Market Structure and Contractionary Devaluation

Abstract

<p>In practice, devaluation has been prescribed as a major policy instrument in many countries, on the presumption that devaluation is expansionary. However, whether devaluation is contractionary is a matter of considerably theoretical and practical importance. This thesis investigates whether and under what conditions devaluation is contractionary under a wide range of assumptions concerning market structures. The investigation is conducted at both micro and macro levels, and for both short-run and long-run time horizons.</p> <p>In general, contractionary devaluation is not an unusual phenomenon; instead, it can easily occur as long as the demand and supply structures in the market satisfy a condition which we derive and interpret.</p> <p>In short-run micro models with homogeneous goods, our findings show that perfect competition, monopoly and oligopoly do not change the nature of the conditions required for expansionary, neutral or contractionary devaluation. However, these three market structures do have an impact through altering the magnitude (not sign) of the output change following a devaluation. makers should be aware Thus both theorists and policy that the existence of imperfect competition can largely reduce the power of a devaluation (if not the direction of that effect).</p> <p>Our partial equilibrium micro model with monopolistic competition provides results which challenge the theory of neutrality of devaluation in the long-run. Also, the micro foundations reveal the mechanism through which the long-run real effects of devaluation occur. It is the devaluation which causes the changes in the number of varieties and it is the change in the number of the varieties which alters the market structure and thus causes the long-run effects on real output.</p> <p>As a key variable, the number of varieties also generates some seemingly odd results which are not seen in perfect competition: following a devaluation, the aggregate price and aggregate output, welfare and employment, may change in the opposite directions.</p> <p>To establish the linkage between the microeconomic foundations and the macroeconomic formulations, we extend an existing closed macro model with monopolistic competition to a small open economy version. The neutrality of devaluation is derived in this context. This macro result should not be considered inconsistent with the result of non-neutrality in the micro model with monopolistic competition. The main reasons is that: the number of varieties is an exogenous variable in the macro model but endogenous variable in the micro model; and the money wage is flexible in the former but fixed in the latter.</p>