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Devaluation, Wealth Effects, and Relative Prices Harvey Lapan Iowa State University, [email protected]

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Devaluation, Wealth Effects, and Relative Prices Harvey Lapan Iowa State University, Hlapan@Iastate.Edu Economics Publications Economics 9-1978 Devaluation, Wealth Effects, and Relative Prices Harvey Lapan Iowa State University, [email protected] Walter Enders Iowa State University Follow this and additional works at: http://lib.dr.iastate.edu/econ_las_pubs Part of the Economic Theory Commons, International Economics Commons, and the Other Economics Commons The ompc lete bibliographic information for this item can be found at http://lib.dr.iastate.edu/ econ_las_pubs/152. For information on how to cite this item, please visit http://lib.dr.iastate.edu/ howtocite.html. This Article is brought to you for free and open access by the Economics at Iowa State University Digital Repository. It has been accepted for inclusion in Economics Publications by an authorized administrator of Iowa State University Digital Repository. For more information, please contact [email protected]. Devaluation, Wealth Effects, and Relative Prices Abstract The mee rgence of the portfolio balance approach 1 has led to a reformulation of the causes of balance-of-trade and payments disequilibria. According to this approach, balance-of-trade deficits and surpluses reflect discrepancies between desired and actual wealth holdings; while balance-of payments deficits and surpluses reflect discrepancies between desired and actual money holdings. Thus, balance-of-trade and payments disequilibria are viewed as representing disequilibria within the asset markets. Using this framework several authors2 have examined the self-correcting nature of disequilibria within the balance of-payments accounts and the ability of a devaluation to reduce the magnitude of a disequilibrium. Disciplines Economic Theory | International Economics | Other Economics Comments This is an article from The American Economic Review 68 (1978): 601. Posted with permission. This article is available at Iowa State University Digital Repository: http://lib.dr.iastate.edu/econ_las_pubs/152 American Economic Association Devaluation, Wealth Effects, and Relative Prices Author(s): Harvey Lapan and Walter Enders Source: The American Economic Review, Vol. 68, No. 4 (Sep., 1978), pp. 601-613 Published by: American Economic Association Stable URL: http://www.jstor.org/stable/1808929 Accessed: 14-09-2016 15:40 UTC REFERENCES Linked references are available on JSTOR for this article: http://www.jstor.org/stable/1808929?seq=1&cid=pdf-reference#references_tab_contents You may need to log in to JSTOR to access the linked references. JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range of content in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new forms of scholarship. For more information about JSTOR, please contact [email protected]. Your use of the JSTOR archive indicates your acceptance of the Terms & Conditions of Use, available at http://about.jstor.org/terms American Economic Association is collaborating with JSTOR to digitize, preserve and extend access to The American Economic Review This content downloaded from 129.186.176.217 on Wed, 14 Sep 2016 15:40:54 UTC All use subject to http://about.jstor.org/terms Devaluation, Wealth Effects, and Relative Prices By HARVEY LAPAN AND WALTER ENDERS* The emergence of the portfolio balance of the absorption approach, the devaluation approach' has led to a reformulation of the reduces absorption via the cash balance causes of balance-of-trade and payments effect. disequilibria. According to this approach, While both of these papers are important balance-of-trade deficits and surpluses re- contributions to the examination of the flect discrepancies between desired and impact of a devaluation on trade balances, actual wealth holdings; while balance-of- they leave some important questions unan- payments deficits and surpluses reflect dis- swered. Neither paper is concerned with the crepancies between desired and actual efficacy of a devaluation when residents of a money holdings. Thus, balance-of-trade country hold assets denominated in terms and payments disequilibria are viewed as of the foreign unit of account. In assuming representing disequilibria within the asset that individuals only hold domestic cur- markets. Using this framework several au- rency denominated assets, each paper dem- thors2 have examined the self-correcting onstrates that a devaluation will be success- nature of disequilibria within the balance- ful if it acts to decrease real wealth in the of-payments accounts and the ability of a devaluing nation. However, when residents devaluation to reduce the magnitude of a of a country hold assets denominated in the disequilibrium. foreign currency, an exchange rate change Two recent examples of this approach will impose capital losses on residents of that have appeared in this Review are a the revaluing nation while residents of the paper by Rudiger Dornbusch and a paper devaluing nation will experience capital by Jacob Frenkel and Carlos Rodriguez. gains. Since a successful devaluation must The Dornbusch paper analyzes a two- reduce (increase) wealth in the devaluing country world in which each country issues (revaluing) nation, the efficacy of a devalua- a fiat money, while the Frenkel and Rodri- tion is directly related to the extent to which guez paper develops a small country, two- domestics hold foreign currency denom- asset model.3 In both papers, a devaluation inated assets. is successful because it reduces real wealth Another problem not addressed in these in the devaluing nation and increases real papers is how changes in the terms of trade wealth in the appreciating nation. In terms affect the balance of trade. The prevailing view (see articles by S. C. Tsiang, Arnold *Iowa State University and Institute for Inter- Harberger, and Svend Laursen and Lloyd national Economic Studies, and Iowa State Uni- Metzler) is that, if a devaluation causes a versity, respectively. We would like to thank the nation's terms of trade to deteriorate, the managing editor for his helpful comments and sug- efficacy of a devaluation is reduced. A re- gestions. ISee Ronald McKinnon or Harry Johnson for the duction in the terms of trade leads to a de- seminal articles on the portfolio or monetary ap- crease in the marginal propensity to save as proach. individuals attempt to maintain their real 2See Bijan B. Aghevli and George Borts, Enders or standard of living. As individuals cannot Donald Mathieson for an analysis of the self-correct- ing nature of balance-of-payments disequilibria. maintain this standard of living forever, it 30ne of the assets in the Frenkel and Rodriguez is still necessary to clarify the impact of paper is physical capital which is immobile. Claims on terms-of-trade changes when balance-of- physical capital are, however, perfectly mobile across trade disequilibrium is viewed as represent- national boundaries such that the domestic and foreign ing disequilibrium in the asset markets. An interest rate must be equal. Further, their paper is re- stricted to the "small country" case, so that domestic emerging view is that relative price changes prices rise by the amount of the devaluation. have little significance in determining the 601 This content downloaded from 129.186.176.217 on Wed, 14 Sep 2016 15:40:54 UTC All use subject to http://about.jstor.org/terms 602 THE AMERICAN ECONOMIC REVIEW SEPTEMBER 1978 size of the balance of trade. For example, where Pi (Pi*) = dollar (pound) price of Frenkel and Harry Johnson state: good i Y (Y*) = dollar (pound) value The accumulation or decumulation of assets depends on the aggregate rela- of U.S. (U.K.) income tionship between domestic expenditure Y ( Y*) = real income in terms and income and does not depend on of good 1 the composition of expenditure be- W (W*) = desired wealth hold- tween exportables and importables, or ings in dollars (pounds) between goods that, given the price k (k*) = desired ratio of wealth structure, are classifiable into tradeable to income in the and nontradeable goods. Conse- United States (United quently, though relative price changes Kingdom) do influence the composition of expen- ditures, they play a secondary role in Assuming the dollar price of pounds is e, the monetary approach.... [p. 23] commodity arbitrage implies Section I considers the case in which (2) Pi - ePi i = 1, 2 there are two traded goods and examines the roles of relative price changes and capi- Under the assumption that each country tal gains and losses in a devaluation. It is produces both goods, shown that relative price changes may be the only way a devaluation can improve the (3) Y = PIQI(p) + P2Q2(P); balance of trade when domestic holdings of Y* = PF*Q*(P) + P2*Q2*(P) foreign currency denominated assets are Y = Q1(P) + PQ2(P); large. Section I1 considers the case of non- traded goods and, in contrast to the stan- = Q *(p) + pQ2*(p) dard result, demonstrates that the efficacy where p P2/PI = P*/P* = relative of a devaluation is inversely related to the price of good 2 absolute values of the changes in the prices Qi(Q*) = output of good i by the United of nontraded goods. Our conclusions are States (United Kingdom) presented in Section III. The Appendix of and production in each country takes place the paper considers the stability properties along a concave production possibility of the model. frontier on which the output of each good depends only on relative prices. I. Devaluation in a Two-Traded-Good World Desired nominal expenditures (E, E*) equal money income minus nominal desired A. The Model saving (S, S*): (4) E = P Y-S; E* = P*Y* - S* The model we analyze is identical to that of Dornbusch, except we assume that there Following Dornbusch, we assume that are two traded goods (Xl, X2), and that resi- desired saving is proportional to any dis- dents of each country may desire to hold crepancy between desired and actual assets denominated in terms of the foreign wealth: unit of account (one asset is denominated in dollars, the other in pounds).
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