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Currency devaluation and aggregate supply.

Currency Devaluation and Aggregate Supply

According to the traditional view [Takayama, 1969, CJE], currency devaluation will have an expansionary effect on domestic output if nominal wages are set by the labor union and actual employment is determined by labor demand. This note shows that this belief may not hold if the negative effect of the interest rate on aggregate supply is taken into consideration, from the viewpoint that wage payments are working capital. [Shaller, 1983, AER and Mitchell, 1984, J. of Macro.]

The model in the context of fixed exchange rates consists of the following equations:

y = E(y,i) + g + B(y, [ep.sup.*]/p); (1)

       L(y,i) = M/p;                (2)
     y = S(w/p,i); and              (3)
   B(y, [ep.sup.*]/p) + K(i) = F.    (4)

Except that the aggregate supply function includes the effect of interest-sensitive supply, the notations and the meaning of equations are similar to those of Lai and Chang [1987, J. of Macro.] As customary, the following restrictions are imposed on the behavior function: 1> [E.sub.y]> 0; [E.sub.i] <0; [B.sub.y] <0; [B.sub.q] >0 (q = [ep.sup.*]/p); [L.sub.y] > 0; [L.sub.i] < 0; [S.sub.w/p] <0; and [K.sub.i] >0. In addition, [S.sub.i] [is less than] O denotes the interest rate effect on aggregate supply, as parts of wage bills are paid by working capital.

Totally differentiating (1)-(4) and using Cramer's rule:

[Mathematical Expression Omitted]

where, [Mathematical Expression Omitted] due to the stability condition proposed by Shaller [1983, AER].

It is clear from (5) that currency devaluation will definitely raise domestic output if the interest-sensitive effect on aggregate supply is ignored (i.e., [S.sub.i] = O). However, currency devaluation may be contractionary if the effect of supply-side interest rate is substantially dominant [Mathematical Expression Omitted]. These differentiated results can be illuminated by using the aggregate supply function. Currency devaluation will stimulate both domestic price and interest rate. If the effect of supply-side interest rate is ignored, in response to the increased domestic price, the output will be expanded. In contrast, if the interest rate effect on aggregate supply is introduced, the increased interest rate will lead to a reduction in domestic output. Provided that the interest rate effect surmounts the price effect, currency devaluation will definitely have a negative impact on domestic output.

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Author:Lai, Ching-Chong; Chang, Wen-Ya
Publication:Atlantic Economic Journal
Date:Jun 1, 1990
Words:397
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