Exchange rate, output and employment: revisiting the contractionary devaluation hypothesis Sa

1
Exchange rate, output and employment revisiting
the contractionary devaluation hypothesisSaúl
KeifmanUniversidad de Buenos Aires
2
I. Introduction

• Purpose discuss the relationship between the
  exchange rate and employment.
• Motivation understand some recent behavioral
  changes in the Argentinean economy to intervene
  in the current macropolicy debate.
• Debate what to do with the exchange under a
  current account and balance of payments surplus.
• Two opposite views
• (a) Heteredox economists support Kirchners
  competitive (undervalued) real exchange rate
  policy to sustain output and employment
  expansion, relying on sterilization and some
  capital controls.
• (b) Orthodox economists propose a clean float
  and inflation targeting, which would lead to
  significant real appreciation.

3

• Novelty in the past, heteredox Argentinean
  economists, criticized IMF adjustment programs
  based on structuralist models that proved that
  devaluations were contractionary, contrary to
  their current view.
• Approach this paper attempts to revisit the
  current relevance of the theory of contractionary
  devaluations which arose from structuralist
  macroeconomics in the seventies and that has been
  recently discarded by many of their former
  proponents. Though the article refers to the
  Argentinean case, we believe this revisionist
  exercise presents a more general interest for two
  reasons
• (1) The contractionary devaluation hypothesis
  was very popular in the developing world.
• (2) From a methodological viewpoint this paper
  presents macroeconomic models that take into
  account the structural characteristics of a
  specific country.

4
II. Devaluation and employment. Structuralism
from the seventies to the new millennium

• Structuralism comprehensive vision of developing
  countries problems in opposition to orthodoxy.
• Contractionary orthodox adjustment and
  stabilization programs applied in Latin America
  inspired alternative macroeconomic models. Two
  outstanding examples
• (a) Structural inflation theory
• (b) Contractionary devaluation theory.
• Background in a Keynesian open economy model,
  achievement of internal balance (full employment
  and price stability) and external balance
  (sustainable current account balance) required
  two kinds of policies expenditure-switching
  policies, to reallocate expenditure between
  tradable and nontradable goods, and
  expenditure-reducing policies, to control
  aggregate expenditure or absorption. If
  Marshall-Lerner conditions held, devaluations
  would improve trade balance and also raise
  output. Devaluations would be expansionary.

5

• Right policy mix depended on initial imbalances.
• But orthodox recipe for balance of payments
  deficits always recommended a currency
  devaluation combined with tight monetary and
  fiscal policies (e.g. IMF during developing
  countries foreign debt crisis in the early 80s
  or in emerging market crises during the 90s).
  Note that even if devaluations were expansionary,
  the treatment of a balance of payments crisis
  under conditions of idle capacity and high
  unemployment, should not include
  expenditure-reducing policies, that is to say, a
  fiscal and monetary contraction, since the latter
  would hinder the achievement of internal balance.

6

• The theory of contractionary devaluations explain
  the recessionary bias of orthodox adjustment
  programs Ferrer (1963), Díaz-Alejandro (1963,
  1965) and Braun and Joy (1968). It is based on
  some typical features of the Argentinean economy
  in the sixties and fifties
• (1) The export good is the wage-good food
• (2) Domestic food supply is inelastic but
  foreign food demand is perfectly elastic
• (3) The price elasticity of the domestic demand
  for food is less than one
• (4) Manufacturing production is oriented to the
  domestic market and its supply curve is very
  elastic
• (5) Imported goods are not substitutes for, but
  rather complementary to domestic production
  (nonproduced manufacturing inputs)
• (6) Workers have a marginal propensity to spend
  on domestic goods greater than urban and rural
  property owners.

7

• Structuralist explanation emphasizes the
  redistributive mechanism. A devaluation makes
  food more expensive and reduces real wages. This
  has a larger impact on the domestic demand for
  other goods (manufactures) because of the low
  price elasticity of domestic food demand. Given
  the inelasticity of the exportable good supply,
  its price increase does not induce higher output
  or employment in the food sector. The fall in
  workers manufactures demand is not offset by a
  higher demand from higher profits or rents in the
  exportable good sector. This can be due to the
  post-Keynesian assumption that workers have a
  marginal propensity to consume higher than
  capitalists, or because higher savings are not
  translated into a higher demand for domestic
  capital goods (negative accelerator effect in
  manufacturing or the increase in the interest
  rate), or because higher profits or rents in the
  exportable sector are channeled to import goods
  demand.

8

• The contractionary view of devaluation spread
  outside Latin America Krugman and Taylor (1978),
  and became popular in the 80s (Hanson, 1983
  Katseli, 1983) providing a robust critique to the
  excessive adjustment external caused the orthodox
  recipe and known as overkill.
• Krueger (1983) replied the critique by blaming
  the contractionary effect of devaluations on the
  distortions caused by the import substitution
  strategy. In her view, opening up the economy
  would give domestic industry enough
  competitiveness as to be able to substitute
  imports efficiently in response to a devaluation.
• Before the 90s, most Argentinean macroeconomists
  supported the contractionary view of devaluations
  regardless of their agreement with structuralism
  in toto. The macroeconomic experience from the
  60s to the 80s had been consistent with the
  former.

9

• The severe consequences of the currency board
  regime, locally known as Convertibility which set
  a one to one parity between the Argentinean peso
  and the US Dollar, from April 1991 to December
  2001, had a deep impact on heterodox and
  structuralist economists views.
• The appearance of two-digit unemployment rates
  since 1993 in a context of strong real
  appreciation of the peso and the strong negative
  impact of currency depreciation in Brazil
  (Argentinas main trade partner) on Argentinean
  manufacturing output in the late nineties,
  weakened the contractionary devaluation view.
• The fast recovery of output and employment which
  started in the second quarter of 2002 just after
  the devaluation had a devastating effect on the
  former.
• As a result, some structuralist and heterodox
  authors such as Roberto Frenkel and Aldo Ferrer
  emphasized the paramount importance of relative
  prices and the need of a competitive
  undervalued exchange rate to foster output and
  employment expansion.

10

• Curious fact structuralist and orthodox
  economists traded places in terms of their
  attitudes towards the relevance of real exchange
  rates!
• In the 60s, in a world of fixed exchange rates
  and low international capital mobility, orthodox
  economists recommended devaluations to get
  prices right, in order to stimulate the
  production of exportable agriculture.
  Structuralist economists dissented not only for
  their contractionary effects but also because
  they distrusted price incentives as they
  emphasized role of structural features such as
  land tenure and the technological and financial
  support from the state.
• Since the 90s, in a world of financial
  globalization, more liberal trade and flexible
  exchange rates, the new monetarist orthodoxy
  associated with the equilibrium approach to
  exchange rates considers that the real exchange
  rate and the current account balance are
  irrelevant.

11

• Given the historically conditioned character of
  structuralist models, this turn does not
  necessarily go against the methodological
  principles of the structuralist approach.
• Insofar as the structure of the Argentinean
  economy has changed, it should not be discarded
  that its behavioral relations have changed too.
  However, in contrast to the hypotheses developed
  in the 60s and 70s that were supported by
  formal models and detailed discussions about the
  features of the Argentinean economy, the recent
  turn has not offered comparable foundations so
  far.

12
III. Summary of three macroeconomic models

• We built three structuralist models intended for
  Argentina that examine the relationship between
  the real exchange rate (given by the ratio of the
  exchange rate to the nominal wage rate) and
  employment (see Appendix). We summarize the main
  assumptions and qualitative results.
• The models attempt to capture some structural
  changes in the economy to assess its theoretical
  impact on the relationship between the exchange
  rate and employment
• (a) Production of food, the exportable good is
  price sensitive (a stylized fact).
• (b) We explicitly take into account the impact
  of trade liberalization (semi-closed economy
  versus open economy) and the presence of domestic
  production of importable manufactures.

13

• In all models we obtain an aggregate labor demand
  that we identify with an employment function
  under the simplifying assumption that labor
  supply is greater than labor demand at the
  prevailing market wage and inelastic to wages.
• The effect of real devaluation (an increase in
  the exchange rate/wage ratio) on employment is
  positive at the minimum level of the exchange
  rate/wage ratio. For some values of the model
  parameters, devaluation will always be
  expansionary but for not for others. The
  employment function could have interior maximum,
  so that devaluation would be expansionary for low
  levels of the exchange rate and contractionary
  for high levels of the exchange rate. In other
  words relationship could have and inverted U
  shape (see Figure, the 1).

14
FIGURE 1 Employment
Exchange rate/wage rate
15

• An important result is that the possibility of an
  inverted U-shape employment function is
  independent of the tariff level, which refutes
  Kruegers conjecture that devaluation cannot be
  contractionary in an open economy.
• A decrease in tariffs shifts the employment
  function downwards and to the right (Figure 1),
  so that
• (1) Employment will be lower in a more open
  economy (given the nominal exchange rate and wage
  rate).
• (2) The exchange rate to wage ratio that
  maximizes employment will be higher in a more
  open economy.
• The shift of the employment function caused by
  tariff reduction implies that there is an
  interval of the exchange rate/wage ratio for
  which devaluation would go from being
  contractionary before the tariff reduction, to
  expansionary, after the tariff reduction,
  although with lower levels of employment.

16
IV. An interpretation of the Argentinean
experience

• The traditional structuralist interpretation
  placed emphasis on a monotonically decreasing
  relationship between the exchange rate and
  employment, that was consistent with the
  Argentinean experience until the nineties.
• The recent structuralist interpretation, that has
  captured the experience of the last decade,
  proposes a reversion of the relationship posed
  before, and stresses a monotonically increasing
  relationship between the exchange rate and
  employment. The change in stance is made without
  discussing the probable determinants of the
  reversion.
• Our point is that employment function could be an
  inverted U.

17

• Two central features of the Convertibility
  policy experiment were
• (a) Strong real appreciation of the peso, which
  implied an important reduction of the exchange
  rate/wage ratio.
• (b) fast, across the board, and deep trade
  liberalization.
• The significant fall in the exchange rate/wage
  ratio could have led the economy from the
  decreasing interval to the increasing interval of
  the employment function.
• On the other hand, the shift of the employment
  curve caused by tariff reductions probably
  strengthened the former effect because the slope
  of the employment function turned from negative
  to positive in some interval of the exchange
  rate/wage ratio.
• The recent structuralist interpretation and ours
  have some similar local predictions. But, they
  might have different policy implications. The
  recent structuralist view assumes that a higher
  real exchange rate will always be beneficial for
  employment. Of course, there would still be a
  conflict between the real exchange rate and real
  wages, something very important for income
  distribution and poverty.

18

• According to our interpretation, there could be a
  level of the real exchange rate that maximizes
  (ceteris paribus) the level of employment. If the
  current real exchange rate was greater than the
  employment maximizing level, there would be room
  to increase both real wages and employment,
  because the economy would lie in the decreasing
  interval of the employment curve.
• From our point of view, the moderate real
  appreciation that followed the initial
  overshooting of the nominal and real exchange
  rate after the collapse of the currency board was
  not necessarily damaging to employment creation
  (let alone, income distribution). On the other
  hand, if an attempt was made to raise the real
  exchange rate to reverse the moderate
  appreciation with the purpose of raising
  employment, the effects could be contrary to
  those expected.

19
V. Conclusions

• This paper has two goals. On the one hand, to
  stimulate the discussion of macroeconomic models
  intended to capture each countrys specific
  traits, in our case, Argentina, thus resuming the
  structuralist methodological tradition.
• On the other hand, we are interested in pointing
  out that macroeconomic policymaking should not be
  based on an empiricism of trends and variables
  associations which could be shortlived, and
  emphasize the need to do more research on these
  issues in order to make policies that help best
  to overcome our severe social crisis. For
  example, such empiricism led to under-estimate
  the job creation ability of output growth in the
  last decade, by extrapolating the nineties low
  employment-output elasticity. Post-convertibility
  strong recovery in output and employment buried
  this hypothesis. To be cautious, we believe that
  we should not limit ourselves to the
  extrapolation of recent trends in employment and
  exchange rates. Instead, we should attempt to
  understand them in a comprehensive analytical
  framework.