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Components of effective devaluation and the domestic rate of inflation
Journal of Development Economics 7 (1980) 117-122. 0 North-Holland Publishing Company
COMI’ONENTS OF EFFECTIVE DEVALUATION E DOMESTIC RATE OW INFLATION
AND
The Case of Israel*
Mario I. BLEJER and Nadav HALEVI The Hebrew University and the Palk Ynstitute, Jerusalem, Israel
Received July 1978, final version received February 1979 Developing countries have frequently resorted to effective devaluation by changing either their formal rate of exchange, or by using non-formal components, such as taxes and subsidies. .I-he ensuing increase in the domestic price of imports has inflationary effects. This paper analyses the Israeli experience to investigate the inflationary effects of increases in import prices and alternative methods of devaluation. It is found that formal and non-formal devaluation r.ppear to have the :same long-run effects on the price level, but are not the same in timing: A formal devaluation leads more quickly to increases in domestic prices.
1. Introduction
.
Many small developing economies which are highly reliant on foreign trade have faced particularly serious problems since the resc.rgence of world inflation in the early 1970s. Rising import prices have been a source of domestic inflation and a deterioration in the terms of trade causes, or adds to, balance-of-payments problems. An obvious way lto combai this is to alter the price of foreign exchange. Developing countries have frequently done this by resorting to a variety of combinations of formal and non-formal devaluations. However, since such a polky raises the domestic price of imports, it may intensify cost inflation. It is therefore important to determine whet?ler the inflationary effects of raising the price of imports is affected by the policy tool chosen. In this paper we analyse the Israeli experience in order to investigate the relative influence of alternative exchange rate policies, and we compare therm with the effects of increases in the foreign price of im:ports. 2. Import prices sand the effective exchange rate The domestic price c.c imports may rise either through increases in the *This research was financed in par; by the Israel Foundations Trustees. We are indebted to Y. Ben-Porath, R. Gronau, Z. Griliches, E. Kieiman, and A. Palres for constructive comments on an earlier draft. We are also grateful to an anor!!-lnous referee for his -;ery helpful suggestions, and the research assistance of D. Blinder is gratefully ;lcknowledged.
118
M.i. Bfe,kr and N. Halevi, ~ectiue demluation and domestic rate of iqhtion
foreign-exchange cost of unports - ‘a factor exogenous to the small economy - or through effective devaluation. The latter can be the resullt of chagges in the formal (or offkial) rate of exchange which transactions, or by ‘non-formal’ devaluation, exports and taxes on imports to achieve devaluation. Many developing countries have multiple effective exchange rates by mauipulation of the non-formal components of the effective rate. Should we exp.xt the inflationary irqact to be the same re of what has caused the rise in the domestic price of imports”! Compare first a rise in foreign prices of imports with an increase in local taxes on imports. We should expect no differen= in their in~ationary impact (if we i allocatkon of tax receipts). However, the numerical results resU\t of WmpaiiGfJ price indexes rather than prices For individual because there are differences in adjustment time. A formal devaluation, however, may be expected to have additional effects. Since it applies to all foreign exchange transactions, and not only to trade in goods, a formal devaluation may have stronger demand efkcts than a nonformal alteration of the exc:han rate, These stronger effects may result from the increase in the domestic-c ncy value of other transactions, pri unilateral and capital transfers, and fr.am the revlnluation of denominated in foreign exchange. Formal devaluation may also have a stronger cost-push effect than non-formal devaluation: an announced than in the formal rate, by being widely public&d, makes it easier to pass on the price increases. However, the possibility that the formal and non-for the effective exehan rate may differ in the of their impact o he rate of d~rn~ti~ maa considered in many well-known studies o developing countries, L 3. The Lraeli experience The results presen.ted below are ba d on the Israeli ex period 196’-*‘%,which was marked by persistent inflation, te latter year ,. Because Israel had large annual balance-of-payments deficits, there had been widespread agreement among Israeli economists that there should a trend of real devaluation, i.e.. a cha in the ~~~iv~ rate of exchan rester than necessary merely to mainta urchasing power parity. Such a trend has not. been achieved, despite constant than in the effective rate of exchange. ‘*,
for exawle. Diu-Alejandro (1965). Harberger (1964, part UI), azd Lee ((977).
M.I. Blejer and N. Halevi, E$itctive devaluation and domestic rate sf inflation
119
Until 1975, there were infrequent formal devaluations; in between, taxes on imports and subsidies for exports, i.e., the non-formal components of the exchange rate, were used to adjust the exchange rate. In general, the infrequent formal devaluations served to achieve temporary real devaluation, and the non-formal ajmponents were used to restore relative prices eroded by domestic inflation.2 The higher inflation rates since 1974 necessitated more rapid adjustments of the exchange rate. Consequently, in mid-1975, a crawling-peg system was adopted, which allowed for monthly devaluations of up to 2 percent. This system too did not achieve real devaluation.’ In October 1977, a new system, controlled floating, replaced the crawling peg. On the basis of quarterly data on changes in the formal and effective exchange rates in 1968-76, import prices and domestic prices (as represented by the implicit GNP deflator), we estimate a number of variations of the following specification of the domestic rate of inflation:
where it is the rate of change of domestic prices, P, is the rate of change in the foreign price of imports, and p is the rate of elective devaluation (which includes changes in purchase taxes as well as customs duties). Ed stands for the excess domestic demand in the goods market; to measure this we use a proxy for the excess flow supply in the money market: the difference between the rate of increase of the money supply (M, ) and the rate of growth of :eal income. This variable captures the excess liquidity created by the government fiscal deficit as well as changes in the demand for money call;ed by income growth.” The main results are presented in table 1. Column (1) reports the results of estimating eq. (1) and is the conventional formulation which does not distinrzuish between the two components of the exchange rate. The excess dcma $d variable is not significant, a result similar to this was obtained by other studies for this period. Although alternative lag patterns and irLg structures were tried the results consistently indicated that lagged variables should not be included for excess demand and for foreign-price changes, *A detailtj analysis of Irrael’s exchange rate system is presented in Michaely (1975. ch. 5), and a briefersurvey appears in Halevi (1978). %rad’s inability to achieve real devaluation has stimulated renewed interest in the relationship berwcen &valuation and domestic inflation. Bruno (1978) has examined the theoretical relationshq~,and Art&n and Sussman (1976) have presented an empirical analysis. *In an alternative formulation we replaced reaJ income by a measure of available domestic r urces defbted as GNP plus the import surplus exclusive of direct defence imports and imports of ship and aircraft. The results, however, were not sensitive to the change. The data used include unpublished data on the non-formal component of the effectiverate of devaluation and uere provided by the Central Bureau of Statistics and the Bank of Israel.
120
M.I. Blejer and N. Halevi, Effective devaluation and domesric rate of inflation
Table 1 Regression results: Dependent variable, rate of change of domestic prices; Israel, 1968/1976.1V”
(1)
1.831+0.122E,,+0.291P,+0.082p,+0.248p,_, (1.77) (1.32) (2.21) (0.92) (2.71) Zp,_i=O.485,
(2)
S~.(Zp,-i)=O.123,
i-(‘:.155p,.+ (1.81)
R2=0.515,
O.W=1.78,
1.752+ O.O69E,+ 0.403P, + 0.398 Wp{ + O.l02Wp[_1+ 0.099 Wp[_z (0.82) (0.81) (1.51) (0.61) (3.23) (3.06) + 0.051Wp;f + 0.225Wp$ , + 0.263 Wp;! 2r (0.52) (2.41) (2.87). c pi’_*= 0.599, R2 = 0.686, S.E.( Z p{- ,)=0.167, r, p;l1 = 0.439,
S.E.(Cp;fi)=0.156,
D.W = 1.95.
‘Notes: t-values are in parentheses. All variables are quarterly rate of changes. Definitions: Ed, excess demand, P,, import prices, p, effective exchange rate, k-t;ol, weighted formal rate, Wp”f, weighted non-formal component.
since their values are all insignificant and their inclusions merely reduce the efliciency of the estimation. The effective exchange rate, however, is signficant with lags of one and of two periods but is not significant in the current quarter. The question arises: why is this variable different in timing from foreign price changes? Import prices are recorded at the time of entry of the goods, which is usually at least several months after the decision to import was made at the prices then known to importers; on the other hk,nd, the relevant effective rate of exchange is that prevailing at the time of payment. Thus, lags for p are consistent with no lag for P,. Since current and lagged variables are bound to be collinear it is worthwhile to consider the sum of coefficients and the standard errors on the sum. As shown in table 1, the sum of the coefficients of p is highly significant, much more than each of the individual cc,efflcients.5 The sum can be interpreted as the cumulative effect over three quarters of a devaluation; thus, a 10 percent effective devaluation appears to lead to an increase in domest c prices by about 5 percent. Although this effect appears to be larger than thz effect of foreign price changes (which has a coefficient of 0.291), the coefflci DLSare not statistically different at the 5 percent level.6 In c ;der to investigate possible differences between the effects of the ‘Alternative estimations including extended lag patterns were also performed. The results indicate that lags beyond pt_ 2 are not significant, and therefore those results, which are available on request, are not reported here. 6The r-value for the difference is 1.02. When eq. (I) is estimated including lagged values of P,, the sum of coefficients for that variable is 0.309 with a standard error of 0.171. The sum of the p coefficients is 0.473 with a standard error of 0.132. A t-test again indicates that the sums are not statistical!y different.
M.I. Blejer and N. Haleoi, Effective devaluation and domestic rute of irgflution
121
components of the effective exchange rate, we estimate eq. (2) as follows
where the formal (pJ) and nonformal (pnf)l components of a devaluation replace p, the aggregate changes in the exchange rate. Since our interest is in the exchange rate as a policy variable and since a desired effective devaluation can be achieved either by formal or non-formal devaluation, the exchange rate component variables entering the regression are weighted by their share in the effective exchange rate (FY). Thus, the coefficient of the formal exchange rate, Wpf, in regression (2), table 1, should be interpreted to mean that a devaluation of the effective rate by 10 percent achieved by means of a change in the formal rate (which requ.ired changing the formal rate by more than IO percent), was associated with an increase in the price level of 3.98 percent during the current quarter. The same interpretation applies to the non-formal component in eq. (2). The breakdown of the effective rate leads to a number of interesting results. When both components of the rate are not constrained to have the same coefficient it seems that the precision of estimalte is improved. Using ,the sum of squared residuals of eqs. (1) and (2) to test the hypothesis that both components have equal effects, the resulting iF-value is 4.35, which allows for the rejection of that hypothesis at the 5 percent level of confidence.’ It is apparent from eq. (2) that the main difference in the effects of the exchange-rate components is in their time patterns; while changes in the formal rate have a significant effect only in the current periold and lagged values are not significant, the effects of the non-formal rate appear only wit.h lags of one and two periods.s This result conforms with the hypothesis that a formal devaluation, being more publicized and having a stronger impact on expectations, can be more easily passed on to domestic prices and, therefore, is reflected fzster in the rate of inflation than an apparently equivalent nonforl-?al devaluation. Regarding the total effects of each component, we observe from the sum of the coefficients that although the aggregate effect of the formal devaluation appears to be larger than that of the non-formal, the coeffici~ents are not statistically* different (t =O.M), in licating that, after all adjusiments have taken place, formal and non-formal devaluations have a similar inflationary impact.” ‘The critical values for F(3.24) are 3.01 (0.05) and 4.72 (0.01). if only two lags of Wp’ are included in the regression, the hypothesis of equal effects can be rejected at the 1 prcent tcvel [F=6.01; F(2,25)=5.57 (C).01)]. sLags further in the past for Wpr and Wp”* and for the other independent variables, were also tried, without satisfactory results. 91n addition, the sum of coefficients of pi and p ml are not statistically different from the coefficient of P,,, (or the sum of coefficient of’ P, when lags are included).
122
M.X. Blejer and N. Hafevi, Effective devaluation and domestic rate of injation
Our regressions treat the 1968-76 period as if it were homogeneous. However, in mid-1975 Israel adopted a crawling-peg system, which not only speeded up exchange rate adjustments but also diminished disparities between changes in formal and effective rates. Because the number of quarterly observations since the introduction of the crawling peg are not sufficient to allow for separate regressions, we analyse the consequences_ of rhis policy change by comparing the results for the entire period, with those obtained in regressions for the’ pre-crawling period. We also use scale and slope dummies for the second period. In all cases we do not find differences in the pattern of results, which leads to the conclusion that the structure of effects of formal and non-formal devaluation was not sensitive to the change in regime. 4. Summary This paper deals with the following question: does fcrmal devaluation, through its impact on invisibles, asset valuation, and inflationary expectations have an effect on domestic prices different than that of an apparently equivalent non-formal devaluation via, say, the increase in import duties? Our results indicate that the hypothesis of equal effects of both components can be rejected. However, the main difference appears to be in timing. While a formal devaluation is passed on to domestic prices faster, the long-run effects of form4 and non-formal changes appear to be the same. These results are not affected by the shift from an adjustable peg to a crawling-peg regime. A policy implication suggested by the results is that the inflationarv effects of a devaluation can not be attenuated simply by the manipulation of the non-formal components of the exchange rate. Indeed, after all adjustments are complete, an increase in import taxes will have an effect on domestic prices similar to those of a change in the formal exchange rate. References Artstein, Yael, and Z. Sussman, 1976, Wage and price controls and the effectiveness of dcv duations: The Israeli experience (B,ank of Israel, Jerusalem). Bruno, bdichael, 1978, Exchange rates, import costs and wage-price dynamics, Journal of Pal tical Economy 86, no. 3, 379-404. Dim--P $_a?dro, Carlos, 1965, Exchange rate devaluation in a semi-industrial country: The exI: ;ncnce of Argentina 1955-1961 (M.I.T. Press, Cambridge, M!1). Halevi, Nildav, 1978, The exchange rate in Israel: Policy and opinion, Revue Economique, forthcoming. Harberger, Arnold C., 1964, Some notes on inflation, in: Werner Baer and Isaac Kerstenetzky, eds., Inflation and growth in Latin America (Irwin, Homewood, IL) 319-351. Lee, Eric Y., 1977, Exchange-rate devaluations and the dynamics of inflation in Korea, 19% 1969, American Economist 21, no. 1.7-15. Michaely, Michael, 1975, Foreign trade regimes and economic development: Israel (National Bureau of Economic Research / Columbia University Press, New York and London).
COMI’ONENTS OF EFFECTIVE DEVALUATION E DOMESTIC RATE OW INFLATION
AND
The Case of Israel*
Mario I. BLEJER and Nadav HALEVI The Hebrew University and the Palk Ynstitute, Jerusalem, Israel
Received July 1978, final version received February 1979 Developing countries have frequently resorted to effective devaluation by changing either their formal rate of exchange, or by using non-formal components, such as taxes and subsidies. .I-he ensuing increase in the domestic price of imports has inflationary effects. This paper analyses the Israeli experience to investigate the inflationary effects of increases in import prices and alternative methods of devaluation. It is found that formal and non-formal devaluation r.ppear to have the :same long-run effects on the price level, but are not the same in timing: A formal devaluation leads more quickly to increases in domestic prices.
1. Introduction
.
Many small developing economies which are highly reliant on foreign trade have faced particularly serious problems since the resc.rgence of world inflation in the early 1970s. Rising import prices have been a source of domestic inflation and a deterioration in the terms of trade causes, or adds to, balance-of-payments problems. An obvious way lto combai this is to alter the price of foreign exchange. Developing countries have frequently done this by resorting to a variety of combinations of formal and non-formal devaluations. However, since such a polky raises the domestic price of imports, it may intensify cost inflation. It is therefore important to determine whet?ler the inflationary effects of raising the price of imports is affected by the policy tool chosen. In this paper we analyse the Israeli experience in order to investigate the relative influence of alternative exchange rate policies, and we compare therm with the effects of increases in the foreign price of im:ports. 2. Import prices sand the effective exchange rate The domestic price c.c imports may rise either through increases in the *This research was financed in par; by the Israel Foundations Trustees. We are indebted to Y. Ben-Porath, R. Gronau, Z. Griliches, E. Kieiman, and A. Palres for constructive comments on an earlier draft. We are also grateful to an anor!!-lnous referee for his -;ery helpful suggestions, and the research assistance of D. Blinder is gratefully ;lcknowledged.
118
M.i. Bfe,kr and N. Halevi, ~ectiue demluation and domestic rate of iqhtion
foreign-exchange cost of unports - ‘a factor exogenous to the small economy - or through effective devaluation. The latter can be the resullt of chagges in the formal (or offkial) rate of exchange which transactions, or by ‘non-formal’ devaluation, exports and taxes on imports to achieve devaluation. Many developing countries have multiple effective exchange rates by mauipulation of the non-formal components of the effective rate. Should we exp.xt the inflationary irqact to be the same re of what has caused the rise in the domestic price of imports”! Compare first a rise in foreign prices of imports with an increase in local taxes on imports. We should expect no differen= in their in~ationary impact (if we i allocatkon of tax receipts). However, the numerical results resU\t of WmpaiiGfJ price indexes rather than prices For individual because there are differences in adjustment time. A formal devaluation, however, may be expected to have additional effects. Since it applies to all foreign exchange transactions, and not only to trade in goods, a formal devaluation may have stronger demand efkcts than a nonformal alteration of the exc:han rate, These stronger effects may result from the increase in the domestic-c ncy value of other transactions, pri unilateral and capital transfers, and fr.am the revlnluation of denominated in foreign exchange. Formal devaluation may also have a stronger cost-push effect than non-formal devaluation: an announced than in the formal rate, by being widely public&d, makes it easier to pass on the price increases. However, the possibility that the formal and non-for the effective exehan rate may differ in the of their impact o he rate of d~rn~ti~ maa considered in many well-known studies o developing countries, L 3. The Lraeli experience The results presen.ted below are ba d on the Israeli ex period 196’-*‘%,which was marked by persistent inflation, te latter year ,. Because Israel had large annual balance-of-payments deficits, there had been widespread agreement among Israeli economists that there should a trend of real devaluation, i.e.. a cha in the ~~~iv~ rate of exchan rester than necessary merely to mainta urchasing power parity. Such a trend has not. been achieved, despite constant than in the effective rate of exchange. ‘*,
for exawle. Diu-Alejandro (1965). Harberger (1964, part UI), azd Lee ((977).
M.I. Blejer and N. Halevi, E$itctive devaluation and domestic rate sf inflation
119
Until 1975, there were infrequent formal devaluations; in between, taxes on imports and subsidies for exports, i.e., the non-formal components of the exchange rate, were used to adjust the exchange rate. In general, the infrequent formal devaluations served to achieve temporary real devaluation, and the non-formal ajmponents were used to restore relative prices eroded by domestic inflation.2 The higher inflation rates since 1974 necessitated more rapid adjustments of the exchange rate. Consequently, in mid-1975, a crawling-peg system was adopted, which allowed for monthly devaluations of up to 2 percent. This system too did not achieve real devaluation.’ In October 1977, a new system, controlled floating, replaced the crawling peg. On the basis of quarterly data on changes in the formal and effective exchange rates in 1968-76, import prices and domestic prices (as represented by the implicit GNP deflator), we estimate a number of variations of the following specification of the domestic rate of inflation:
where it is the rate of change of domestic prices, P, is the rate of change in the foreign price of imports, and p is the rate of elective devaluation (which includes changes in purchase taxes as well as customs duties). Ed stands for the excess domestic demand in the goods market; to measure this we use a proxy for the excess flow supply in the money market: the difference between the rate of increase of the money supply (M, ) and the rate of growth of :eal income. This variable captures the excess liquidity created by the government fiscal deficit as well as changes in the demand for money call;ed by income growth.” The main results are presented in table 1. Column (1) reports the results of estimating eq. (1) and is the conventional formulation which does not distinrzuish between the two components of the exchange rate. The excess dcma $d variable is not significant, a result similar to this was obtained by other studies for this period. Although alternative lag patterns and irLg structures were tried the results consistently indicated that lagged variables should not be included for excess demand and for foreign-price changes, *A detailtj analysis of Irrael’s exchange rate system is presented in Michaely (1975. ch. 5), and a briefersurvey appears in Halevi (1978). %rad’s inability to achieve real devaluation has stimulated renewed interest in the relationship berwcen &valuation and domestic inflation. Bruno (1978) has examined the theoretical relationshq~,and Art&n and Sussman (1976) have presented an empirical analysis. *In an alternative formulation we replaced reaJ income by a measure of available domestic r urces defbted as GNP plus the import surplus exclusive of direct defence imports and imports of ship and aircraft. The results, however, were not sensitive to the change. The data used include unpublished data on the non-formal component of the effectiverate of devaluation and uere provided by the Central Bureau of Statistics and the Bank of Israel.
120
M.I. Blejer and N. Halevi, Effective devaluation and domesric rate of inflation
Table 1 Regression results: Dependent variable, rate of change of domestic prices; Israel, 1968/1976.1V”
(1)
1.831+0.122E,,+0.291P,+0.082p,+0.248p,_, (1.77) (1.32) (2.21) (0.92) (2.71) Zp,_i=O.485,
(2)
S~.(Zp,-i)=O.123,
i-(‘:.155p,.+ (1.81)
R2=0.515,
O.W=1.78,
1.752+ O.O69E,+ 0.403P, + 0.398 Wp{ + O.l02Wp[_1+ 0.099 Wp[_z (0.82) (0.81) (1.51) (0.61) (3.23) (3.06) + 0.051Wp;f + 0.225Wp$ , + 0.263 Wp;! 2r (0.52) (2.41) (2.87). c pi’_*= 0.599, R2 = 0.686, S.E.( Z p{- ,)=0.167, r, p;l1 = 0.439,
S.E.(Cp;fi)=0.156,
D.W = 1.95.
‘Notes: t-values are in parentheses. All variables are quarterly rate of changes. Definitions: Ed, excess demand, P,, import prices, p, effective exchange rate, k-t;ol, weighted formal rate, Wp”f, weighted non-formal component.
since their values are all insignificant and their inclusions merely reduce the efliciency of the estimation. The effective exchange rate, however, is signficant with lags of one and of two periods but is not significant in the current quarter. The question arises: why is this variable different in timing from foreign price changes? Import prices are recorded at the time of entry of the goods, which is usually at least several months after the decision to import was made at the prices then known to importers; on the other hk,nd, the relevant effective rate of exchange is that prevailing at the time of payment. Thus, lags for p are consistent with no lag for P,. Since current and lagged variables are bound to be collinear it is worthwhile to consider the sum of coefficients and the standard errors on the sum. As shown in table 1, the sum of the coefficients of p is highly significant, much more than each of the individual cc,efflcients.5 The sum can be interpreted as the cumulative effect over three quarters of a devaluation; thus, a 10 percent effective devaluation appears to lead to an increase in domest c prices by about 5 percent. Although this effect appears to be larger than thz effect of foreign price changes (which has a coefficient of 0.291), the coefflci DLSare not statistically different at the 5 percent level.6 In c ;der to investigate possible differences between the effects of the ‘Alternative estimations including extended lag patterns were also performed. The results indicate that lags beyond pt_ 2 are not significant, and therefore those results, which are available on request, are not reported here. 6The r-value for the difference is 1.02. When eq. (I) is estimated including lagged values of P,, the sum of coefficients for that variable is 0.309 with a standard error of 0.171. The sum of the p coefficients is 0.473 with a standard error of 0.132. A t-test again indicates that the sums are not statistical!y different.
M.I. Blejer and N. Haleoi, Effective devaluation and domestic rute of irgflution
121
components of the effective exchange rate, we estimate eq. (2) as follows
where the formal (pJ) and nonformal (pnf)l components of a devaluation replace p, the aggregate changes in the exchange rate. Since our interest is in the exchange rate as a policy variable and since a desired effective devaluation can be achieved either by formal or non-formal devaluation, the exchange rate component variables entering the regression are weighted by their share in the effective exchange rate (FY). Thus, the coefficient of the formal exchange rate, Wpf, in regression (2), table 1, should be interpreted to mean that a devaluation of the effective rate by 10 percent achieved by means of a change in the formal rate (which requ.ired changing the formal rate by more than IO percent), was associated with an increase in the price level of 3.98 percent during the current quarter. The same interpretation applies to the non-formal component in eq. (2). The breakdown of the effective rate leads to a number of interesting results. When both components of the rate are not constrained to have the same coefficient it seems that the precision of estimalte is improved. Using ,the sum of squared residuals of eqs. (1) and (2) to test the hypothesis that both components have equal effects, the resulting iF-value is 4.35, which allows for the rejection of that hypothesis at the 5 percent level of confidence.’ It is apparent from eq. (2) that the main difference in the effects of the exchange-rate components is in their time patterns; while changes in the formal rate have a significant effect only in the current periold and lagged values are not significant, the effects of the non-formal rate appear only wit.h lags of one and two periods.s This result conforms with the hypothesis that a formal devaluation, being more publicized and having a stronger impact on expectations, can be more easily passed on to domestic prices and, therefore, is reflected fzster in the rate of inflation than an apparently equivalent nonforl-?al devaluation. Regarding the total effects of each component, we observe from the sum of the coefficients that although the aggregate effect of the formal devaluation appears to be larger than that of the non-formal, the coeffici~ents are not statistically* different (t =O.M), in licating that, after all adjusiments have taken place, formal and non-formal devaluations have a similar inflationary impact.” ‘The critical values for F(3.24) are 3.01 (0.05) and 4.72 (0.01). if only two lags of Wp’ are included in the regression, the hypothesis of equal effects can be rejected at the 1 prcent tcvel [F=6.01; F(2,25)=5.57 (C).01)]. sLags further in the past for Wpr and Wp”* and for the other independent variables, were also tried, without satisfactory results. 91n addition, the sum of coefficients of pi and p ml are not statistically different from the coefficient of P,,, (or the sum of coefficient of’ P, when lags are included).
122
M.X. Blejer and N. Hafevi, Effective devaluation and domestic rate of injation
Our regressions treat the 1968-76 period as if it were homogeneous. However, in mid-1975 Israel adopted a crawling-peg system, which not only speeded up exchange rate adjustments but also diminished disparities between changes in formal and effective rates. Because the number of quarterly observations since the introduction of the crawling peg are not sufficient to allow for separate regressions, we analyse the consequences_ of rhis policy change by comparing the results for the entire period, with those obtained in regressions for the’ pre-crawling period. We also use scale and slope dummies for the second period. In all cases we do not find differences in the pattern of results, which leads to the conclusion that the structure of effects of formal and non-formal devaluation was not sensitive to the change in regime. 4. Summary This paper deals with the following question: does fcrmal devaluation, through its impact on invisibles, asset valuation, and inflationary expectations have an effect on domestic prices different than that of an apparently equivalent non-formal devaluation via, say, the increase in import duties? Our results indicate that the hypothesis of equal effects of both components can be rejected. However, the main difference appears to be in timing. While a formal devaluation is passed on to domestic prices faster, the long-run effects of form4 and non-formal changes appear to be the same. These results are not affected by the shift from an adjustable peg to a crawling-peg regime. A policy implication suggested by the results is that the inflationarv effects of a devaluation can not be attenuated simply by the manipulation of the non-formal components of the exchange rate. Indeed, after all adjustments are complete, an increase in import taxes will have an effect on domestic prices similar to those of a change in the formal exchange rate. References Artstein, Yael, and Z. Sussman, 1976, Wage and price controls and the effectiveness of dcv duations: The Israeli experience (B,ank of Israel, Jerusalem). Bruno, bdichael, 1978, Exchange rates, import costs and wage-price dynamics, Journal of Pal tical Economy 86, no. 3, 379-404. Dim--P $_a?dro, Carlos, 1965, Exchange rate devaluation in a semi-industrial country: The exI: ;ncnce of Argentina 1955-1961 (M.I.T. Press, Cambridge, M!1). Halevi, Nildav, 1978, The exchange rate in Israel: Policy and opinion, Revue Economique, forthcoming. Harberger, Arnold C., 1964, Some notes on inflation, in: Werner Baer and Isaac Kerstenetzky, eds., Inflation and growth in Latin America (Irwin, Homewood, IL) 319-351. Lee, Eric Y., 1977, Exchange-rate devaluations and the dynamics of inflation in Korea, 19% 1969, American Economist 21, no. 1.7-15. Michaely, Michael, 1975, Foreign trade regimes and economic development: Israel (National Bureau of Economic Research / Columbia University Press, New York and London).