Exchange Rate Evaluations
When do they work?

It has long been recognized that, under certain conditions, a nominal devaluation might fail to change the real exchange rate. Domestic prices might adjust fully to the exchange rate change, leaving the relative price of domestic- and foreign-produced goods unaffected. This could be due for example to the importance of imported intermediate goods or to full wage indexation in the labour market.

In Discussion Paper No. 199, Research Fellow Louka Katseli argues that the effectiveness of a devaluation depends not only on the structural characteristics of the economy but also on the nature of exchange rate management. She investigates a model in which commodity markets are characterized by oligopolistic competition and price-setting behaviour; the expected demand for each firm's output is negatively related to its own price and positively related to the expected (unobservable) price of substitute commodities. The firm forms its expectations of other price goods by observing the pricing decisions of neighbouring firms. These in turn depend on a firm-specific disturbance and on the aggregate price component. As the variance of the aggregate increases, this leads the firm to expect a positive increase in the demand for its output. Thus, in cases of managed floating, it is reasonable to expect that an increase in the variance of the exchange rate would give rise to expected increase in demand for the firm output. Thus, the price charged by each firm is positively related to the variance of the exchange rate. As this variance increases, the firm's prices rise.

Katseli tests this proposition on Greek monthly data for 1981-5, which included two large discrete devaluations in January 1983 and October 1985. During the rest of the period the exchange rate was allowed to follow a crawling peg. Katseli regresses the monthly rate of change in the consumer price index on a number of explanatory variables, including the rate of change of the nominal effective exchange rate and the variance of this rate of change (over the preceding three months).

The regressions suggest that, traditional factors aside, the variance of exchange rate changes seems to play an important role in explaining domestic price behaviour. It also suggests that, during the period under consideration, expectations about future price developments were the driving force behind firms' price- setting behaviour. The two discrete devaluations strengthened expectations that all prices in the domestic market would be raised and led to yet more rapid price-adjustment, which could be justified readily to potential customers who also observed the exchange rate signal. This is consistent with other evidence regarding speculative movements in the economy, such as hoarding of consumer goods and highly volatile import behaviour by firms. From a policy perspective, this confirms the view that macroeconomic performance depends not only on economic fundamentals but also to a large extent on the psychology of the market. This can easily be upset by careless exchange rate management.

On the Effectiveness of Discrete Devaluation in Balance of Payments Adjustment Louka Katseli

Discussion Paper No. 199, August 1987 (IM)