Optimal Devaluations

According to the conventional wisdom, when an economy enters a recession and nominal prices adjust slowly, the monetary authority should devalue the domestic currency to make the recession less severe. The reason is that a devaluation of the curren...

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Bibliographic Details
Main Authors:	Hevia, Constantino, Nicolini, Juan Pablo
Format:	Policy Research Working Paper
Language:	English
Published:	2012
Subjects:	ARBITRAGE ARBITRAGE CONDITION ARBITRAGE CONDITIONS ASSET HOLDINGS BONDS BUDGET CONSTRAINT CAPITAL MARKETS CENTRAL BANK CLOSED ECONOMY CONSTANT EXCHANGE RATE CONSTANT RETURNS TO SCALE CONSUMERS CURRENCY MARKET CURRENCY UNION CURRENT ACCOUNT DEBT DECENTRALIZATION DEPRECIATION DEVALUATION DEVALUATIONS DEVELOPING COUNTRIES DISTORTION DISTORTIONS DIVIDEND DIVIDEND TAXES DIVIDENDS DOMESTIC BONDS DOMESTIC CURRENCY DOMESTIC CURRENCY PRICE DOMESTIC DEBT DOMESTIC SECURITIES ECONOMIC CONDITIONS ELASTICITY ELASTICITY OF DEMAND ELASTICITY OF SUBSTITUTION EQUATIONS EQUILIBRIA EQUILIBRIUM EQUILIBRIUM CONDITION EQUILIBRIUM CONDITIONS EQUILIBRIUM PRICE EQUILIBRIUM PRICES EXCHANGE RATE EXCHANGE RATE DYNAMICS EXCHANGE RATE FLEXIBILITY EXCHANGE RATE POLICY EXCHANGE RATE REGIMES EXCHANGE RATE VOLATILITY EXCHANGE RATES EXOGENOUS SHOCKS FEDERAL RESERVE FINANCIAL STUDIES FISCAL POLICY FOREIGN ASSETS FOREIGN CURRENCY FOREIGN CURRENCY MARKET FOREIGN DEBT FOREIGN INTEREST FOREIGN INTEREST RATE FOREIGN INVESTORS GENERAL EQUILIBRIUM GENERAL EQUILIBRIUM MODEL GOVERNMENT BUDGET GOVERNMENT EXPENDITURE GOVERNMENT EXPENDITURES GOVERNMENT POLICIES GOVERNMENT POLICY GOVERNMENT SPENDING HOLDING IMPERFECT SUBSTITUTES IMPORTS INCOME INCOME TAXES INITIAL DEBT INSTRUMENT INTEREST PARITY INTEREST RATE INTEREST RATES INTERNATIONAL BANK INTERNATIONAL CAPITAL INTERNATIONAL CAPITAL MARKETS INTERNATIONAL CAPITAL MOBILITY INTERNATIONAL CREDIT INTERNATIONAL ECONOMICS INTERNATIONAL MACROECONOMICS INTERNATIONAL MONEY INTERNATIONAL PRICE INTERNATIONAL TRADE LEVY MACROECONOMICS MARGINAL COST MARGINAL UTILITY MARGINAL UTILITY OF CONSUMPTION MONETARY AUTHORITY MONETARY ECONOMICS MONETARY INSTRUMENTS MONETARY POLICY MONEY DEMAND MONEY SUPPLY MONOPOLISTIC COMPETITION MONOPOLY MULTIPLIERS NEGATIVE SHOCK NEGATIVE SHOCKS NET EXPORTS NOMINAL DIVIDENDS NOMINAL EXCHANGE RATE NOMINAL INTEREST RATE NOMINAL INTEREST RATES NOMINAL WAGE NOMINAL WAGES OPEN ECONOMIES OPEN ECONOMY OPTIMAL ALLOCATION OPTIMIZATION OUTPUT POLICY RESPONSE POLITICAL ECONOMY POWER PARITY PRICE INDEX PRICE INDEXES PRICE STABILITY PRIVATE CONSUMPTION PRODUCTION FUNCTION PUBLIC POLICY PURCHASING POWER PURCHASING POWER PARITY REAL EXCHANGE RATE REAL WAGE RECESSION RECESSIONS RELATIVE PRICE RELATIVE PRICES REPUTATION RESPONSE TO SHOCKS RETURN RETURNS REVALUATION RISK NEUTRAL STABILIZATION POLICY STATE CONTINGENT BONDS STATE CONTINGENT DEBT STICKY PRICES STICKY WAGES TAX TAX POLICIES TAX RATE TAX RATES TAXATION TRADABLE GOOD TRADABLE GOODS TRADE BALANCE TRADE SHOCK TRADE SHOCKS TRANSMISSION MECHANISM UNCERTAINTY UTILITY FUNCTION UTILITY MAXIMIZATION VOLATILITY WAGES WEALTH
Online Access:	http://www-wds.worldbank.org/external/default/main?menuPK=64187510&pagePK=64193027&piPK=64187937&theSitePK=523679&menuPK=64187510&searchMenuPK=64187283&siteName=WDS&entityID=000158349_20090511090457 http://hdl.handle.net/10986/4121

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Summary:	According to the conventional wisdom, when an economy enters a recession and nominal prices adjust slowly, the monetary authority should devalue the domestic currency to make the recession less severe. The reason is that a devaluation of the currency lowers the relative price of non-tradable goods, and this reduces the necessary adjustment in output relative to the case in which the exchange rate remains constant. This paper uses a simple small open economy model with sticky prices to characterize optimal fiscal and monetary policy in response to productivity and terms of trade shocks. Contrary to the conventional wisdom, in this framework optimal exchange rate policy cannot be characterized just by the cyclical properties of output. The source of the shock matters: while recessions induced by a drop in the price of exportable goods call for a devaluation of the currency, those induced by a drop in productivity in the non-tradable sector require a revaluation.

Optimal Devaluations

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