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Optimal devaluations
 
Author:Hevia, Constantino; Nicolini, Juan Pablo; Collection Title:Policy Research working paper ; no. WPS 4926
Country:World; Date Stored:2009/05/11
Document Date:2009/05/01Document Type:Policy Research Working Paper
Language:EnglishMajor Sector:Finance
Rel. Proj ID:1W-Capital Flows And Financial Integration -- -- P053639;Region:The World Region
Report Number:WPS4926Sub Sectors:General finance sector
SubTopics:Economic Theory & Research; Emerging Markets; Currencies and Exchange Rates; Economic Stabilization; Debt MarketsTF No/Name:TF040198-WORLD:; TF040145-WORLD:; TF090949-KCP HOW DO INSTITUTIONAL INVESTORS MANAGE WORLD SAVINGS?
Volume No:1 of 1  

Summary: 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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