Devaluation, Investment and Factor Intensity in Two-Sector Two-Factor Small Open Economy

This paper analyzes the impact of devaluation on the balance of payments, sectoral investment, aggregate investment, sectoral employment and real output in a perfect foresight dynamic optimizing model of a small open economy with two sectors and two factors of production. We emphasize the role of imported capital goods, and the labor market distortions that are prevalent in most developing countries. In particular, we trace the impact effect and the transitional dynamics of devaluation when factor intensity varies in the tradables sector. Our simulation results show that devaluation improves the balance of payments on impact in all cases considered. The more labor-intensive the tradables sector is, the smaller is the initial improvement in the balance of payments. Surprisingly, investment in the tradables sector falls in most plausible cases. Aggregate investment as well as investment in the nontradables sector always drops on impact regardless of parameter values, and it drops more as the tradables sector becomes more labor-intensive. Employment in the nontradables sector and real output of the economy fall in all cases considered. The results of the paper show that devaluation may trun out to be quite a harsh experience for developing economies, especially those with more labor-intensive tradables sector.