On the relation between currency depreciation and domestic investment

Abstract

In introducing an absorption approach to the trade balance, Alexander (1952) argued that if wages do not adjust fully to the inflationary effects of devaluation, devaluation can redistribute income from workers to producers in the form of increased profits. Increased profits, in turn, could give incentive to producers to invest more. On the other hand, because devaluation raises the costs of imported inputs, it could lower profits. Depending on the relative strength of these two channels, domestic investment could increase or decrease. By giving greater consideration to the short-run and the long-run effect of currency depreciation on domestic investment, this paper presents empirical results from a time-series model of 50 countries. We find that the devaluation-investment link is mostly a short-run phenomenon. However, in 21 countries in which the short-run effects last into the long run, both views are supported, almost equally.

Keywords:

• bounds testing
• devaluation
• domestic investment