Pakistan Institute of Development Economics

PDR

THE PAKISTAN DEVELOPMENT REVIEW 

Stability, Wage Contracts, Rational Expectations, and Devaluations

The effects of devaluations on economies have caused a great deal of concern in recent years. Conventional economists such as Robinson (1947) and Meade (1951) hold the view that due to high unemployment and the absence of any supplyside effects of the exchange rates, devaluation will increase employment if it increases the demand for home goods. A number of papers have been written which serioUsly challenge this result on a number of grounds. For example, Turnovsky (1981) has derived the result that if agents under-predict changes in the exchange rate then output will increase with devaluation. On the other hand, if agents over predict changes in the exchange rate then output will reduce with devaluation. However, economists such as Calvo (1983) and Larrian and Sachs (1986) have supported the standard result by arguing that the stability of the system is sufficient to rule out perverse outcomes of devaluation. Buffie (1986), on the other hand, has derived the result that for stable economies, devaluation mayor may not increase output. However, Buffie shows that if the production function is separable between primary factors and the imported input then devaluation will increase employment. Lai and Chang (1989) have derived the result that currency devaluation has a negative impact on output if workers are free from money illusion. Gylfason and Schmid (1983), report a similar result: if the real wage is assumed to be constant then devaluation contracts the real income.

Syed Zahid Ali

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