Devaluation: necessary or not?

Recently, there has been much public discussion about the devaluation of the Jamaican dollar. Unfortunately, persons engaging in these discussions have failed to make a distinction between the nominal exchange rate and the real exchange rate.

The nominal exchange rate is the amount of one currency that is required to purchase one unit of another, e.g., US$1 = J$99 or US$1 = J$110. The real exchange rate, on the other hand, is the amount of one item in one country that would be required to be exchanged for a unit of a similar item in another country, for example, how many American oranges are required to be exchanged for a Jamaican orange. In economics, it is real variables that matter; not nominal variables. We will try to clarify the differences in these two measures of an exchange rate and, therefore, the appropriateness of devaluations.

Let us assume a one-good (orange), two-country (United States and Jamaica) world. This assumption is purely for the purpose of making the discussion easy to understand. On Tuesday, January 4, 2000 (the first working day of that year), the nominal exchange rate was US$1 = J$41.49. We will further assume (in order to concentrate on the essence of what we are trying to examine) that there is no transportation cost between Jamaica and the United States (US) and that there are no tariffs or any other impediments to trade between the two countries.

If on January 4, 2000, an American orange cost US$1 and a Jamaican orange cost J$41.49, it would not matter to a Jamaican consumer if she bought an American orange or a Jamaican orange. It would cost her J$41.49 to buy the Jamaican orange directly, or she could take her J$41.49 and buy US$1, which she could then use to buy an American orange. Similarly, it would not matter to an American consumer if he bought an American or a Jamaican orange; both would cost him US$1. The real exchange rate was one Jamaican orange equals one American orange.

The accompanying diagram shows the actual inflation rates in both the US and Jamaica between 2000 and 2012. It is clear that in every single year, the Jamaican inflation rate was higher than the inflation rate in the US, even in years where there was little movement in the nominal exchange rate.

Let us further assume that the price of oranges in both countries moved in line with their respective inflation rates. Over the entire period, prices in the US increased by 37.8%, while in Jamaica they increased by 265%. An orange in the US at the end of 2012 would, therefore, cost US$1.38 while a Jamaican orange in Jamaica would cost J$151.42. If the nominal exchange rate remains unchanged at US$1 = J$41.49, the cost of a Jamaican orange in US dollars would then have been US$3.65. Comparing this figure with the cost of an American orange (US$1.38) implies that one Jamaican orange could then buy 2.65 American oranges. The Jamaican dollar would, therefore, have experienced a real appreciation, moving from one to one to one to 2.65, although the nominal value of the currency would have remained unchanged.

REAL APPRECIATION

What does all of this mean? If the exchange rate had remained fixed at US$1 = J$41.49, a Jamaican orange selling in the US would cost US$3.65. Why would any American consumer choose to buy Jamaican oranges at this price when he can obtain American oranges for US$1.38? The real appreciation of the Jamaican dollar would cause export markets to be closed to Jamaican producers. Worse than that, an American orange selling in Jamaica would cost J$57.18, while a Jamaican orange would cost J$151.42. No Jamaican would buy Jamaican oranges since she could now get American oranges cheaper.

The real appreciation of the Jamaican currency would cause imports to soar, Jamaican entrepreneurs to go out of business, and Jamaican workers to be laid off. Of course, the Government could protect the Jamaican businesses by putting high tariffs on imports, but this restricts these businesses to the size of the Jamaican economy, which is very small by world standards. Such a policy would confine the Jamaican population to a low standard of living in perpetuity.

To restore the real exchange rate to its original level of one to one, the nominal value of the Jamaica dollar would have had to be depreciated to US$1 = JS109.87. Any depreciation less than that would mean that Jamaican oranges would not have regained their relative competitiveness to US oranges as of 2000. Note that these figures are merely indicative on the underlying story and are not meant to indicate the precise nominal value which the Jamaica dollar should have had at the end of 2012. Exchange-rate determination is a little more complex than what has been outlined above.

Stable nominal/real rate

Many persons are mistaken that if we somehow fix the exchange rate, all our problems would go away. We have indicated that even with a fixed nominal exchange rate, the real exchange rate changes, and it is the real exchange that is of importance. If we want a stable nominal rate and a stable real rate, we have to bring our inflation rate in line with our major trading partners. A number of different factors do influence the inflation rate: government policy (printing of money and the protection of local industry, for example), wage increases which are unmatched by increases in labour productivity, high prices in crucial inputs facilitated by inefficiencies, etc.

The economy is like a balloon. Squeezing one point will result in bulges elsewhere. We cannot artificially control one price, be it the nominal exchange rate or the interest rate by itself, and think that we have solved our problems. In the language of economics, there has to be a general equilibrium, i.e., the fundamentals must be such that all markets are in equilibrium.

Economics, like medicine, has many subdisciplines, with different economists specialising in different areas, each being reluctant to venture into an area which is not his own. Macroeconomists spend their entire professional lives trying to understand the dynamics of an economy and how the various components fit together. We delude ourselves it we think that everyone is an economist, and worse, that every economist understands all the various aspects of economics.

Peter-John Gordon is a lecturer in the Department of Economics, UWI. Email feedback to columns@gleanerjm.com and peterjohn.gordon@uwimona.edu.jm.