1. Introduction

Research on the relationship between the exchange rate and output is an important topic that has been the subject of anat a competitivee usually suggestsaluation, becausean peso has beenin & Klau, 1998).

Journal of Asian Economics 34 (2014) 2741

Received 28 November 2012

Received in revised form 4 March 2014

Accepted 15 March 2014

Available online 25 April 2014

JEL classication:

F31

F41

Keywords:

Contractionary devaluation

Vector autoregression

Sign restrictions

devaluation or real depreciation on outputs in 16 countries that fall within one of the

three groups: Latin American countries, Asian countries, and non-G3 developed countries.

For the rst time in the contractionary devaluation literature, the analysis is based on a

Vector Autoregression (VAR) model with sign restrictions method by Uhlig (2005) and Fry

and Pagan (2011). The exchange rate shock is identied by imposing restrictions on the

signs of impulse responses for a small subset of variables. The ndings are as follows: (1)

whether output increases after a real devaluation or not has little to do with whether the

current account improves or not; (2) Latin American countries are quite homogenous in

that the current account generally improves while output decreases after real devaluation;

and (3) contractionary devaluation could happen in developed countries as well as in

developing countries.

2014 Elsevier Inc. All rights reserved.

Contents lists available at ScienceDirect

Journal of Asian EconomicsThe importance of understanding the effect of devaluation on output cannot be ignored, as it provides important policyinsights. For example, in a textbook model, adverse external shocks lead to a depreciation of the real exchange rate that, bystimulating net exports, boosts aggregate demand and offsets the effects of the initial shock. If devaluation is genuinelycontractionary, the benets of exchange rate exibility may be overrated. In addition, contractionary devaluation may pose adilemma to policy-makers seeking to achieve simultaneously both high output growth and a strong balance-of-paymentextensive debate for a long time. The conventional wisdom on the exchange rate-output nexus is thexchange rate encourages exports and hence, encourages growth. However, much of the empirical evidencthe contrary. According to Kamin and Klau (1998), many developing countries have tended to resist devsuch policy would be contractionary, rather than expansionary. For example, depreciation of the Mexicconsistently associated with decline in output, while appreciation has been linked to expansion (KamTherefore, one natural question to be raised: is devaluation contractionary or expansionary after all?Is devaluation expansionary or contractionary: Evidencebased on vector autoregression with sign restrictions

Lian An a,*, Gil Kimb, Xiaomei Ren c

aDepartment of Economics and Geography, Coggin College of Business, University of North Florida, Jacksonville, FL 32224, United StatesbDepartment of Economics, California State University, Fresno, United StatescReliant Energy, 1201 Fannin Street, Houston, TX 77002, United States

A R T I C L E I N F O

Article history:

A B S T R A C T

The purpose of the paper is to examine the impact of real exchange rate changes realposition. It is of great signicance to understand the nexus between exchange rate and output.

* Corresponding author. Tel.: +1 8594202878.

E-mail address: lian.an@unf.edu (L. An).

http://dx.doi.org/10.1016/j.asieco.2014.03.003

1049-0078/ 2014 Elsevier Inc. All rights reserved.

Is devaluation contractionary or expansionary? In the context of AD-AS model of a typical textbook, the devaluation of thedomestic currency makes foreign goods and services more expensive relative to domestic in the short-run, which will causean upward shift in the aggregate demand curve and an expansion of output, all else being equal (see Edwards, 1989; Frankel,1988; Goldstein & Khan, 1985). In addition, when a countrys currency depreciates in real terms, foreign rms will nd thatthe country with currency depreciation can supply intermediate production inputs more cheaply. Because the economy has

L. An et al. / Journal of Asian Economics 34 (2014) 274128been globalized with multinational rms, rms can shift their production to the country with currency depreciation forlower production cost.1 As a result, the country with depreciation might have an increase of demand for their labor andoutput (Krugman et al., 2009, p. 424), and thus increase of output. Empirical studies, such as Goldstein and Khan (1985) andGylfason and Schmid (1983), also provide evidence of the expansionary devaluation in the short- and medium-run for anumber of countries.

However, an opposing opinion contends that devaluation can have adverse effects on domestic output if contractionaryeffects outperform expansionary demand-side effects (Cooper, 1971; Diaz-Alejandro, 1963; Krugman & Taylor, 1978). Thecontractionary effects of devaluation may occur from the demand side, supply side, and balance-sheet side effects. First, if theprice elasticities of demand for exports and imports are too low, or if the country faces an initial large trade decit, according tothe monetary model, the domestic price level will increase due to higher prices of imported goods and thereby the real moneybalance is lowered and aggregate demand is reduced (Frenkel & Johnson, 1976). Second, if there is redistribution of income froma low saving group (wage) to a high-saving group (prot), aggregate demand will be reduced (Krugman & Taylor, 1978). Third,devaluation can be contractionary if government revenues are increased (Krugman & Taylor, 1978). Fourth, devaluation raisesthe price of imported intermediate goods and results in an upward shift in the aggregate supply (see the works of Findlay &Rodriguez, 1977; Sachs, 1980, and etc.), which may result in decreased output. Fifth, as argued by Cooper (1971) and Lizondoand Montiel (1989), real devaluation may increase the real domestic currency value of the countrys foreign liabilities, whichresults in a contraction in aggregate demand. Sixth, devaluation often triggers capital outow and acts as a caveat on foreignborrowings, which will induce a decline in consumer spending and investor condence in the domestic economy. Lastly, centralbanks may be depleted of foreign reserves, which is likely to have a contractionary effect on output. Therefore, whetherdevaluation is contractionary or expansionary depends on two opposing forces.

Empirical studies also produce conicting evidence on the connection between output and devaluation. For example,Kwan (1994) nds that currency devaluation appears strongly expansionary in East Asian countries, while reviews by Kaminand Rogers (2000) and Upadhyaya, Dhakal, and Mixon (2000) indicate that devaluation almost uniformly results in reducedoutput without signicant evidence for subsequent reversal. Upadhyaya and Upadhyay (1999) and Edwards (1986) nd theeffects of devaluation to be neutral in the long run. Although many studies nd that contractionary devaluation is moreprevalent in developing countries, Kamin and Klau (1998) show that contractionary devaluation applies to other developedeconomies. In addition, Bahmani-Oskooee and Kandil (2009) nd that the expansionary effect of unanticipated depreciationis only transitory on output growth, while unanticipated depreciation is found to have a contractionary effect on outputgrowth in the long-run via an increase in the cost of imported inputs. Different results might be due to different countries,different model specications, and data spans.

The purpose of this paper is to investigate the empirical relationship between output and devaluation for 16 countries:Mexico, Brazil, Argentina, Chile, Korea, Malaysia, Indonesia, the Philippines, Australia, Canada, Denmark, Austria,Switzerland, the Netherlands, New Zealand, and Portugal. While the choice of countries is mostly dictated by dataavailability, we strive to make the sample as diverse as possible. The sample is large enough to be divided into three groups:Latin American countries (Mexico, Brazil, Argentina, and Chile), Asian countries (Korea, Malaysia, Indonesia, and thePhilippines), and non G-3 developed countries (Australia, Canada, Denmark, Austria, Switzerland, the Netherlands, NewZealand, and Portugal). The sample countries also encompass different exchange rate regimes. For example, Latin Americanand Asian countries have alternated between xed and oating exchange rate regime but generally have had xed regimes.Australia, Canada, Switzerland, and New Zealand have oating exchange rate regime for most of the sample time period,while Austria, the Netherlands and Portugal belong to the Euro area. Denmark, which is in European Union (EU) but does notadopt Euro, xed its currency, the Krone, to the Euro from 1999.2 Studying a sample of countries as diverse as this allows adirect comparison of the output-exchange rate relationship across different groups of economies, and enables us to study ifcontractionary devaluation is particular to a certain group of countries. Germany, Japan, and the US are not included, becausethe economies of these countries are large enough to inuence many of the external control variables.

A fairly comprehensive vector autoregression (VAR) model is used, as it allows consideration of the endogeneity of theexchange rate. Many past studies that have adopted VAR models, such as Kamin and Rogers (2000), Kim and Ying (2007),Ahmed, Gust, Kamin, and Huntley (2002), and Shi (2006), have resorted to the Choleski decomposition to identify the shocks.For the rst time in the devaluation output literature, the VAR model based on the sign restriction approach is employed.

There are several advantages in using the sign restriction approach. First, compared with the traditional structural VARmodel, restrictions that are often used implicitly, consistent with the conventional view, are made more explicit in the sign

1 For example, the German auto manufacturer BMW can shift production from Germany to its US plant if dollar depreciation lowers the relative cost of

production in the US (Krugman, Obstfeld, & Melitz, 2009, p. 424).2 Devaluation usually applies to exchange rate changes under a xed exchange rate regime. For the countries in this study, some of them maintained a

oating exchange rate. In this paper, we use devaluation and depreciation interchangeably.

restriction approach. Second, sign restrictions are weak in the sense that they do not lead to exact identications of thereduced form VAR. We regard this as an important advantage, because it circumvents incredible zero restrictions on the

L. An et al. / Journal of Asian Economics 34 (2014) 2741 29contemporaneous and the long-run impact of shocks. Peersman (2005) nds that impulse responses based on traditionalzero restrictions can be considered as a single solution of a whole distribution of possible responses that are consistent withthe imposed sign constraints. Third, the sign restriction method involves the Bayesian Monte Carlo procedure. According toSims (1988), the Bayesian method is applicable irrespective of whether or not the variables are nonstationary, thus obviatingthe need for pre-testing the variables for unit roots. In sum, results from the sign restriction approach can provide animportant complementary method of analysis, which is automatically systematic and can be universally applied.

As a preview to the results, this paper has the following ndings: (1) whether output increases or not after a realdevaluation has little to do with whether the current account improves or not; (2) Latin American countries are quitehomogenous in that the current account generally improves while output decreases after real devaluation; and (3)contractionary devaluation could happen in developed countries as well as in developing countries.

The paper is organized as follows: Section 2 provides bivariate data analysis between the real exchange rate and outputfor each country. Section 3 presents a comprehensive VAR model with the discussion of the sign restrictions methodology.Estimation results and robustness checks are reported in Sections 4 and 5, respectively. The paper concludes in Section 6.

2. Bivariate data analysis

It is well-known from macroeconomic data that output and real exchange rate exhibit a feedback relationship, and thereis no clear-cut consensus on the relationship. On the one hand, real exchange rate depreciation could be both expansionaryand contractionary on output. On the other hand, real output growth could cause real exchange rate to appreciate ordepreciate. According to the BalassaSamuelson effect, in fast-growing economies, the relative price of nontradable goodswould rise faster and thus lead to appreciation of the real exchange rate over time. However, existing empirical studies seemto suggest that the growth effects on real exchange rates are nonexistent or small (see Tica & Druzic, 2006, for acomprehensive survey on the empirical evidence).

This paper rst evaluates the bivariate relationship between real exchange rates and seasonally adjusted GDP using crosscorrelations with leads and lags of up to four quarters. To make the results robust to the method of detrending, this paperemploys three lters: linear detrending, rst difference, and the HodrickPrescott lter.

Table 1 reports the representative short-term cross correlations between real exchange rates and output at lags 4, 2, 0,2, 4. A positive (negative) lag indicates the number of quarters by which the real income leads (lag) the real exchange rate.The possible effects of devaluation on output can be gleaned from correlation at negative lags while correlation at positivelags suggests the possible reverse causation effect of output growth on real exchange rates. We use real effective exchangerate, which is constructed in a way that a decrease reects a real appreciation of the domestic currency.

Correlations at negative lags are clearly negative in the four Latin American countries. That is to say, depreciation of realexchange rate is followed by a cyclical downturn, consistent with the fact that the contractionary devaluation hypothesis hasreceived surprisingly strong empirical support in the context of Latin American countries (Kim & Ying, 2007). For example,real devaluations are uniformly associated with recessions and real appreciations with expansions in Mexico (see Kamin &Rogers, 2000). As for the East Asian countries, the evidence is mixed: In Korea and Indonesia, depreciation of real exchangerates is followed by output growth; while in Malaysia and the Philippines, depreciation is associated with outputcontraction. The evidence is murky for non-G3 developed countries, which is quite sensitive to the mechanism of detrending.

The cross correlation at positive lags, which summarizes the effect of output growth on real exchange rates, areunanimously negative for Latin American countries. This concurs with the phenomenon of the BalassaSamuelson effect thatincome growth precedes the appreciation of real exchange rate. However, this does not necessarily mean that the BalassaSamuelson effect is present as the relationship maybe due to spurious correlation. For Asian and developed countries, theevidence is divided, rendering minor evidence for the BalassaSamuelson effect, if any. Korea particularly has ve out of sixpositive correlations and Switzerland has six positive correlations, indicating that real exchange rate does not appreciatedespite the rapid catching-up.

To further explore the bivariate relationship, Granger Causality tests are carried out. Foreign income, foreign interest rate,current account, and real money supply are included to control external inuences that affect both real exchange rate andoutput simultaneously.3 In all regressions, four lags are employed.

Table 2 reports the results. In Latin American countries, causality runs from the real exchange rate to output in Mexicoand Brazil. For Argentina and Chile, causality runs in both directions. For Asian countries, the causality generally runs fromthe real exchange rate to real income with Malaysia observing bilateral causality. As for the developed countries, it is veryinteresting to note that there is unanimous lack of causality in both ways, except that Switzerland and New Zealand haveevidenced causality from real exchange rates to output. In general, for the three groups of countries, the results indicate thatlags of real output do not help to explain movements in real exchange rates, but lagged real exchange rates help to explainthe movement of real outputs to some extent.

3 The description of the data is in Appendix A.

L. An et al. / Journal of Asian Economics 34 (2014) 274130Table 1

Cross correlations between exchange rate and output.

Lag 4 2 0 2 4Mexico LT 0.24 0.01 0.10 0.12 0.053. The VAR model with sign restrictions

The section comprises two parts. The rst part sets up the baseline model. The second part illustrates the implementationof the sign restriction approach.

DIF 0.10 0.11 0.35 0.17 0.06HP 0.04 0.32 0.62 0.54 0.20

Brazil LT 0.23 0.21 0.22 0.17 0.13DIF 0.01 0.08 0.04 0.03 0.10HP 0.08 0.11 0.04 0.12 0.26

Argentina LT 0.11 0.12 0.07 0.02 0.12DIF 0.04 0.2 0.22 0.09 0.02HP 0.15 0.35 0.45 0.15 0.04

Chile LT 0.25 0.18 0.14 0.06 0.37DIF 0.11 0.23 0.16 0.03 0.12HP 0.11 0.35 0.35 0.18 0.06

Korea LT 0.27 0.21 0.16 0.16 0.16

DIF 0.06 0.00 0.30 0.04 0.08HP 0.11 0.09 0.29 0.13 0.05

Malaysia LT 0.19 0.21 0.25 0.28 0.34DIF 0.07 0.17 0.26 0.13 0.04HP 0.26 0.44 0.54 0.39 0.07

Indonesia LT 0.56 0.51 0.41 0.33 0.29

DIF 0.02 0.24 0.01 0.13 0.05HP 0.22 0.15 0.26 0.48 0.31

Philippines LT 0.30 0.24 0.19 0.16 0.11DIF 0.14 0.07 0.01 0.01 0.08HP 0.18 0.02 0.03 0.01 0.01

Lag 2 4 0 2 4Australia LT 0.25 0.22 0.16 0.07 0.03

DIF 0.10 0.03 0.13 0.03 0.01HP 0.01 0.11 0.15 0.05 0.11

Canada LT 0.08 0.06 0.05 0.01 0.11DIF 0.07 0.01 0.14 0.10 0.05HP 0.12 0.01 0.18 0.20 0.07

Denmark LT 0.17 0.14 0.11 0.07 0.02DIF 0.07 0.03 0.04 0.02 0.03HP 0.09 0.05 0.02 0.04 0.10

Austria LT 0.13 0.12 0.14 0.12 0.07

DIF 0.03 0.08 0.01 0.10 0.07HP 0.06 0.10 0.06 0.04 0.10

Switzerland LT 0.24 0.38 0.52 0.53 0.41

DIF 0.07 0.02 0.13 0.33 0.16HP 0.07 0.11 0.39 0.53 0.35

Netherlands LT 0.19 0.14 0.07 0.07 0.04DIF 0.12 0.03 0.14 0.03 0.04HP 0.03 0.16 0.30 0.22 0.10

New Zealand LT 0.18 0.23 0.26 0.24 0.21DIF 0.01 0.07 0.05 0.05 0.01HP 0.03 0.08 0.10 0.08 0.04

Portugal LT 0.30 0.28 0.23 0.24 0.19DIF 0.16 0.00 0.11 0.11 0.00HP 0.32 0.11 0.12 0.15 0.07

Source: Authors calculations.

Note: LT denotes linear detrending, DIF denotes rst difference, and HP denotes HodrickPrescott lter. A positive (negative) lag indicates the

number of quarters by which the real income leads (lag) the real exchange rate.

L. An et al. / Journal of Asian Economics 34 (2014) 2741 31Table 2

Granger causality tests between real exchange rate and output.

LT DIF HP

Mexico RX GC Y 6.05 (0.00) 6.07 (0.00) 6.90 (0.00)

Y GC RX 0.71 (0.59) 0.52 (0.72) 1.07 (0.37)

Brazil RX GC Y 1.39 (0.24) 2.71 (0.04) 2.19 (0.08)

Y GC RX 0.73 (0.58) 0.84 (0.50) 0.50 (0.74)

Argentina RX GC Y 2.69 (0.03) 0.76 (0.55) 1.18 (0.32)

Y GC RX 1.57 (0.19) 2.21 (0.07) 2.39 (0.05)

Chile RX GC Y 3.25 (0.01) 2.53 (0.04) 2.13 (0.08)

Y GC RX 5.49 (0.00) 4.35 (0.00) 4.77 (0.00)

Korea RX GC Y 2.75 (0.04) 3.38 (0.01) 1.75 (0.14)

Y GC RX 1.19 (0.32) 0.21 (0.93) 0.59 (0.67)

Malaysia RX GC Y 5.33 (0.00) 2.07 (0.09) 4.76 (0.00)

Y GC RX 2.09 (0.09) 3.06 (0.02) 3.37 (0.01)

Indonesia RX GC Y 11.11 (0.00) 11.29 (0.00) 11.74 (0.00)

Y GC RX 2.33 (0.06) 1.24 (0.30) 0.54 (0.71)3.1. Model setup

The documented relationships either positive or negative between real output and real exchange rates in the previoussection might arise due to spurious correlation, where both variables are affected by some third factor. For example, sharpchanges in oil prices may depress output and depreciate the real exchange rate, causing them to move in opposite directions.In Asian and Latin American countries, large capital inows lead to a temporary boom and real appreciation. Thus, it isimportant to have a control for macroeconomic conditions and to separate exchange rate changes that may be classied asexogenous policy shocks from those that are reactions to macroeconomic events.

This paper designs a comprehensive VAR model, consisting of ve endogenous variables: current account (CAR),measured as a ratio to GDP; price level (CPI); real effective exchange rate (REER), denominated as units of domestic good perunit of foreign good; real output (Y), measured by the index of seasonally adjusted GDP; and real money supply (MS). Inaddition, two exogenous variables, foreign income (Y*) and foreign interest rate (R*), are incorporated to capture the externalshocks. The US 3-month treasury bill rate and the US real GDP are used as foreign interest rate and income.

Real money supply is included. According to Shahbaz, Islam, and Aamir (2012), money supply affects investment andoutput. An increase in money supply lowers interests, reduces borrowing costs, and promotes investment which mightenhance domestic output. In addition, a higher money supply will reduce the value of currency. Thus, we include moneysupply in the model. This paper also incorporates the price level to control for the price environment for an economy.According to Meja-Reyes, Osborn, and Sensier (2010), an inationary environment may affect output negatively because it

Philippines RX GC Y 2.60 (0.04) 2.49 (0.05) 1.74 (0.14)

Y GC RX 2.15 (0.08) 1.34 (0.26) 1.14 (0.34)

Australia RX GC Y 0.89 (0.47) 0.16 (0.96) 0.18 (0.95)

Y GC RX 0.20 (0.94) 0.45 (0.77) 0.13 (0.97)

Canada RX GC Y 1.10 (0.36) 0.20 (0.94) 0.25 (0.91)

Y GC RX 0.88 (0.48) 0.50 (0.73) 1.18 (0.32)

Denmark RX GC Y 0.77 (0.54) 0.77 (0.54) 0.82 (0.51)

Y GC RX 0.83 (0.51) 0.54 (0.71) 0.59 (0.67)

Austria RX GC Y 0.44 (0.78) 0.70 (0.59) 0.32 (0.87)

Y GC RX 0.63 (0.64) 0.64 (0.64) 0.58 (0.68)

Switzerland RX GC Y 7.27 (0.00) 7.78 (0.00) 8.81 (0.00)

Y GC RX 0.66 (0.69) 0.84 (0.50) 0.33 (0.86)

Netherlands RX GC Y 0.71 (0.58) 0.87 (0.48) 0.97 (0.43)

Y GC RX 0.29 (0.88) 0.69 (0.60) 0.11 (0.98)

New Zealand RX GC Y 3.16 (0.02) 1.58 (0.18) 2.80 (0.03)

Y GC RX 0.46 (0.76) 0.29 (0.88) 0.34 (0.85)

Portugal RX GC Y 0.65 (0.63) 0.19 (0.95) 0.10 (0.98)

Y GC RX 1.30 (0.27) 0.94 (0.44) 0.51 (0.73)

Source: Authors calculations.

Note: Reported are F-statistics with P values inside the parentheses. LT denotes linear detrending, DIF denotes rst difference, HP denotes

HodrickPrescott lter. RX denotes real exchange rates, Y denotes real outputs, and GC denotes granger cause. RX GC Y tests the hypothesis that

the real exchange rate granger causes real income. Y GC RX tests the hypothesis that real income granger causes the real exchange rate.

might provoke inefcient allocation of resources due to distortions in relative prices and higher administration costs forrms. Current accounts are included for two reasons. On the one hand, it allows direct investigation of the effect of exchangerate uctuation on output through the demand channel (net exports).4 On the other hand, the current account incorporates

L. An et al. / Journal of Asian Economics 34 (2014) 274132information of capital ows implicitly, because current accounts and capital accounts are mirror images of each other. Theinformation on capital ows is very important. According to Kamin and Rogers (2000), shocks to capital ow have beenimportant to movements in the real exchange rate and output for Mexico. Reinhart (2000) also maintains that, devaluationcan lead to a loss of access to international capital markets and, thus, generate contractionary effects on output. Kim and Ying(2007) also include this variable in their model. The US short-term interest rate and real GDP are included to captureinternational markets conditions. According to Meja-Reyes et al. (2010), including the US interest rate and GDP can proxy forthe US (or international) business cycle, and export-led growth in Latin American or Asian countries depends uponinternational economic conditions. As the focus of this paper, real output and exchange rate are naturally included.

The data set is quarterly and has been primarily collected from International Financial Statistics (IFS), Direction of TradeStatistics (DOTS), Department of Statistics and from central banks for each country. The sample periods are generally from1973:1 to 2012:4, except for Brazil (1980:1-2011:4), Canada (1973:1-2012:1), Denmark (1975:1-2012:1), Korea (1976:1-2012:1), Indonesia (1980:1-2012:4), Mexico (1985:4-2012:4), and Philippines (1973:1-2011:4). Appendix A lists the detailsof the data sources and the sample periods.

Eq. (1) summarizes the model in a compact reduced form:

CARtCPItYtREERtMSt

266664

377775

a1a2a3a4a5

266664

377775 Ai jL

CARt1CPIt1Yt1REERt1MSt1

266664

377775 Bi jL

DYt1DRt1

e1te2te3te4te5t

2666664

3777775

(1)

All the variables are in log except the interest rate and the ratio of current account to GDP. There are several features of themodel. First, the VAR model controls for both internal and external shocks that might simultaneously induce devaluation andeconomic contraction, such as a reversal of capital inow or a decline in foreign country GDP, leading to a spuriouscorrelation between the two variables. Second, while we tried to be comprehensive in controlling for various factors,parsimony is also sought. For example, we do not include the capital account as in Kim and Ying (2007). Because currentaccounts and capital accounts are mirror images of each other, including both variables will include redundant information.Third, instead of using nominal exchange rate as in Kim and Ying (2007), this paper chooses to use real exchange rate. In thelong run, nominal devaluations are believed to lead to a proportionate increase in prices that leave real exchange rates andeconomic activity unchanged, analysis based on nominal exchange rate has been usually conned to short-run effects (seeLizondo and Montiel, 1989). Furthermore, an essential element in the traditional view of devaluation is that it is theimprovement in the domestic relative price of tradables to nontradables, that is, real exchange rate depreciation, generatesthe process of expenditure-switching, balance-of-payments improvement and economic expansion.

3.2. Implementation of the sign restrictions

Disagreements start when researchers discuss how to decompose the prediction errors into economically meaningfulfundamental innovations, that is, how to identify the structural shocks. Five methods are present in the literature, four ofwhich are parametric restrictions. These parametric restrictions can vary according to whether particular variables appear,whether there is recursive causal structure (Sims, 1988), and whether the shocks have known short-run or long-run effectsor some combination (see Blanchard & Quah, 1989). Each type has its own disadvantages as well as advantages. For example,there is no clear consensus about the ordering, and some ordering may not be justied by the economic structure, and thestandard recursive identifying assumptions may be over-identifying restrictions that have been developed over time in adata-mining like manner as researchers looked for restrictions that can provide sensible results (see Rudebusch, 1998). Thezero contemporaneous impact may not be consistent with a large class of general equilibrium models (Canova & Pina, 1999).In addition, Faust and Leeper (1997) show that substantial distortions in the estimations are possible due to small samplebiases and measurement errors when using zero restrictions in long-run effects.

As an alternative, this paper pursues the recent sign restriction approach by Uhlig (2005) to identify exchange rate shockswith the median response calculated by Fry and Pagan (2011). Uhlig (2005) suits best here for two reasons. First, Uhlig (2005)does not aim at a complete decomposition of the one-step-ahead prediction errors into all components due to underlyingstructural shocks, but rather concentrates on identifying only one shock. The intention is to be minimalistic and to imposenot much more than the sign restrictions themselves, as they can be reasonably agreed upon across many economists. In thispaper, our primary interest is to obtain evidence on how exchange rate devaluation affects output. Instead of identifying allstructural disturbances, this paper uses minimal restrictions that are sufcient to identify the depreciationary exchange rateshock and examines its effect on the output. As such, this paper circumvents the incredible zero restrictions on the

4 Trade balance is the dominant part of the current account in other countries, except for the Philippines, whose income balance is the main component of

the current account balance.

L. An et al. / Journal of Asian Economics 34 (2014) 2741 33contemporaneous and long-run impact of shocks. Second, given the nature of multi-country study, data availabilitiesdiffer across countries. The use of the Uhlig (2005) sign restrictions identication methodology allows for a verysimilar identication to be achieved across countries despite these data problems. This is because the sign restrictionidentication strategy identies shocks using mild restrictions on multiple time-series, and because the sign restrictionsput no quantitative restriction on the responses, it does not matter which denition of the variable is used(see Raq & Mallick, 2008). In addition, compared with the traditional structural VAR model, restrictions whichare often used implicitly, consistent with the conventional view, are made more explicit in the sign restrictionapproach.

Nonetheless, it is important to note that sign restrictions are not without criticism. For example Fry and Pagan (2011)have cast doubt with regard to the shocks identied and the optimal responses using median criteria. Specically, withidentifying only one shock, that is, exchange rate shocks, combinations of other shocks could potentially look like exchangerate shocks. One way to avoid this problem would be to identify other shocks explicitly. According to Uhlig (2005), themultiple shocks problem is not particular to the sign restrictions method. For example, if the true data generatingmechanism have more shocks than variables, and if one uses a conventional Cholesky decomposition to identify an exchangerate shock by ordering it last, then the shocks identied will actually be a linear combination of several underlying shocks. Insum, this paper does not claim that the identifying assumptions are ironclad or perfect, but rather they are particularlyreasonable, minimal and neat.

Fry and Pagan (2011) point out that the optimal response using median criteria for different shocks and horizons maycombine information from several identication schemes and thus is a composite of different structural response functions.They propose an alternative method to overcome this problem by choosing a response as close as possible to the medianwhile imposing that the responses are generated from one single identifying matrix, termed as median target method. Assuch, this paper employs the Uhlig (2005) method to identify the exchange rate and uses the Fry and Pagan (2011) method tocalculate the median response. We term this as the Uhlig (2005)FryPagan (2011) method.

In the following, we provide a brief review of the method. The detailed methodology can be found in Uhlig (2005). Let Ytbe a vector of n endogenous variables containing time-t values whose dynamic relationships are described by the followingvector autoregression of order k (VAR(k)):

Yt B1Yt1 B2Yt2 BkYtk Vt; t 1; . . . ; T; (2)where B(k) are coefcient matrices of size n n and Vt is the one step-ahead prediction error with variancecovariance matrixS. Let Wt be an n 1 vector containing time-t values of structural disturbances. The reduced-form residuals and structuraldisturbances are linked through:

Vt AWt (3)where it is assumed that the structural disturbances are mutually independent and normalized to be of variance 1: it cantherefore be written as EWtW 0t I. In addition, the jth column of A (or its negative) represents the immediate impact on allvariables of the jth structural innovation one standard error in size. The only restriction on A thus far that emerges from thecovariance structure is:

AA0 S (4)the identication problem amounts to uncovering the n(n 1)/2 free elements in A by imposing identifying restrictions.According to Uhlig (2005), the matrix A can always be written as:

A X ^ Q (5)where X is an orthogonal matrix whose columns are the orthonormal eigenvectors of S, ^ denotes a diagonal matrix with theeigenvalues of S on its principal diagonal, and Q denotes some orthogonal matrix (i.e., QQ0 = I). Eq. (5) shows that choosingelements in an orthonormal set can determine the free elements in A. As we are only interested in responses to one particularshock, the exchange rate shock, the problem amounts to determining an orthonormal vector q in the following equation:

a X ^1=2

q (6)

where a is a column of A, termed as impulse vector by Uhlig (2005), containing the contemporaneous responses of nendogenous variables to the exchange rate shock, and q is a column of Q in the corresponding location. The main idea of theidentication scheme is to impose a set of inequality constraints. This does not uniquely identify a but supports ranges ofpossible responses consistent with the sign restrictions.

For each set of the estimates for (B, S), we can compute impulse vectors and hence impulse response functionscorresponding to different unit vectors in an n-dimensional sphere. We generate n numbers from a normal distribution withmean zero and standard deviation one, treat them as coordinates, and normalize the resulting vector into a unit vector. Thenormalized n-dimensional vector corresponds to each point on the sphere. We can repeatedly generate n-dimensionalvectors to uniformly cover the sphere.

The sampling uncertainty about the VAR parameters (B, S) is covered in a Bayesian manner. Following Uhlig (2005), weassume that prior and posterior distributions for (B, S) belong to the Normal-Wishart family. We simulate 500 pairs of

(B, S). For each pair, we evaluate 500 unit vectors on the n-dimensional sphere. Thus a total of 250,000 qs and impulsevectors are evaluated. After computing each set of the impulse response functions corresponding to each unit vector, wecheck if the sign restrictions are satised. Only the impulse vectors that meet the following restrictions are stored:

de

L. An et al. / Journal of Asian Economics 34 (2014) 2741345 Uhlig (2005) sets K = 5 in the baseline. However, considering that our data are quarterly rather than monthly as in Uhlig (2005), we choose to set K = 2.6 The results of the impulse responses of other variables with sign restrictions are not reported in this paper due to the length of the paper. Results are

available upon request.negThe Latin American countries are very homogenous in that the current account generally improves while outputcreases after exchange rate depreciation, which is quite consistent with the uniformly negative cross correlations atative lags reported in Table 1.in Switzerland and New Zealand, whose current account and output behave quite consistently.

ach1. The price level does not decrease (0) in response to a positive exchange rate shock, that is, exchange rate depreciation,because the price level is likely to be driven up by an increase in net export due to the exchange rate depreciation. SeeAhmed et al. (2002) for more discussion.

2. By denition, the exchange rate will not decrease (0) in response to its own positive shock.3. The real money supply does not increase (0) facing exchange rate depreciation. There are two reasons. First, when the

price level increases in response to the exchange rate depreciation, the real money supply will fall. Second, as the exchangerate depreciates, central banks will tend to decrease the money supply to support the currency. As an example, Rogers andWang (1995), among many others, nd empirically that real exchange rate depreciation lead to signicant decrease inmoney supply. In a similar spirit, Farrant and Peersman (2006) impose that the interest rate differential does not fall afteran exogenous depreciation of the exchange rate.

These restrictions seem reasonable as they only make use of a priori appealing and consensual views about the effects ofexchange rate shocks on price, exchange rate, and money supply. Because the response of output is the focus of the paper, weleave it unrestricted to let the data determine it. The current account is left unrestricted because it reects the response oftrade balance to the exchange rate. Therefore, the method remains agnostic with respect to the responses of the key variablesof interest. However, one degree of the choice remains: the horizon K for the sign restrictions. We follow the convention ofsetting K = 2, and leave other possible values of K for robustness check.5

4. Results

Figs. 1 and 2 present the impulse responses of current account and real output to a one-standard-deviation positiveexchange rate shock (indicating depreciation) in each country over 48 quarters.6 The median target responses in each chartwith 16 percent and 84 percent quintiles are plotted.

As shown in Fig. 1, in Latin American countries, the current account generally improves for the rst 48 quartersafter the exchange rate depreciation, which is consistent with the conventional view that the depreciation of realexchange rate increases the trade balance by making domestic goods more competitive. In Asian countries, the currentaccount improves in the Philippines and Indonesia. More interestingly, the current accounts in Malaysia and Koreaexhibit the phenomenon known as J-curve, that is, in response to exchange rate depreciation, the current account rstworsens (marginally signicantly for Malaysia) before improving and eventually reaching the long-run equilibrium. Inthe developed countries, the current account improves signicantly in Canada, Switzerland, Austria (marginallysignicant), while it decreases signicantly in Australia, New Zealand, and Portugal. There is no signicant change inDenmark or the Netherlands.

Does improvement in current accounts after exchange rate depreciation imply unambiguous expansion of output? Notnecessarily. Fig. 2 displays the response of output to a positive exchange rate shock. It is noticeable that, in Latin Americancountries, current accounts generally improve but outputs are depressed simultaneously in all Latin American countries. Thecurrent account also improves and output deteriorates in response to exchange rate depreciation in the Philippines andIndonesia.

Diaz-Alejandro (1963) points out that an observer of devaluation could be puzzled to see that devaluations resulted in animprovement of the trade balance which was accompanied by a decline in the level of total output. Kim and Ying (2007) havesimilar ndings. This is not a bizarre result. First, the observed improvement in the current account may not be achievedthrough an export boom but through a deep contraction in imports as a result of output contraction (see Frankel, 2005).Second, the contractionary effects from exchange rate depreciation may offset the expansionary effect on trade balance,making the overall output decrease.

Therefore, the behavior of the current account does not have a direct bearing on the behavior of output in response to anexchange rate shock. The phenomenon of current account and output responding oppositely might pose a dilemma forpolicy-makers: Exchange rate policy aiming to result in expenditure-switching that leads to a boost in the production oftradable goods may have contractionary side effects on the overall economic activity. Thus, there will be a trade-off between

ieving high output growth and a strong balance-of-payments by using exchange rate policy. The effect is least discernible

Fig. 1. Impulse response of current account to a positive exchange rate shock (K = 2). Note: Horizontal axis: quarters; vertical axis: percent. We assume tha

prior and posterior distributions for (B, S) belong to the Normal-Wishart family. We simulate 500 pairs of (B, S). For each pair, we evaluate 500 unit vectoron the 5-dimensional sphere. Thus a total of 250,000 qs and impulse vectors are evaluated.

Source: Authors calculations.

L. An et al. / Journal of Asian Economics 34 (2014) 2741 35t

s

Fig. 1. (Continued ).

L. An et al. / Journal of Asian Economics 34 (2014) 274136

Fig. 2. Impulse response of real output to a positive exchange rate shock (K = 2). Note: Horizontal axis: quarters; vertical axis: percent. We assume that prio

and posterior distributions for (B, S) belong to the Normal-Wishart family. We simulate 500 pairs of (B, S). For each pair, we evaluate 500 unit vectors onthe 5-dimensional sphere. Thus a total of 250,000 qs and impulse vectors are evaluated.

Source: Authors calculations.

L. An et al. / Journal of Asian Economics 34 (2014) 2741 37r

Fig. 2. (Continued ).

L. An et al. / Journal of Asian Economics 34 (2014) 274138

This homogeneity may illustrate the importance of the balance sheet effect. Latin American countries are well-known forbeing subject to original sin, that is, not being able to borrow abroad in their domestic currencies. Eichengreen, Hausmannand Panizza (2002) estimate the original sin measure of one for Latin American countries, meaning that these countries issuealmost all of their securities in foreign currency. Therefore, currency devaluation will increase debt-servicing obligationsand, similar to a negative supply shock, generate stagationary effects (Gylfason & Risager, 1984). In addition, devaluationmay cause the countries to lose access to international capital markets and accelerate capital outow, which constitutesanother negative supply-side shock.

In Asian countries, output contracts signicantly in Malaysia, Indonesia, and the Philippines. In developed countriesoutput contracts signicantly after exchange rate depreciation in New Zealand and Australia while it expands signicantly inSwitzerland, Denmark, the Netherlands, and Portugal. Output in Canada and Austria does not respond signicantly to anexchange rate shock. Contractionary devaluation could happen in developed countries as well as in developing countriesand could exist in any exchange rate regime, whether it is a exible exchange rate, or a xed exchange rate, or in a commoncurrency area. Therefore, contractionary devaluation may not be a function of exchange rate regimes nor types of economiesAhmed et al. (2002) also report that contractionary devaluation in the developed countries is as strong as in the developingcountries.

In addition, from the standpoint of the exchange rate regime, Australia and New Zealand may not enjoy the benet of aexible exchange rate regime to a full extent, because exchange rate depreciation induced by adverse external shocks cannoboost aggregate demand, and thus has limited effects in offsetting adverse shocks.

While impulse response functions reveal the dynamic effects of a one-time shock, variance decompositions are aconvenient measure of the importance of such shocks in the system. Table 3 reports the fraction of the uctuations of currentaccount and output that is attributable to exchange rate shocks at 0-, 4-, 8-, 12-quarter horizons. Exchange rate shocks play asimilar role in the three groups of countries. Exchange rate shocks account for between 3 and 33 percent of the currentaccount variation and 7 to 42 percent of the real output uctuations. In comparison, we nd a slightly larger role of the reaexchange rate shocks than that found in Ahmed et al. (2002), which reports about 8.111 percent in Latin Americancountries, 1.612.2 percent in Asian countries, and 0.43.9 percent in developed countries.

In sum, several conclusions emerge: (1) whether output increases or not after a real devaluation has little to do withwhether the current account improves or not; (2) compared with Asia and the developed countries, Latin American countriesare quite homogenous in that current account generally improves while output decreases, which is consistent with theuniform negative cross correlations between real exchange rate and output at the negative lags; and (3) although Latin

L. An et al. / Journal of Asian Economics 34 (2014) 2741 39American countries exhibit obvious contractionary devaluation, the phenomenon is not particular to Latin Americancountries. Asia and the developed countries are also subject to contractionary devaluations. However, we acknowledge that

Table 3

Variance decomposition of current account and output due to exchange rate shocks.

0 4 8 12 0 4 8 12

Mexico Brazil

CA 0.09 0.13 0.14 0.16 CA 0.03 0.08 0.11 0.12

Y 0.10 0.12 0.13 0.14 Y 0.10 0.14 0.16 0.17

Argentina Chile

CA 0.13 0.14 0.15 0.16 CA 0.33 0.29 0.25 0.22

Y 0.11 0.17 0.18 0.19 Y 0.42 0.23 0.26 0.15

Korea Malaysia

CA 0.11 0.14 0.15 0.16 CA 0.06 0.08 0.11 0.15

Y 0.07 0.19 0.20 0.22 Y 0.11 0.13 0.17 0.20

Indonesia Philippines

CA 0.06 0.20 0.23 0.25 CA 0.12 0.16 0.17 0.18

Y 0.25 0.26 0.30 0.32 Y 0.09 0.11 0.13 0.18

Australia Canada

CA 0.04 0.09 0.11 0.16 CA 0.13 0.15 0.11 0.13

Y 0.08 0.09 0.12 0.17 Y 0.11 0.12 0.14 0.16

Denmark Austria

CA 0.10 0.14 0.15 0.16 CA 0.10 0.10 0.11 0.13

Y 0.09 0.13 0.15 0.16 Y 0.10 0.14 0.16 0.16

Switzerland Netherlands

CA 0.09 0.13 0.16 0.17 CA 0.09 0.11 0.13 0.14

Y 0.10 0.12 0.13 0.15 Y 0.08 0.11 0.12 0.13

New Zealand Portugal

CA 0.07 0.13 0.15 0.17 CA 0.12 0.14 0.15 0.16

Y 0.10 0.13 0.14 0.14 Y 0.09 0.13 0.14 0.15

Source: Authors calculations.

Note: CA denotes current account, and Y denotes output.,

,

;

.

t

l

L. An et al. / Journal of Asian Economics 34 (2014) 274140it may not be appropriate to draw straightforward policy implications from the results in this paper. For example, ndingthat a real devaluation increases output in Switzerland, Denmark, the Netherlands, and Portugal does not mean that theexchange rates in these countries should be targeted at increasing competitiveness, because there is consensus that the realexchange rate cannot be viably targeted on a sustained basis and such policy may be very inationary. In a similar vein,nding that real devaluation is contractionary in Latin American and other developed countries does not provide a basis forencouraging real exchange rate appreciation, as real exchange rate appreciation may lead to renewed balance of paymentcrisis in the future.

5. Robustness check

How sensitive are the results to the different values of horizon K for the sign restrictions? In the benchmark case, K is set to2. Here, we consider the cases for K = 1 and K = 4 for robustness check.

In the Latin American countries, the dynamics of the output response are similar to those in our benchmark specication.In Asian countries, the results are quite robust, except that the decrease of output in Indonesia is not signicant when K = 1and 4. In developed countries, the results are generally very robust. In sum, the results are not sensitive to the differentspecication of restriction horizons. Due to space constraint, the detailed results are not reported here, but they are availableupon request.

6. Conclusion

In this paper, the effects of real exchange rate changes on real output growth for 16 countries that belong to three groups(Latin American countries, Asian countries, and non-G3 developed countries) have been analyzed using quarterly data from1973 to 2012. For the rst time in the contractionary devaluation literature, the empirical evidence based on a VAR modelwith sign restrictions is provided. We established a model with plausible restrictions for a small subset of variables withwhich to identify the exchange rate shock. The results show that whether output increases or not after a real devaluation haslittle to do with whether the current account improves or not; and while contractionary devaluation is quite a homogeneousphenomenon for the Latin American countries, the output-reduction effect of devaluation is not a function of types ofeconomies or of the exchange rate regimes. Contractionary devaluation may happen in developed countries as well as indeveloping countries. The results are robust to several different choices of the restrictions horizon.

Based on these results, this paper attempts to offer some policy implications. Countries with contractionary devaluation,such as Latin American countries, should not rely on exchange rate depreciation to grow the economy. Meanwhile,overvaluation should be prevented, because real depreciation may follow periods of sustained real appreciation, andcorrection of the exchange rate will have severe consequences in countries with contractionary devaluations. Does this meanthat countries with expansionary devaluation can resort to exchange rate depreciation to stimulate the economy? Webelieve that it is dangerous to draw conclusions like this as well because currency depreciation tends to reduce the growthpotential of the economy, and introduce an additional uncertainty which acts as a deterrent to the investment needed tobuild production capacity.

Appendix A. Data and denitions

The current account variable, CAR, is obtained as the ratio of the current account balance to the trend nominal GDP. If thebalance of payments statistics are unavailable, the current account balance is approximated by the difference between exportsand imports. The domestic consumption price index is measured by the consumer price index (CPI). The real effective exchangerate, REER, is the trade weighted exchange rate measured by the weighted average of the bilateral exchange rates against the USdollar. The real output, Y is measured by the index of seasonally adjusted GDP. For the money supply, MS, M1 is used for mostcountries and money in the national denition is used for Switzerland, Korea, Mexico, and Malaysia.

Two exogenous variables, foreign income (Y*) and foreign interest rate (R*), are incorporated to capture the external shocks.The US 3-month Treasury bill rate and US real GDP is used as foreign interest rate and income. The data set is quarterly and hasbeen collected from International Financial Statistics (IFS), Direction of Trade Statistics (DOTS), and central banks and Departmentof Statistics of these countries. All variables are in logarithm except R* and CAR ratios.

The sample periods are as follows: Argentina (1973:12012:4), Austria (1973:12012:4), Australia (1973:12012:4), Brazil(1980:12011:4), Canada (1973:12012:1), Chile (1973:12012:4), Denmark (1975:12012:1), Korea (1976:12012:1),Malaysia (1973:12012:4), Indonesia (1980:12012:4), the Netherlands (1973:12012:4), Mexico (1985:42012:4), NewZealand (1973:12012:4), the Philippines (1973:012011:4), Portugal (1973:12012:4), and Switzerland (1973:12012:4).

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Is devaluation expansionary or contractionary: Evidence based on vector autoregression with sign restrictionsIntroductionBivariate data analysisThe VAR model with sign restrictionsModel setupImplementation of the sign restrictions

ResultsRobustness checkConclusionData and definitionsReferences