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Mr. Calvo is a Senior Advisor in the Research Department, where he is on leave from the University of Pennsylvania. He holds a doctorate from Yale University.
The author thanks Joshua Aizenman, Willem Buìter, Maury Obstfeld, Lars Svensson, and his colleagues in the Fund for their perceptive comments on earlier versions of this paper.
Unfortunately. Keynes does not seem to have gone beyond the mere description of this money-illusion type of phenomenon.
This point of view has received further support from Spaventa (1987). He says, for example, that for inflation to be effective, a necessary condition “is that a large share of the outstanding debt consists of fixed-coupon long-term bonds, so that real interest payments can fall roughly in proportion with the real value of the stock of debt” (p. 385).
Blanchard, Dornbusch, and Buiter (1985) claim that inflation is negatively related to the real rate of interest, r, and that this is an important channel through which inflation can influence the stock of government debt obligations. Although they present some empirical evidence to that effect, however, no specific mechanism is thoroughly discussed in their paper.
This does not rule out that bond holders invest in domestic capital. With perfect capital mobility, however, the opportunity cost of funds at the margin is given by the rate of return on foreign bonds, so equation (4) has to hold.
For the analysis of this section it is irrelevant whether the devaluation has or has not been anticipated. It is more important that no further devaluation is expected—an approximation of the more realistic case in which a devaluation momentarily restores trust in the currency’s value. See Section II for further discussion of these issues.
Thus, contrary to the previous case, the focus here is on a particular point in time, T, but the (constant) operational deficit, d. can be any arbitrary number.
In the staggered-prices model studied in Calvo (1983), however, prices never rise by the full amount of the devaluation before the devaluation takes place.
In my opinion, some clear and interesting examples of “incomplete” devaluations can be found in Argentina’s recent history. These are the Martínez de Hoz devaluation of February 1981 and the one carried out by Sìgaut in March 1981 (see Calvo (1986) and de Pablo and Martinez (1988)).
In a study of several “crisis” episodes in various member countries of the Organization for Economic Cooperation and Development, it is shown that “in no case did a new crisis erupt within the first year or so of the measures having been taken” (OECD (1988, p. 17)).
If a devaluation was expected and does not take place, unemployment is likely to increase. Furthermore, once the public realizes that a devaluation will not happen, prices will begin to fall, increasing the real value of debt. All of these effects are likely to give rise to further devaluation incentives.
It is worth noting, however, that if prices rise ahead of the expected devaluation, then the monetary authority may still have incentives to inflate in order to get rid of unemployment.