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Optimal devaluations

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  • Hevia, Constantino
  • Nicolini, Juan Pablo

Abstract

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.

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Bibliographic Info

Paper provided by The World Bank in its series Policy Research Working Paper Series with number 4926.

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Date of creation: 01 May 2009
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Handle: RePEc:wbk:wbrwps:4926

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Keywords: Economic Theory&Research; Debt Markets; Emerging Markets; Currencies and Exchange Rates; Economic Stabilization;

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Citations

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Cited by:
  1. Dmitriev, Mikhail & Hoddenbagh, Jonathan, 2012. "Price Stability In Small Open Economies," MPRA Paper 46118, University Library of Munich, Germany, revised Feb 2013.
  2. De Paoli, Bianca, 2009. "Monetary policy and welfare in a small open economy," Journal of International Economics, Elsevier, Elsevier, vol. 77(1), pages 11-22, February.
  3. Tommaso Monacelli, 2013. "Is Monetary Policy in an Open Economy Fundamentally Different?," IMF Economic Review, Palgrave Macmillan, Palgrave Macmillan, vol. 61(1), pages 6-21, April.
  4. Emmanuel Farhi & Gita Gopinath & Oleg Itskhoki, 2012. "Fiscal devaluations," Working Papers, Federal Reserve Bank of Boston 12-10, Federal Reserve Bank of Boston.
  5. Constantino Hevia & Juan Pablo Nicolini, 2013. "Optimal Devaluations," IMF Economic Review, Palgrave Macmillan, Palgrave Macmillan, vol. 61(1), pages 22-51, April.
  6. Luis Catão & Roberto Chang, 2012. "Monetary Rules for Commodity Traders," NBER Working Papers 18536, National Bureau of Economic Research, Inc.
  7. Adao, Bernardino & Correia, Isabel & Teles, Pedro, 2009. "On the relevance of exchange rate regimes for stabilization policy," Journal of Economic Theory, Elsevier, Elsevier, vol. 144(4), pages 1468-1488, July.
  8. Tommaso Monacelli, 2012. "Is Monetary Policy in an Open Economy Fundamentally Different?," Working Papers 449, IGIER (Innocenzo Gasparini Institute for Economic Research), Bocconi University.
  9. Jacek Rothert, 2012. "Productivity or Demand? Identifying Sources of Fluctuations in Small Open Economies," 2012 Meeting Papers, Society for Economic Dynamics 187, Society for Economic Dynamics.

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