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To devalue or not to devalue? How East European countries responded to the outflow of capital in 1997-99 and in 2008-09

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  • Popov, Vladimir

Abstract

If there is a negative terms of trade or financial shock leading to the deterioration in the balance of payments, there are two basic options for a country that has limited foreign exchange reserves. First, a country can maintain a fixed exchange rate (or even a currency board) and wait until the reduction of foreign exchange reserves leads to the reduction of money supply: this will drive domestic prices down and stimulate exports, raise interest rates and stimulate the inflow of capital, and finally will correct the balance of payments. Second, the country can allow the devaluation of national currency – flexible exchange rate will automatically bring the balance of payments back into the equilibrium. Because national prices are less flexible than exchange rates, the first type of adjustment is associated with the greater reduction of output. The empirical evidence on East European countries and other transition economies for 1998-99 period (outflow of capital after the 1997 Asian and 1998 Russian currency crises and slowdown of output growth rates) suggests that the second type of policy response (devaluation) was associated with smaller loss of output than the first type (monetary contraction). 2008-09 developments provide additional evidence for this hypothesis.

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Bibliographic Info

Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 28112.

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Date of creation: 2010
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Handle: RePEc:pra:mprapa:28112

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Keywords: Devaluation; capital account shocks; fixed and flexible exchange rates; macroeconomic response to shocks;

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  1. Andrew K. Rose, 1999. "One Money, One Market: Estimating the Effect of Common Currencies on Trade," NBER Working Papers 7432, National Bureau of Economic Research, Inc.
  2. Jeffrey A. Frankel, 2009. "The estimated effects of the euro on trade: why are they below historical effects of monetary unions among smaller countries?," LSE Research Online Documents on Economics 53362, London School of Economics and Political Science, LSE Library.
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  6. Polterovich, Victor & Popov, Vladimir, 2003. "Accumulation of Foreign Exchange Reserves and Long Term Growth," MPRA Paper 20069, University Library of Munich, Germany.
  7. Steve Hanke, 2002. "On dollarization and currency boards: Error and deception," Journal of Economic Policy Reform, Taylor & Francis Journals, vol. 5(4), pages 203-222.
  8. Eichengreen, Barry, 2001. "What problems can dollarization solve?," Journal of Policy Modeling, Elsevier, vol. 23(3), pages 267-277, April.
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Cited by:
  1. Popov, Vladimir, 2013. "Economic Miracle of Post-Soviet Space: Why Uzbekistan Managed to Achieve What No Other Post-Soviet State Achieved," MPRA Paper 48723, University Library of Munich, Germany.
  2. Popov, Vladimir, 2011. "Why transition economies did worse than others in 2008-09 recession?," MPRA Paper 32388, University Library of Munich, Germany.

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