Bulletin June 2012 – Does Devaluation increase the Rate of Inflation?

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June 15, 2012 by johnmillsjml

It is very widely believed that if any currency is devalued, inflation in the devaluing country will increase and prices will rise more rapidly than would have been the case if no currency depreciation had occurred.

There are two main reasons why this view is so prevalent. They are:

1.A It is obvious that if the currency is weaker, imports of goods and services must become more expensive, thus pushing up the price level.

1.B There is a powerful intellectual argument, buttressing the monetarist view of the world, which states that the competitiveness benefits of any devaluation will automatically be lost over a short period as the extra inflation caused by the devaluation erodes away the original competitiveness advantage.

This combination of an apparently common sense – if erroneous – view of the situation combined with plausible intellectual underpinning has produced a consensus which is so well established that it is almost never challenged. There is, however, a problem. Almost all historical statistics show that what almost everyone believes is wrong. Devaluations do not, generally produce more inflation than would otherwise have been experienced. If anything they produce less.

Here are the figures for numerous devaluations, showing that the conventional view is mistaken:

Cons- Real Industrial Unem-

umer Wage Wage GDP Output ployment

Year Prices Rates Change Change Change Per Cent

Britain – 31% 1930 -6.0 -0.7 5.3 -0.7 -1.4 11.2

Devaluation against 1931 -5.7 -2.1 3.6 -5.1 -3.6 15.1

the dollar and 24% 1932 -3.3 -1.7 1.6 0.8 0.3 15.6

against all currencies 1933 0.0 -0.1 -0.1 2.9 4.0 14.1

in 1931 1934 0.0 1.5 1.5 6.6 5.5 11.9

Cons- Real Industrial Unem-

umer Wage Wage GDP Output ployment

Year Prices Rates Change Change Change Per Cent

France – 27% 1956 2.0 9.7 7.7 5.1 9.4 1.1

Devaluation 1957 3.5 8.2 4.7 6.0 8.3 0.8

against all 1958 15.1 12.3 -2.8 2.5 4.5 0.9

currencies in 1959 6.2 6.8 0.6 2.9 3.3 1.3

1957/58 1960 3.5 6.3 2.8 7.0 10.1 1.2

1961 3.3 9.6 6.3 5.5 4.8 1.1

USA – 28% 1984 4.3 4.0 -0.3 6.2 11.3 7.4

Devaluation 1985 3.6 3.9 0.3 3.2 2.0 7.1

against all 1986 1.9 2.0 0.1 2.9 1.0 6.9

currencies over 1987 3.7 1.8 -1.9 3.1 3.7 6.1

1985/87 1988 4.0 2.8 -1.2 3.9 5.3 5.4

1989 5.0 2.9 -2.1 2.5 2.6 5.2

Italy – 20% 1990 6.47.3 0.9 2.1 -0.6 9.1

Devaluation 1991 6.3 9.8 3.5 1.3 -2.2 8.6

against all 1992 5.2 5.4 0.2 0.9 -0.6 9.0

currencies over 1993 4.5 3.8 -0.7 -1.2 -2.9 10.3

1990/93 1994 4.0 3.5 -0.5 2,2 5.6 11.4

1995 5.4 3.1 -2.3 2.9 5.4 11.9

Finland – 24% 1990 6.1 9.4 3.3 0.0 -0.1 3.5

Devaluation 1991 4.1 6.4 2.3 -7.1 -9.7 7.6

against all 1992 2.6 3.8 1.2 -3.6 2.2 13.0

currencies over 1993 2.1 3.7 1.6 -1.6 5.5 17.5

1991/93 1994 1.1 7.4 6.3 4.5 10.5 17.4

1995 1.0 4.7 3.7 5.1 7.8 16.2

Spain – 18% 1991 5.9 8.2 2.3 2.3 -0.7 16.3

Devaluation 1992 5.9 7.7 1.8 0.7 -3.2 18.5

against all 1993 4.6 6.8 2.2 -1.2 -4.4 22.8

currencies over 1994 4.7 4.5 -0.2 2.1 7.5 24.1

1992/94 1995 4.7 4.8 0.1 2.8 4.7 22.9

1996 3.6 4.8 1.2 2.2 -0.7 22.2

Britain – 19% 1990 9.5 9.7 0.2 0.6 -0.4 6.8

Devaluation 1991 5.9 7.8 1.9 -1.5 -3.3 8.4

against all 1992 3.7 11.3 7.6 0.1 0.3 9.7

currencies 1993 1.6 3.2 1.6 2.3 2.2 10.3

in 1992 1994 2.4 3.6 1.2 4.4 5.4 9.6

1995 3.5 3.1 -0.4 2.8 1.7 8.6

Argentina – 72% 2000 -1.1 1.2 3.3 -0.8 -0.3 14.7

Devaluation 2001 25.9 -2.6 -23.3 -4.4 -7.6 18.1

against all 2002 13.4 1.9 -11.5 -10.9 -10.5 17.5

currencies 2003 4.4 22.0 17.6 8.8 16.2 16.8

early 2002 2004 9.6 23.3 13.7 9.0 10.7 13.6

2005 10.9 22.8 11.9 9.2 8.5 8.7

Iceland – 50% 2005 4.0 7.2 3.2 7.5 4.6 2.6

Devaluation 2006 6.7 9.8 3.1 4.3 8.4 2.9

against all 2007 5.1 8.6 3.5 5.6 5.2 2.3

currencies 2008 12.7 8.3 -4.4 1.3 7.0 3.0

2007/2009 2009 12.0 3.6 -8.4 -6.3 -5.9 7.2

2010 7.1 4.7 -2.4 -4.2 7.6

2011 4.0

Sources: Economic Statistics 1900-198 byThelma Liesner. London: The Economist 1985. IMF International Financial Statistics Yearbooks, Eurostatistics and British, Argentine and Icelandic official statistics and International Labour Organisation tables. All figures are year on year percentage changes except for Unemployment

How can it be the case that, if devaluations increase import prices, there is usually no increase in inflation? The answer is that while prices of imported goods and services are bound to go up if the currency is devalued, there are a number of powerful factors which come into play at the same time which reduce rather than increase the rate at which prices go up. These are:

2.A Interest rates are lower. While Bank Base Rate, at 0.5%, and Three Month LIBOR, at a little over 1%, are historically very low at present, these are not the rates which most borrowers are paying in the UK at the moment. The actual rates are much higher both for mortgages, for commercial finance and for personal borrowing. The much more accommodating stance which would be needed to bring the foreign exchange value of the currency down would increase the supply of funds and would therefore reduce their cost.

2.B Taxation can be reduced. Part of the strategy required to get the exchange rate down would be to increase demand on the economy by reducing taxation. This could be done by, for example, reducing VAT or reducing National Insurance which is now not much more than a thinly disguised tax on labour. Both of these changes would act directly on the rate of inflation, helping to moderate it.

2.C Production runs get longer. As the economy starts to expand as a result of it being more competitive, output will pick up, especially in manufacturing. This will allow all physical assets and the labour force to be used more intensively

2.D Orders are switched to the home market. As the exchange rate goes down so home market suppliers, who were previously uncompetitive, start gaining orders at lower prices than would be available from abroad once the currency had depreciated, thus reducing input prices.

For those who are interested in quantification, it is not too difficult to calculate at least rough estimates for the strength of both the impact of a devaluation on the price level via higher import prices and those of the counter-inflationary factors.

Assume a devaluation of 25%. If import prices rise by two thirds of this amount , while foreign suppliers absorb the rest, and that imports of goods and services make up around 30% of the Gross Domestic Product, the impact on the price level from increased import prices in these circumstances would be about two thirds of 25% x 30%, which comes to close to 5%. Now consider the major factors working in the opposite direction:

3.A The total money supply currently equates to about twice the value of GDP across much of the developed world. All of this is essentially debt of one kind or another and nearly all of it is interest bearing. If variable interest costs in the market were reduced by, say, 1%, not all interest charges would be affected but a significant proportion would be. If half were reduced on average by 1%, the average borrowing costs on the whole of the money supply, which is twice the size of GDP, would fall by about 1.0%, producing a reduction of around 1% in the price level.

3.B Devaluation always substantially improves public sector finances, as calls on public expenditure for welfare benefits, particularly charges associated with unemployment, fall away while tax receipts rise. This enables taxation to be reduced. Reducing VAT by 2.5% on its own would knock over 1% off the rate of inflation, while reducing National Insurance charges by a proportionally similar amount would have the same effect. Reducing the rate at which prices rise by 2% as a result of tax changes is therefore well within the bounds of possibility.

3.C The effect of a devaluation is to increase the demand for output from most enterprises in the domestic economy. If growth goes up by 3% per annum, and two thirds of this can be achieved by using the existing capital stock and labour force more intensively and efficiently, the benefits would amount to around a 2% contribution to reduced prices at least in year one, thus producing a heavy initial offset to any cumulative price increases caused by the rise in costs of imports.

3.D Switching supplies from abroad to home suppliers who become competitive with previous foreign suppliers as a result of a devaluation reduces costs. Suppose this happens to 10% of all demand. Allowing for an import content of one-third, the cost of the remaining two thirds of this output would, broadly speaking, not be affected by increased costs as a result of the exchange rate change. Perhaps half of it, however, would become economical to produce at rather higher world pries than applied previously. These rations multiply up as 10% x 25% x 2 /3 /2. This factor reduced the inflationary devaluation impact by about a further 0.8%.

These calculations are, of course, broad brush and therefore inevitably subject to margins of error. They nevertheless show that there are powerful disinflationary factors which often counteract in full the impact of higher import costs, even if there is a substantial devaluation. Factors such as this must have been in play in Britain both in the 1930s and the 1990s, as can clearly be seen from the figures above. They explain why devaluation does not necessarily increase inflation at all.

If it is true that reducing sterling to a more competitive level would not increase inflation, it means that any improvement in competitiveness thus secured for the British economy would not be eroded away quickly – or necessarily at all. This is indeed the general experience shown by the figures in the table above. This is why devaluing sterling to a level which would enable us to avoid balance of payments deficits would both not have adverse inflationary consequences, while at the same time the gain in competitiveness achieved would be permanent and not temporary.

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