Some unpleasant currency-devaluation arithmetic in a post Keynesian macromodel

ABSTRACT

The conventional view argues that devaluation increases the price competitiveness of domestic goods, thus allowing the economy to achieve a higher level of economic activity. However, these theoretical treatments largely neglect two important effects following devaluation: (1) the inflationary impact on the price of imported intermediate inputs, which raises the prime costs of firms and deteriorates partially or totally their price competitiveness; and (2) the redistribution of income from wages to profits, which ambiguously affects the aggregate demand as workers and capitalists have different propensities to save. New structuralist economists have explored these stylized facts neglected by the orthodox literature and, by and large, conclude that devaluation has contractionary effects on growth and positive effects on the external balance. Given that empirical evidence on the correlation between devaluation and growth is quite mixed, we develop a more general Keynesian–Kaleckian model that takes into account both opposing views in order to analyze the net impact of currency depreciation on the short-run growth rate and the current account. We demonstrate that this impact can go either way, depending on several conditions such as the type of growth regime, that is, wage-led or profit-led, and the degree of international price competitiveness of domestic goods.

KEYWORDS:

• Currency devaluation
• price competitiveness
• profit-led
• wage-led

JEL CLASSIFICATIONS:

• O40
• O33
• E25

Notes

¹For a summary of the discussion, see Johnson (1976).

²For a summary of the new structuralist approach to devaluation, see Bahmani-Oskooee and Miteza (2003).

³A more inclusive model would also take into account contractionary effects of devaluation through an increase in interest rates and external debt, as in Bruno (1979) and Médici and Panigo (2015). However, in order to keep the model more tractable and focus on cost composition and income distribution effects, we abstract from these channels.

⁴Admittedly, though, an extension of the model developed herein to feature a small open economy with two sectors (tradable and nontradable) along with other related transmission channels is a possibility worth saving for future research.

⁵Kaldor (1966) persuasively argues that the growth of labor productivity is an increasing function of the growth of output in the long run (the so-called Verdoorn law). However, Verdoorn’s law is interpreted as a long-run relationship between demand growth and labor productivity, as a demand increase leads, for instance, to the higher growth of R&D activities, higher investment rate, and the consequent acquisition of new and more efficient machines in some future period.

Additional information

Notes on contributors

Rafael Saulo Marques Ribeiro

Rafael S. M. Ribeiro is in the Department of Land Economy, University of Cambridge.

John S. L. McCombie

John S. L. McCombie is fellow in economics at Downing College, professor and director of the Cambridge Centre for Economic and Public Policy, Department of Land Economy, University of Cambridge.

Gilberto Tadeu Lima

Gilberto Tadeu Lima is a professor in the Department of Economics, University of São Paulo, Brazil. The authors gratefully acknowledge useful comments and suggestions from Ricardo Araujo and Nigel Allington. The usual disclaimer applies.