According to conventional models, flexible exchange rates play an equilibrating role in open economies, depreciating in response to adverse shocks, boosting net exports, and stimulating aggregate demand. However, critics argue that, at least in developing countries, devaluations are more contractionary and more inflationary than conventional theories would predict. Yet, it is not clear whether devaluations per se have led to adverse outcomes, or rather the disruptive abandonments of pegged exchange-rate regimes associated with devaluations. To explore this hypothesis, we estimate VAR models to compare the responses to devaluation of developing economies and two types of industrial economies: those that have consistently floated, and those that have sustained fixed exchange-rate regimes as well. We find that both of these types of industrial economies exhibit conventional (i.e., expansionary) responses to devaluation shocks, compared with the contractionary responses exhibited by developing countries. This finding suggests that exchange rate movements may be more destabilizing in developing countries than in industrial countries, regardless of exchange rate regime.
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Last update: August 21, 2002