Exchange Rate Parity for Trade and Development

The landscape of development is strewn with overvalued domestic currencies. This phenomenon flies in the face of conventional wisdom, which emphasizes the salubrious effects of devaluation: by “setting the prices right,” devaluation restores competitiveness and through its effect on the balance of payments leads to an expansion in output and employment. The leading explanation of this paradox considers overvaluation as one of the instruments that debauched politicians employ for capturing economic rents (Krueger, 1974; Bhagwati, 1982). Yet, again paradoxically, in the majority of the 24 cases of devaluation that Cooper (1971a) analyzed, the finance minister who had presided over the devaluation had been ousted from office within the next 18 months. This uncharitable verdict on hapless ministers is easier to understand if devaluations perchance turn out to be contractionary, thus imposing a real cost to the economy. Even then, the former paradox would still remain. If an overvalued nominal exchange rate rests on base motivations, why isn't the world replete with venal, rent-seeking bureaucrats?

This chapter first sets the stage by providing a short review of the literature on the effects of devaluations. Next, nominal exchange rate devaluation is introduced in a quasi-Australian model in real variables that includes tradables, nontradables, and their respective prices, which define the real exchange rate. The model is not dynamic. As a result, it cannot compare the real gross domestic product at time t with that at time 0 in terms of purchasing power parity in order to capture the output effects of devaluation.