The effects of devaluation on real output: The case of Jamaica, 1975-1985
In small open economies nominal devaluation is generally the government's policy instrument for dealing with balance of payments problems. There is general agreement that at least among developing economies devaluation is an effective means of improving a country's external balance. The effect of devaluation on the rest of the economy is, however, still a subject of some controversy. Most open economy models and the so-called "orthodox" approach to stabilization policy claim that devaluation ultimately has an expansionary effect on domestic production and incomes as demand shifts from non-tradables to tradables. Both the increase in exports and the substitution of domestic for imported goods stimulate domestic output. In recent years this 'orthodox' view has been increasingly challenged by the so-called contractionary devaluation hypothesis which holds that for various reasons devaluation restores external balance mainly via a reduction of domestic demand for imports rather than an expansion of tradables. The argument that devaluation has contractionary effects is of course not new. Alexander (1952), Diaz-Alejandro (1963) and Cooper (1971) stressed the potentially contractionary effects of devaluation on aggregate demand due to the inevitable redistributive effect and the difference in the savings rate of wage and profit earners. In addition, the monetary approach to the balance of payments has always stressed the initial contractionary effect of the decline in real balances as nominal devaluation increases the domestic price level. Consumption expenditure declines as individuals seek to restore the real value of holdings of financial assets. Like many other small developing countries, Jamaica has implemented a number of IMF supervised adjustment programs as well as tried a number of its own "unorthodox" stabilization policies. For Jamaica, devaluation has not only reduced consumption of wage earners whose nominal wages are fixed or increase at a lower rate than the price level, it has also reduced consumption of those making profit, the level of which tends to fall as imported capital reduces profit in the home goods sector. Even if the Marshall-Lerner condition is satisfied, the decline in real wages and investment (due to low elasticity of substitution between domestic and imported inputs) cause the level of output to fall.
Rhodd, Rupert George, "The effects of devaluation on real output: The case of Jamaica, 1975-1985" (1989). ETD Collection for Fordham University. AAI9020021.