Economics Letters 22 (1986) 67-71

North-Holland

67

COMPETITIVE DEVALUATION AND THE GREAT DEPRESSION A Theoretical Reassessment

Barry EICHENGREEN and Jeffrey SACHS

Hurvurd Uniuersi(v, Cambridge, MA 01138, USA

Received 8 May 1986 Final version received 9 June 1986

Historical accounts indict the devaluations of the 1930s for worsening the Great Depression. To assess the consistency of these arguments, we develop a two-country model of the gold-exchange standard. Its analysis reveals that devaluation under a gold

standard need not be beggar-thy-neighbor. Contrary to the thrust of the existing literature, competitive devaluations like those

of the 1930s could have hastened recovery from the Great Depression.

Several influential historical accounts have indicted the devaluation cycle of the 1930s for worsening the Great Depression [Nurkse (1944) Kindleberger (1973)]. Individual devaluations, it is alleged, transmitted beggar-thy-neighbor effects abroad. Competitive devaluations neutralized one another’s effects and may have even left the devaluing countries worse off. Unfortunately, the consistency of these arguments remains difficult to assess, since there exists no multi-country model of devaluation in a gold-exchange-standard setting with which they can be analyzed.

In this paper we develop and analyze such a model. This analysis indicates that the standard conclusions about competitive depreciation in a gold standard setting are not necessarily correct. Individual devaluations under a gold standard need not be beggar-thy-neighbor. Whether they are depends on the form of devaluation - specifically, on the management of gold reserves and domestic credit. When initiated simultaneously in several countries, competitive devaluations need not neutralize one another. Again, whether they do depends on the form of devaluation and on the structure of domestic markets. Contrary to the thrust of the existing literature, under reasonable assumptions competitive devaluations taken in the conditions of the 1930s could have hastened recovery from the Great Depression.

Our model is an adaptation of the two-country Mundell-Fleming framework, with added emphasis on aggregate supply and the monetary links to gold [see Mundell (1963) Bruno and Sachs (1985)]. We consider two symmetric economies, with identical coefficients in all equations. The first three components of the model are familiar. Money demand is specified in standard transaction-bal- ance form,

m-p=+q-Xi, (1)

where m is the log of nominal money balances, p the log of domestic output price, q the log of GNP and i the nominal interest rate. (Since the model is not dynamic, we do not distinguish the real and

0165-1765/86/$3.50 0 1986, Elsevier Science Publishers B.V. (North-Holland)

68 B. Eichengreen. J. Sachs / Competitm deualuutiott and the Greut Depression

nominal interest rates.) Throughout, we assume an identical relationship for the foreign country (in this case, m* -p* = +q* - Xi* where asterisks denote foreign variables), but we provide the foreign equations only where required for clarity.

Aggregate demand depends on relative prices and interest rates,

q= -S(p-e-p*)-ai, (2)

where e is the log nominal exchange rate (domestic price of one unit of foreign exchange). We assume perfect capital mobility, perfect asset substitutability and the expectation that exchange rates will remain fixed, so that interest arbitrage leads to the equality of home and foreign interest rates,

i = i*. (3)

We write aggregate supply as a negative function of the product wage,

q= -a(w-p),

where w is the log nominal wage. In line with our focus on relatively short-run fluctuations during the interwar years, we adopt the Keynesian assumption of nominal wage rigidity,

w=w. (5)

What is necessary for our results is not a rigid nominal wage but that the nominal wage adjusts only partially to changes in prices.

The world gold stock R” is assumed fixed and divided between the two countries (R” = R + R*).

Since dr = d log(r) = dR/R,

ydr+(l-y)dr*=O, (6)

where y = R/R” in the initial equilibrium. All that remain to be specified are definitions of the money supply and the exchange rate. The

home country fixes the domestic-currency price of gold. Let G denote ounces of gold per unit of domestic currency. Since l/G is the domestic-currency price of gold, a fall in G signifies a devaluation. The foreign country fixes the own-currency price of gold at l/G*, so the exchange rate E (units of foreign currency per unit of domestic currency) is G/G*. Since e = log E,

e=g-g*. (7)

Under a gold standard, the money supply can be decomposed into the value of gold reserves and the gold backing ratio. With a gold price of l/G, the domestic currency value of a quantity of reserves R is R/G. Define 1c, to be the gold backing ratio [ $ = (R/G)/M]. Rearranging and taking

logs,

m=r-g-4,

where again the lower-case letters are logs of their capital counterparts. This definition of the money

B. Bchengreen, _I. Sachs / Competitive devuluuiion und the Great Depression 69

supply can be converted into a statement about policy by assuming, for example, that JI or r is fixed. ’

The full model, with analogous equations for the foreign country, is comprised of 12 equations determining 12 endogenous variables: q, w, p, i, m, r, q*, w*, p*, i*, m* and r*. We assume that each country has two policy instruments, g and 4. Under this assumption, money balances m and gold reserves r are endogenous.

During the interwar period devaluations could and did take a number of distinct forms [see Eichengreen and Sachs (1985)]. Therefore, we consider five types of policy initiatives. First, the home country undertakes a devaluation (dg < 0) but allows the gold backing (4) to change enough so that reserves are unchanged (dr = 0). This is termed a sterilized devaluation. The foreign country does not undertake any policy actions (dg* = 0 = d+*). In the second case, the home country devalues, but with an unchanged gold backing (dg < 0, drC, = 0). Again, dg* = 0 = d+*. This is an unsterilized devaluation. In the third case, both countries devalue by an equal amount, at an unchanged gold backing (dg = dg* -C 0, d# = d#* = 0). In the fourth case, both countries devalue by an equal amount, but sterilize the capital gains on gold reserves so that dm = dm* = 0. Finally, we consider a fifth case, suggested by Nurkse (1944) in which fear of competitive depreciation leads to a scramble for gold and a rise in the backing ratio.

Case 1. Sterilized devaluation (dg -C 0, dr = 0). In this case, it is easiest to consider the home policy instruments as r and g (with m and $ endogenous). Since dr = 0, we have dr* = 0. With IyI*=r*- *_ g V, with d$* = dg* = 0 by assumption, dm* also equals zero. Solving the entire model,

dq = (l/A)[ S/3 + 2d( a + $)] dg > 0,

dq*=(@/A)dg<O,

d(w-p)=(-l/cYA)[@+2a~(a++)] dg<O,

di=(-l/A)[S(a++)] dg<O,

where

A= -(l+Sa)[P(l+??a)+a(a++)] +sa[LSaj?-a(a+$)] ~0.

In this case, devaluation is beggar-thy-neighbor. It raises output at home but necessarily reduces output abroad. As expected, devaluation reduces the domestic product wage, increasing aggregate supply, and reduces the world nominal interest rate.

Case 2. Unsterilized devaluation (dg -C 0, drC/ = 0). In this case, gold reserves in the home country (r) may rise or fall after the devaluation. Since dr* = - [y/(1 - y)] dr, a fall in r produces a rise in r*. Since dm* = dr* (assuming d$* = dg* = 0), it is possible that home devaluation raises the foreign

1 Note that the monetary base could equivalently be defined as the sum of domestic credit and foreign reserves. Since the way the ratio of reserve backing falls is through the creation of domestic credit, (6) could be specified as an identity relating the

volume of domestic credit to the money supply, the value of gold reserves and the backing ratio. Here we focus not on domestic credit but on the monetary base and the backing ratio as central to the issues at hand.

70 B. Eichengreen, J. Sachs / Competitive deduution und the Greut Depression

money stock, which was ruled out in Case 1. It is possible that dq* > 0 if the rise in r* is large enough. Specifically,

dq = (- 1/52)[ /IS + 2a8( a + +) + rpS + I%(1 + 2&j)] dg > 0,

dq*=(l/Q>[SP(r+l)] dg+odr*/[P+o(a+$)] 20,

dr* = (l/L’)[ j3 + u( u + +)] [2$S - l]r dg >< 0,

di=(1,‘9)[I(l+2~8)+(1-T)(u++)S] dg><O,

where

a = [l/(1 - y)] { /3[1+ 2u6] + (u + +)[2eq6 + 01) ’ 0,

r=Y/(l-Y).

Note that if dr* < 0 then dq * is necessarily negative for dg < 0. In other words, dr* > 0 is a necessary condition for dq* > 0. Clearly, dr* > 0 is not a sufficient condition, since dq* can still be negative even when dr* > 0. An example of positive transmission of the devaluation is for 6 and p very small. With 6 = /? = 0, for example, dq* = dr*/(u + +) and dr* = -y dg > 0.

Case 3. Simultaneous devaluation, unchanged gold bucking (dg = dg* < 0, d+ = d+* = 0). In this case, the devaluation is expansionary for the world as a whole, and reduces product wages and nominal interest rates. By symmetry, neither country gains or loses reserves. Specifically,

dq=dq*=(-u/A)dg>O, di = (l/A) dg < 0, d(w-p)=(u/crA)dg<O,

where

Case 4. Simultaneous devaluation, unchanged monetary base (dg = dg* < 0, dm = dm* = 0). In this case, the devaluation has no effects on output or interest rates. The only effect is a rise in gold backing of each country’s monetary base,

dg=dg*=O, di = 0, d(w-p) =0

Case 5. Simultaneous rise in gold bucking (dg = dg* = 0, drC, = d$* > 0). The rise in Ic, and +* causes a proportionate fall in the monetary base, dm = dm* = -d$ = -d$*. This monetary contraction has effects exactly opposite to the effects of simultaneous devaluation in Case 3,

dq=dq*=(-u/A) dJ,<O, di=(l/A) d+>O, d(w-p)=(u,‘aA)drC,>O,

where

Thus, devaluation under a gold standard may or may not be beggar-thy-neighbor, since it operates simultaneously through differential channels. Moreover, depending on their form, competitive

B. Eichengreen, J. Suchs / Competitrve devcrlucrtion and the Greut Depression 71

devaluations can raise output in all the participating countries. The importance of the channels specified here and the effects of competitive devaluations in the 1930s are empirical questions. In Eichengreen and Sachs (1985) we present evidence from that historical episode in support of our specification.

References

Bruno, Michael and Jeffrey Sachs, 1985, The economics of worldwide stagflation (Harvard University Press, Cambridge, MA).

Eichengreen, Barry and Jeffrey Sachs, 1985, Exchange rates and economic recovery in the 1930s. Journal of Economic History

45, 925-946.

Kindleberger, Charles, 1973, The world in depression, 192991939 (University of California Press, Berkeley, CA).

Mundell, Robert, 1963, Capital mobility and stabilization policy under fixed and flexible exchange rates, Canadian Journal of Economic and Political Science 29, no. 4, 475-485.

Nurkse, Ragnar, 1944, International currency experience (League of Nations, Geneva).