate of devaluation.

To complete the description of household behavior, the accumulation of domestic money is given by the household budget constraint:

M˙P=ytc,

or, equivalently,

m˙=eθ1(ytc)p^zm.(10)
Public Sector

The government levies taxes on households and purchases both importables and nontradable goods. It finances any resultant deficit by borrowing from the central bank. The government’s budget constraint is given by

def=gz+e1gNeθ1t,(11)

where gz and gN denote government spending on importables and nontradable goods, respectively, and def is the government deficit measured in terms of importables. Initially, the government is assumed to allocate its spending in the same proportions as households:

gz=θeθ1g(12a)
gN=(1θ)eθg,(12b)

where g is total real government spending measured in units of the consumption bundle.

The final agent in the model is the central bank, which issues money to finance government deficits and to purchase foreign exchange in the official market generated by trade balance surpluses. The balance of trade measured in terms of importables, denoted b, is given by

b=ρyx+yzczgz.(13)

Thus, at any instant the stock of money in domestic-currency units, M, is given by

Mt=1[b(u)+def(u)]Pz(u)u.

The domestic-currency value of the stock of international reserves (denoted R) depends on the current official exchange rate rather than on the rate that prevailed at the time the foreign exchange was purchased by the central bank:

Rt=stb(u)Pz*(u)u.(15)

Equilibrium

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

Px=sPx*,Pz=sPz*.(16)

Since 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

yN=cN+gN.

Using equations (3), (5b), (6), (7), and (8) allows this expression to be rewritten as

yN(ρ,e)=(1θ)eθc[y(ρ,e)t,e1θ(m+v)]+gN.(17)

Equation (17) can be solved for the real exchange rate that clears the market for nontradable goods. To do so, assume that the initial equilibrium is characterized by trade balance equilibrium. In this case, it can be shown that y2 = 0 (see Khan and Montiel (1987)). The solution for e is given by

e=e(ρ,gN,t,m+v),(18)

with the following expressions for the partial derivatives:

e1=[yN(1θ)eθc1y1]/Φ<0e2=1/Φ<0e3=(1/θ)eθc1/Φ>0e4=(1θ)ec2/Φ<0,

where d

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, note first that, since F and Pz are both exogenous and since we will be considering only discrete changes in these variables, the definition of v implies that d^=v^. Making use of this property, we can rewrite equation (9) as

v^=h(ρ,m/v),(19)

where

h1=m2y1/m1>0h2=1/m1<0.

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

m˙=g(ρ,gN,t,m+v),(20)

where

g1=y1(1c1)c2e1(1θ)(m+v)e1>0g2=c2(1θ)eθ(m+v)e2>0g3=(1c1)(1θ)c2e1(m+v)e3<0g4=c2[(1θ)e1(m+v)e4+1]<0,

and where all derivatives are evaluated at m˙=v˙=0.10

The equilibrium defined by m = v = 0 can be shown to be saddle-point stable. The determinant of the system consisting of the linearized versions of equations (19) and (20) is given by

Δ=h2g4(1+m/v)<0,(21)

so that the roots are indeed of opposite sign. The phase diagram for this system is depicted in Figure 1. The equations m˙=0 and v˙=0 trace a pair of loci in m—v space with slopes given by

dvdm|m˙=0=1anddvdm|v˙=0=v*/m*>0.

The signs of the arrows in Figure 1 are derived from the partial derivatives in equations (18) and (20), and the saddle path SS through the equilibrium point A must have a positive slope,

dvdm|ss=h2λ1+h2mv>0,

where λi is the negative root. Thus, along stable paths the real money supply and the premium in the dual exchange market will tend to move in the same direction.

III. The Role of Devaluation

To analyze the workings of the model, we consider the effects of the two types of shocks that in Section I were associated with a devaluation crisis: an expansionary fiscal shock, consisting of an increase in government spending on nontradable goods, and an adverse terms of trade shock. We begin this section by analyzing the role of a nominal official devaluation in the model. We then analyze the effects of an expansionary fiscal shock and of a permanent adverse terms of trade shock in consecutive subsections.

Devaluation

A steady-state configuration such as A in Figure 1 is characterized by m˙=0 By differentiating equation (14), this can be shown to imply that b = -def. This condition is not sufficient, however, to ensure that a point such as A will be sustainable. If it is assumed 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 because such values 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 to equal zero in the steady state.

Figure 1.
Figure 1.

Steady-State Equilibrium

Citation: IMF Staff Papers 1989, 004; 10.5089/9781451930757.024.A005

Although a balanced government budget is a necessary condition for sustainability in the 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 that 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 equations (14) and (16b) and the fact that a nominal devaluation does not alter the steady-state value of m(m*), we have

m*=M0/sPz*+t0[b(u)+def(u)]u(22)

(recall that Pz* is constant). From equations (15) and (22) and because d[def(u)]/ds = 0, we find that a nominal devaluation will affect the stock of international reserves as follows:

d(R/s)ds=ddst0b(u)pz*u=M0/s2Pz*>0.(23)

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 is that such a devaluation will reduce the cumulative loss of reserves during the transition to the new steady state. A similar analysis applies in the case of a terms of trade shock. We now examine the effects of fiscal and terms of trade shocks under adjustment with devaluation.

Fiscal Shocks and Devaluation Crises

The effects of an increase in government spending on nontraded goods are depicted in Figure 2. An increase in gN shifts the m˙=0 locus to the right, by

dmdgN|m˙=0=(1θ)eθ(m+v)e2(1θ)e1(m+v)e4+1>0.

The 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. Note that because t has been held constant in equation (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 predevaluation stylized facts presented in Section I.11

Figure 2.
Figure 2.

Effects of an Expansionary Fiscal Shock

Citation: IMF Staff Papers 1989, 004; 10.5089/9781451930757.024.A005

Because 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 (that is, that the spending increase is temporary), but also that the eventual adjustment in spending will be accompanied by an official devaluation. Because 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. Since v=dF/sPz* and m=M/sPz*, at the instant of devaluation, v 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 trajectory after adjustment. The location of D, in contrast, is determined by the condition that DE/E0 = Δs/s; that is, by the size of the devaluation. To see how the position of D is determined, suppose that ΔS/S takes on some known value, say π. Consider the family of rays from the origin of which OR is a member. Each of these rays will contain a point such as E where the ray intersects 55 and a point such as D with the property DE/E0 = π. The set of all such points D traces out a locus LL located above SS and with a slope given by

dvdm|LL=(1+π)dvdm|ss.

Note that there will be one such locus for each rate of devaluation IT. If it is known that the fiscal expansion will last for t periods and that its termination will coincide with an official devaluation of TT percent, then the location of the point D will be determined by the intersection of the locus LL and a path, such as CD, that 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 point B—as well as below LL. The reason 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. Note 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 v) in anticipation of the eventual devaluation, which is consistent with the stylized facts presented in Section I. At the moment of adjustment the economy jumps from D to E along 0R, then gradually returns to A along 55. We can now analyze the behavior of other key macro variables under the adjustment with 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

b=b(e,ρ,gz,t,m+v),(24)

with

b1=ρy2x+y2z+θ(1θ)e1[eθ1cc2(m+v)]>0b2=(1θc1)yx+y1x+y1z>012b3=1b4=θeθ1c1>0b5=θc2<0.

The sign of b1 assumes that the term in 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 noting that m + v rises continuously along the range CD, we can show that the trade balance moves into deficit on impact and that 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 predevaluation 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 I.

Note that because 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 situation of misalignment. 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, causing it to fall below its preshock 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 6) ensures that private real consumption also rises over this period.13

Macroeconomic Adjustment When Devaluation Is Postponed

We now examine how the dynamics of adjustment are affected by postponing the eventual measures. Consider first a postponement of adjustment that 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’—that is, the initial depreciation in the dual rate is dampened.14 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 v 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 before 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 longer adjustment is postponed.

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

m=R/s1Pz*+(s0/s1)Pz*tdef(u)u,(25)

where s0 and s1 denote the official exchange rate before and after devaluation. Because m and Pz* are unchanging across steady states, for a given value of s0/s1 the larger is the cumulative fiscal deficit (which depends only on how long devaluation is postponed), the smaller must be R/s1.

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—that is, 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. If the duration of the fiscal expansion is held constant, this shift 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 deviations of v, v +m and the other macroeconomic variables from their steady-state values after adjustment 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:

  • Since the longer fiscal expansion tends to lower the initial value of v (that is, point C in Figure 2) while the larger official devaluation tends to raise it, the impact effects on v of postponing adjustment in the presence of a reserve target are ambiguous.

  • Over time, however, the longer that adjustment is postponed, the larger are the cumulative deviations of key macroeconomic variables from their steady-state values.

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

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

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 v˙=0 and m˙=0 loci are affected.15 The shift in v˙=0 is given by

dmdρ|v˙=0=h1vh2=m2y1v<0,

whereas that in m˙=0 is given by

dmdρ|m˙=0=g1g4<0.

Because 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 on the terms of trade deterioration causes domestic agents to seek to shift their portfolios away from money and into foreign currency, thus increasing v. But the reduction in real income also reduces saving, and to restore saving to its steady-state level of zero, wealth must fall. This is brought about in part 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.

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 that involves an official devaluation. In contrast to the preceding subsection, however, the size of the required official devaluation is unaffected by its timing. This can be verified from equation (25) if it is recalled 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 equation (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. However, 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.

Figure 3.
Figure 3.

Effects of an Adverse Terms of Trade Shock

Citation: IMF Staff Papers 1989, 004; 10.5089/9781451930757.024.A005

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, m and v must again contract along a ray from the origin at the instant of devaluation, from a point such as D on the ray 0R1, 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), the implied loss of reserves must be offset by eventual surpluses—that is, the point after devaluation 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.16 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 assumes 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 0R2, say—as the point D moves along the locus LL (derived as in the previous subsection). 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.17

Thus, the predevaluation period is characterized by trade deficits and increasing premiums in the dual exchange market that increase at an accelerating rate (since v/m rises).

The effects of postponing adjustment on the deviations of macro variables from their steady-state values differ markedly in the present case from the case of a temporary fiscal expansion. Since LL in Figure 3 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 macro variables from their steady-state values during this period is diminished when adjustment is postponed, in contrast to what is observed under a temporary fiscal expansion. However, at the point H the cumulative reserve loss exceeds that at D (note that m is smaller), so that larger cumulative trade surpluses are needed in the period after adjustment. Thus, the point I is to the southwest of E on S’S’ in Figure 3, and the deviations of macro variables from their steady-state values after adjustment are magnified, as in the previous subsection.

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 the following.

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

  • Similarly, with the exception of foreign exchange reserves and the money supply, the cumulative deviation of macro variables from their steady-state values before adjustment is smaller when adjustment is postponed.

  • However, as in the case of a temporary fiscal expansion, postponement magnifies overshooting after adjustment.

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

IV. Concluding Remarks

Adjustment programs in developing countries are usually the consequence of severe macroeconomic crises. These crises have tended to share several common features, such as an acceleration in the rate of inflation, continuous appreciation of the official real exchange rate, an increase in the current account deficit, the sustained depletion of foreign exchange reserves, and a continuously increasing premium in the black market for foreign exchange. When adjustment is undertaken, it usually includes a substantial devaluation of the official rate, after which the parallel market premium shrinks appreciably. The purpose of this paper has been to derive a dynamic model that is able to capture these common features of balance of payments crises. An important property of the model is that it allows one to analyze the consequences of different timings of adjustment.

From a brief discussion of 20 major devaluation episodes in the developing countries we derived a list of “stylized facts” that we believe models of macroeconomic adjustment should account for. The model that is presented is based on fully articulated microeconomic principles. It considers an economy that produces three goods. The public holds domestic and foreign money, and there are dual exchange rates. An important feature of the model is that the central bank has a well-defined demand for international reserves. We used the model to analyze how the economy reacts to two types of shocks: an increase in government consumption of nontradables financed with domestic credit creation, and a negative shock to the terms of trade. We showed that in this model the adjustment paths followed by inflation, the current account, the real exchange rate, wages, the parallel market premium, and net foreign assets correspond closely to the stylized facts described in the first section of the paper.

A central result of the analysis refers to the consequences of postponing adjustment when the central bank has a well-defined target for international reserves. We showed that the effects of postponement will depend on the type of shock. If the disturbance is a fiscal expansion, postponing adjustment will require a larger official devaluation. However, this relationship between the timing of the devaluation and its magnitude is not linear. If the postponement period is doubled, the required magnitude of the devaluation will not double.18 Delaying the adjustment will affect the path followed by the endogenous variables. In particular, the longer that adjustment is postponed, the larger will be the deviations of the macro variables from their steady-state values. When adjustment is finally implemented, the macro variables will tend to overshoot their steady-state values. The extent of overshooting will depend on the postponement period; a delayed adjustment magnifies the extent of the overshooting.

For the case of a negative terms of trade disturbance, the size of the official devaluation will be unaffected by the timing of the adjustment. Furthermore, the longer the adjustment is postponed, the smaller will be the peak deviation of the macro variables (except for reserves and money) from their steady-state values. However, as in the case of fiscal shock, following adjustment the required degree of overshooting of the macro variables will be magnified by postponement.

An important conclusion of our analysis of the effects of the timing of adjustment is that the observed pattern of continuously rising black market premiums, rising inflation, and increasing current account deficits can be unambiguously inferred only in the context of sufficiently postponed adjustment. The suggestion is that “devaluation crisis” episodes in developing countries have resulted not so much from the occurrence of domestic or external shocks, but from a failure to adjust promptly in response to such shocks.

Although the model presented here goes a long way toward tying together the more salient features of devaluation crises in developing countries, it has some limitations. In particular, it fails to incorporate at least two important issues. First, since there is no capital mobility (the official rate is available only for current transactions, and there are no leakages between markets), the role of capital flight is not investigated. Second, since the model exhibits continuous full employment, the dynamics of real output over the course of the crisis-adjustment period have been omitted. Although both phenomena are of substantial empirical and analytical interest, their incorporation into our framework would add substantially to the model’s complexity, and they therefore remain topics for future research.19

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*

Professor Edwards was a consultant with the Research Department when this paper was written. He is currently with the University of California, Los Angeles, and with the National Bureau of Economic Research. He is a graduate of the Universidad Catolica de Chile and of the University of Chicago.

Mr. Montiel is Assistant Division Chief of the Developing Country Studies Division of the Research Department. He is a graduate of Yale University and the Massachusetts Institute of Technology.

1

Several authors have investigated the process of macroeconomic adjustment in developing countries. Most studies, however, have focused on a particular aspect of the adjustment process, without providing a general and integrated picture that “fits” (or is consistent with) the more salient stylized facts. See, for example, Blanco and Garber (1986), Connolly and others (1987), Rodriguez (1978), Khan and Lizondo (1987), Krugman (1979), and Edwards (1983).

2

Extreme care should be taken when using “control groups” to perform macroeconomic empirical studies. See Goldstein and Montiel (1986) and Edwards (1989b). The countries that constituted the control group in this analysis were Côte d’Ivoire, Dominican Republic, Ecuador, Egypt, El Salvador, Ethiopia, Greece, Guatemala, Honduras, the Islamic Republic of Iran, Iraq, Jordan, Malaysia, Mexico, Nicaragua, Nigeria, Panama, Paraguay, Singapore, Sudan, Thailand, Tunisia, Venezuela, and Zambia. See Edwards and Montiel (1989) for the specific periods considered for each of these countries.

3

The values of the x2 statistics ranged from 9.1 to 14.6. This statistic has two degrees of freedom.

4

We have arbitrarily defined “significant” as a decline in the terms of trade of at least 5 percent.

5

Note that these are net foreign assets of the monetary system; thus, the change in this variable is influenced by private capital movements, including capital flight.

6

Naturally, to the extent that there have not been changes in the equilibrium real exchange rates, these appreciations reflect disequilibrium situations (that is, real overvaluations). Note that the extent of real exchange rate appreciation before the crisis not only varied across countries, but also was more marked in recent years (the 1980s). This has been the case particularly for the countries that adopted a crawling peg after the devaluation.

7

This model is partially based on Khan and Montiel (1987). It differs in that the present version incorporates a dual exchange rate market and ignores the bond market. Kiguel and Lizondo (1986) and Edwards (1988) have presented models somewhat similar to the one developed here.

8

The initial steady state around which the model will be solved below will have the property that y2 = 0. This will be the case when the country is initially neither a net international debtor nor creditor, since in this case (1 -%)y = yNle (see Khan and Montiel (1987)).

9

The literature on dual exchange markets in developing countries is now quite extensive. For recent expositions, see Lizondo (1987a, b) and Dornbusch (1986).

10

The sign of g4 is derived after substituting for e4 from equation (18).

11

Of course, in this case the increase in gN will have to be temporary.

12

Although y1z<0, using equations (2) and (3) we can show that y1x>y1z.

13

Note that m + v rises up to point D. Although e falls, if 1- θ is small, equation (8) indicates that a will increase. Since by equation (7) y is unaffected by changes in e, the behavior of c will depend on that of a.

14

Note that, if the economy jumped above C, the new path would intersect LL to the southwest of D. Since the increase in v along this path (call it C’D’) is smaller than that along CD, and since for each value of v on this path v^ exceeds its value along CD (because the ratio v/m is greater), such paths must be traversed in less time than CD, which is contrary to the assumption of delayed adjustment.

15

We are here considering an adverse terms of trade shock that takes the form of a reduction in Px* The case of an increase in Pz* is similar, except that the initial value of m will be affected.

16

The initial point C must be below v˙=0 to ensure convergence to a point D on the ray OR with the property DE/D0 = (m0 -m1)/m0.

17

That the paths such as GH, located below CD, require more time to traverse than CD follows from the fact that, for each m, the trade deficit on CD exceeds that on GH, yet the cumulative deficit along GH (the reduction in m) exceeds that along CD. It follows that, in the case of prolonged adjustment, the initial jump from point A must be to a path below CD, rather than to one above it.

18

This can be verified by implicitly differentiating equation (25).

19

In particular, adding endogenous capital flows triggered by perceived interest rate differentials would result in a system with three state variables.

IMF Staff papers: Volume 36 No. 4
Author: International Monetary Fund. Research Dept.