ABSTRACT
Since at least 1949, a number of economists have noted that devaluation may have deflationary effects on an economy (Hirschman 1949, Diaz-Alejandro 1963, Cooper 1971, Krugman and Taylor 1978). In general, this literature is based on ‘elasticity pessimism’, i.e. the absence of the Marshall-Lerner conditions under which a currency depreciation is supposed to improve the trade balance. These critics of devaluation argue that, in the absence of adequate expenditure-switching in response to exchange rate-related changes in prices, currency devaluation results a fall in real income, due to the rise in import costs. This paper argues that exchange rate flexibility effects changes in total output through its effect on profits. Furthermore, the effect on profits depends crucially on trade imbalances, so that the usual exchange rate fluctuations tend to squeeze profits in surplus as well as deficit countries. In the longer term, such fluctuations discourage international trade.
