Vol. 17 No. 1 (1997)
How to Cite
The three forms of exchange devaluation
Abstract
When the exchange rate is overvalued and the trade balance is negative, there
are three forms of devaluating the local currency: direct devaluation, fiscal adjustment, and
increase of productivity at a higher rate than the competitors. The three forms involve a
change in relative prices, with the reduction of the prices of nontradables in relation to tradables,
and, so, a relative reduction of real wages. Productivity increase is a first best, since
it does not entail real wage reduction, fiscal adjustment is a second best since it is anyway
necessary and does not contain the risk of inflation. Given this risk, direct devaluation is a
third best. Yet, since it is difficult to control productivity increase in the local economy and
impossible in the competing ones, and since fiscal adjustment leads to devaluation only indirectly
as it reduces the demand for non-tradables, quite often policymakers resort to the
third best alternative.
JEL Classification: F31; E58.
Keywords: Exchange rate policy exchange rate devaluation