Large Devaluations and the Real Exchange Rate

This paper asks why large devaluations are typically followed by large, persistent declines in the real exchange rate (RER) rather than being quickly offset by domestic inflation. The authors argue that the primary force behind this pattern is slow adjustment in the price of nontradable goods and services, not slow adjustment in the price of goods that are actually imported or exported (Section 1, Introduction). Using data from five large devaluation episodes – Argentina (2001), Brazil (1999), Korea (1997), Mexico (1994), and Thailand (1997) – they show that at-the-dock import and export prices move roughly in line with the nominal exchange rate, so relative purchasing power parity (PPP) is a reasonable description of “pure-traded-goods” prices even during large devaluations; it is the retail price of nominally tradable goods, and the price of nontradable goods and services, that adjust slowly. The key insight the authors offer for why the traditional tradable/nontradable CPI split is misleading is that the retail price of a tradable good embeds two nontradable components – distribution costs (wholesaling, retailing, marketing, and local transport, estimated at roughly 50 percent of the retail price) and “local goods” that are conventionally classified as tradable but are in practice produced and consumed only domestically. Once the CPI basket is re-decomposed to account for these components, a series of “price-accounting” exercises show that the resulting predicted inflation rates are close to actual post-devaluation inflation in each country, and an Engel (1999) decomposition of the RER confirms that the great majority of the RER’s post-devaluation movement reflects the price of nontradables relative to pure-traded goods, not movements in the relative price of pure-traded goods themselves. A detailed case study of Argentina’s 2001 devaluation, using disaggregated CPI data, a purpose-built survey of prices in Buenos Aires, and supermarket scanner data, corroborates these findings and documents that retail-goods prices adjust far more frequently than services prices, and that there was substantial “flight from quality” toward cheaper goods after the devaluation. The authors test the robustness of their findings against two large real-appreciation episodes (Argentina 1991-95, Mexico 1988-94), four medium-size devaluations (Finland, Italy, Sweden, and the UK in 1992), and small business-cycle-frequency exchange-rate fluctuations in ten OECD countries (1971-2001), finding that the nontradables-relative-to-pure-traded-goods channel remains important in the medium and small cases too, though relatively less dominant than in the large-devaluation episodes, where fluctuations in pure-traded-goods prices instead account for most of the movement.

Ariel Burstein | Macro Paper Warehouse

Large Devaluations and the Real Exchange Rate