David K.H. Begg, Gianluigi Vernasca-Economics-McGraw Hill Higher Education (2011)

CHAPTER 25 Open economy macroeconomics
competitiveness achieved by devaluation. When domestic prices and wages have risen as much as the
exchange rate was initially devalued, the real exchange rate and competitiveness return to their original
levels. If the economy began from internal and external balance, long-run equilibrium is now restored.
If devaluation is meant to raise net exports for a sustained period, for example to raise more money to
service foreign debts, this is compatible with internal balance [ Y* = ( C +I+ G) + (X - Z)] only if domestic
absorption ( C +I+ G) is permanently cut, for example by tightening fiscal policy.
Thus, beginning at full employment, devaluation accompanied by higher taxes will raise the demand for
net exports without increasing total aggregate demand. Since there is no upward pressure on domestic
prices, higher competitiveness can be sustained in the medium run.
The long run
Can altering the nominal exchange rate permanently change the value of real variables? Suppose devaluation
is accompanied by tighter fiscal policy to allow the economy to meet the higher demand for net exports
without any direct upward pressure on prices. Although this takes care of demand-side effects on prices,
we must also think about supply-side effects.
Domestic firms importing raw materials want to pass on these cost increases in higher prices. Workers
buying imported TVs realize that import prices are higher and demand higher nominal wages to maintain
their real wages. These price and wage rises lead other firms and other workers to react in similar fashion.
In the absence of any real change in the economy, the eventual effect of a devaluation is a rise in all other
nominal wages and prices in line with the higher import prices, leaving all real variables unchanged.
Eventually, devaluation has no real effect. Most empirical evidence suggests that the effect of a devaluation
is completely offset by a rise in domestic prices and wages after four or five years.
Figure 25.4 summarizes this discussion. A once-off nominal devaluation leads to an instant real devaluation
that is gradually unwound again; to a rise in output that is gradually unwound as the real exchange rate
stimulus wears off; and to a complicated response in the current account balance in value terms. Initially,
the devaluation is effectively a price cut - until quantities can respond, making exports cheaper actually
harms export revenue. In the medium run, the induced quantity rise in exports benefits the current account
in value terms, provided quantities respond sufficiently to price incentives. Eventually, since the real
exchange rate is restored to its original level, so is the current account.
In September 1992 sterling left the Exchange Rate Mechanism and quickly fell about 15 per cent against other
currencies. The UK also had big devaluations in 1949 and 1967. Table 25.l shows the effect of the sterling
devaluation by 15 per cent in 1967. It took two years for the current account to move from deficit into surplus.
Devaluation did not improve the current account until quantities of imports and exports had time to respond.
Real exchange
rate
Output and
demand
Current account
(value)
Time
Time
Time
Figure 25.4
Evolving responses to a devaluation
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