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-7-realm and into the fiscal side of the economy.Indeed,these panels providefour different ways of looking at fiscal pressures.Anumber of revealing facts emerge from this table.First, macro-economic--and in particular fiscal- -policies became increasingly expansivein the devaluing countries immediately preceding the year of the devaluation.Second,the devaluing countries as a group behaved quite differ-ently than the control group of fixers.fiscal policy indicators,This is particularly clear for theFor example, during the year prior to thecrisis half of the devaluing countries allocated one quarter or more oftotal domestic credit to the public sector; the median for the control groupcountries, on the other hand, was only slightly more than 10 percent.Formal.tests indicate that the probability of these policy indicatorsfor the devaluing countries coming from the same population as the controlgroup is very low. j/featureThis strong empirical evidence suggests a thirdthat any model that attempts to capture the dynamics of crisis andstabilization should possess, i.e., it should have a well developed fiscalside.3.Terms of Trade and Devaluation CrisesOf course, balance of payments difficulties are not always the resultof inconsistent domestic macroeconomic policies; historically, exogenousshocks have sometimes been the sources of serious external imbalances,our sample there is a wide variety of experience.the terms of tradedidinWhile in some episodesnot change in the period preceding the exchange rarej./ The values of the x2 statistics ranged from 9.1 to 14.6.Statistic hasdegrees of freedom.This

-8-collapse,in others there was a substantial change.In aix of the fxteenepisodes for which there are data there was a significant worsening inthe terms of trade before the devaluation (see Appendix,Existing models of exchange rate collapse,however,TableAl).1/have ignored thepossibility of terms of trade shocks being the generating cause ofdevaluations. This possibility is explicitly taken up in our model.4.Real Exchanze Rates, The External Sector and DevaluationsIn the vaar majority of our 20 devaluation episodes the external aecrorexperienced a aerious deterioration in the period leading to the criaia.In16 out of the 20 episodes the ratio of net foreign assets to money experi-enced a steep decline during this two year period (see Appendix, Table A.2).This,of course, is in acrord with the traditional modela of exchange rarecrises developed by Krugmen (1979) and others, where the devaluation takesplace when the level of international reserves hire a lower threshold. 2/Also,in 14 of the 20 episodes the current account ratio experienced aworsening in the two years before the crisis,In fact, in some of theseepisodes the current account to GDP ratio reached remarkable levels.InKenya and Israel 1971 the deficit was approximately equal to one-fourth ofGDP!An important characteristic of these devaluation episodes ia thetendency,present in most countries, for the ratio of net foreign assets toreturn to its pre-crisis level following the devaluation. This suggeststhat countries have a well-established desired level of reserves to whichj/ We have arbitrarily defined "significant" as a decline in the terms oftrade of at least 5%.foreign assets of the monetary system; thus,2/ Notice that these areits evolution includes private capital movements including capital flight.

they seek to return.This characteristic, which has been ignored in theliterature, is explicitly incorporated in our model.Regarding real exchange rates, in 15 out of the 19 countries wsthrelevant data the bilateral real exchange rate experienced a real appreciation in the three years prior to the devaluation; in 13 out of the 19 casesthere also was a real appreciation of the multilateral RER during the periodimmediately preceding the crisis.The average real appreciation during the3 years preceding the devaluation crisis was almost 9.2 percent, while thereal multilateral appreciation was 9.01 (see Appendix,Table A.3). 1/Thesereal appreciations were the result of domestic rates of inflation thatincreasingly exceeded the world rate of inflation.A set ofx2tests,infact, indicate that as the crisis date approached the rate of CPI inflationin the devaluing countries became more distinct from that of the fixed ratecontrol group.This evidence is particularly important for determining ourmodelling strategy. What these data suggest is that devaluation decisionsare based on the behavior of (at least) two indicators:and the real exchange rates.foreign reservesIt is possible to think of some devaluationsas undertaken in order to improve a country's competitive position ratherthan because reserves have disappeared Indonesia in 1978 comes to mind)This means that, contrary to the traditional literature,a model thatattempts to capture the stylized facts surrounding crises in the LOGs shouldj/ Naturally, to the extent that there have not been changes in theequilibrium RERs, this appreciation reflects a disequilibrium situation(i.e., real overvaluation). Notice that the extent of real exchange rateappreciation before the crisis not only varied across countries, but alsowas more marked in recent years (i.e., in the l980s). This has been particularly the case for the countries that after the devaluation becamecrawlers.

- ICexplicitly incorporate nontradeble goocaand.bthe possibility of.i,domestic rnflaticn exceeding world inflation-A particularly interesting featureofepisodes the authorities postponed the irplmeasures, ever after it had become evident,ra is that in manytCesentionctaof the adjustaeortne eoonoay was facing ain a number of cases in itssevere maccceconomic disequilibrium. Moreo'er,effort to postpone the adjustment the government resorted to exchange andcapital controls 'Edwards 1989aj,Devaluation Crises and Black Msrket Premia5Wecould obtain inforration rn ne black market rate for foreignexchangefor cost of the countries InourThesesample.data are, infatt,extremely suggeetive, showing a marked-increase it the premium in the periodleading to the exchange rate collapse. In all but rae of the episodes theblack market premium was higher one month before the devaluation thanpriorto the devaluation (see Appendix,TableAC'It-3yeatsis interesting tonote that in every country isssediately following the devaluation the parallelmarket premium experienced a sudden downward jumpThis type of behavior is,in fact. consistent with perfect foresight models of the rvpe developed byLizondo (l98Ta, and Kiguel and Lizondo (1986,.It the acdci we developedbelow we also incorporate this feature ci the parallel racket behavior.Devaluation Crises and Real Wagg.6.Critics of orthodox stabilization programs have argued that devaluations result in important reductions in real wages./Inorder todata on the evolution of teal wages in theanalyze this issue we collectedj/See, for example, Pastor (1986).

-manufacturing sector11in the period surrounding our devaluation crises (seeAppendix, Table A.5).Since these data have not been corrected by productivity gains, they should be analyzed with care.These figures show noclearcut behavior of real manufacturing wages in the period surrounding thedevaluationcrises.In only 8 out of 18 episodes for which there are data,real wages increased in the period preceding the crisis.eight cases real wages dropped after the devaluation.In all of thesein the otherepisodes for which there are data, real wages did not decline after thecrisis.Thus, the popular belief that all devaluations arewage reduction is not sustained by our7,followed by adata.SummaryThe data discussed in this section provide a fairly clearcut patternregarding the stylized facts surrounding a large number of devaluationcrises in the developing countries. These facts--which we believe anadequate model of devaluation crises should capture--can be brieflysummarizeda.as follows:Historically the vast majority of devaluation crises have beenpreceded by loose and inconsistent macroeconomic policies.theevidence showsIn particular,that fiscal policy in the devaluing countries as a groupwas significantly more expansive than in a control group of fixers.In a nontrivial number of episodes we detected a significantworsening in the international terms of trade immediately before the crisis.b.Thissuggests chathistoricallysome collapses may have been caused byexogenous external shocks.clflsignificantthe periodpreceding the devaluations we observed (a) areal exchange rate appreciation; (b) the depletion ad the s0c5

22of-international reserves; (c) a deterioration of the current accountdefioit and;(d)fora decline in the ratio ofgnassets of themonetary system.Devaluations crises have been preceded by very steep increases ind.the black market premium.Moreover, the evidence shows that ir.mediatelyfollowing the devaluation the premium experienced a significant decline.Regarding real wages, the evidence is less clear.e.There are someindications, however, that in acme countries reel wages followed aninverteddroppedUpath.They increased in the years preceding the crisis, andin the years that followed.III.The ModelIn this section we develop a model of a typical developing countrywhich is designed to trace the dynamic response of certain key macroeconomicvariables to a variety of shocks that eventually culminate in a devaluationepisode.The model is able to generate dynamic responses which mimic quiteclosely the stylized facts described above.It turns out that, for a givenshock whioh eventually results in adjustment-ca-devaluation, the primarydeterminants of the path followed by domestic macroeconomic variables arethe nature of the eventual macroeconomic adjustment to the shock and themagnitude of the associated devaluation.1.SurelyWe consider a small open economy which produces exportables (X)importables(Z) andnontraded goods (N) using sector-specific capital and

-Laboroomogeneous labor. L/13is available in fixed supply,and all pricesare flexible; full employment prevails continuously. The labor marketequilibrium conditionLx(w/p) (1)ere wis:L(w) L(we)I.is the real wage measured in terms of importables, pdomestic price of exportables in terms of importables (i.e.ter'nsisthethe externalof trade), and e is the real exchange rate, defined as the ratio ofthe domestic price of importables to that of nontraded goods; esP/P;,where s is the predetermined nominal exchange rate applicable to comlnerciaitransactions andfor laborPn sectoris the world price of importables. Lj is the demandi,and LI0,Equation (1) impliesrelationshipbetween p, e, and the equilibrium real wage:(2)Sinceww(p,e),wl(w/p2)/(/p L Le) 0;w2-(Lw)/(/p L Le) 0each sector employs only one variable factor, conventional secroralsupply functions that relate output in each sector to the two relativeprices p and e can be derived.(3)1Xyx(pe);yzyZ(Pe); yNyN(pe)Consequently, an improvement in the terms of trade increases output ofexportables while reducing that of importables and nontraded goods.A realexchange rate depreciation, on the other hand, increases output of importables and exportables while reducing that of nontraded goods.1/ This model is partially based on Khan and Montiel (1987). It differsfrom Khan and Montiel in that it incorporates a dual exchange rate marketand ignores the bond market. Kiguel and Lizondo (1986) and Edwards (1988)present models somewhat similar to that developed here,

- 142.-DemandHousehold Sectora.We assume that households consume only importables and noncradableTo simplify the analysis we suppose that households'goods.functions(denotedutilityThis implies constant expenditure sharesare Cobh-Douglas.for importables and 1-6 for nontradable goods) and permits us to6write an 'exact" price index P as:(4)where1-6P P and6-1P5eP4 are the domestic-currencyprices of importables of non-Letting c denote real consumption measured in units of thetradables,consumption bundle with pricethe household demand functions forP,and nontradable goods can be written as:importables(5a;tz(Sb)c4—fiPc/Pzbe6-1 c(l-6)Fc/PN(l-6)e8cin turn, is taken to depend on realReal household consumption,disposable factor income and real financial wealth:(6)cc(y-t,a);cc 0 4,where y is real factor income, t is real (lump sum) taxes, and a is realfinancial wealth, all measured in terms of the consumption bundle.Realtaxes on households are taken to be exogenous.Real factor income can be expressed as the product of the relativeprice of imports measured in terms of the consumption bundle and real factorincome in terms of importables:(7)18x zy — e(py y eFrom equation(7)y) y(p,e).it follows that an improvementin the terms of trade

-increases15-real factor income, while a real exchange depreciation has anambiguous impact on this variable. j/Household financial wealth consists of domestic money and foreignThe economy is assumed to operate under a dual nominal exchangeexchange.rate system,consisting of a predetermined official exchange rate for cur-rent transactions and a freely-fluctuatingrate which governs.n foreign exchange among private citizens.desired/transactionsConsequently changesrestock of foreign money will result in changes in the freely floacir.grate without accompanying capital flows.In that sense the stock of foreignexchange in private hands at any one time reflects past central bank intervention in the dual exchange market, i.e., it is exogenous when measured inforeign currency units.Letting H denote the stock of money, F theforeign-currencyvalue of the stock of foreign exchange held by the privatesector and d the dual exchange rate, real household financial wealth is:aM dF)/F.(8)where mit is convenient to write this as:aM/Pand v —dF/P.Finally, we assume that households continu-ously maintain their financial portfolios in their desired composition,which is specified in conventional fashion as a function of the nominal rateof return on the money substitute and of income:(9)Jm(d,y); m1 0, m20,The initial steady state around which the model will be solved below— 0. This will be he case when theviii have the poperty thatcountryis initially neither a net international debtor nor creditor, since in thiscase (l-)yKhanandMontiely/e (see(1987)).ZI The literature on dual exchange markets in developing countries is nowquite extensive. For recent expositions, see Lizondo '1.987a,b) andDornbusch (1986).y

-where ais16-the expected rate of depreciation of the dual exchange rate,which under the assumption of perfect foresightto the actual rateis equalof devaluation.To complete the description of household behavior,the accumulation ofdomestic money is given by the household budget constraint:Ftor equivsiently:e8l(ytc) -th(10)b.Public SectorThegovernmentP5m.levies taxeson households and purchasesbothimportables and nontradable goods. It finances any resulting deficit byborrowing(11)from the central bank,defg5 eJgNIts budget constraint is given by:-where g5 and gN denote government spending on importablesgoods respectively andimportables.Initially,defand nontradableis the government deficit measured in terms ofthe government is assumed to allocate its spendingin the same proportions as households:(12a)gZOe0g(12b)gN(1-9)e8g,where g is cotal real government spending meaaured in units of theconsumption bundle,The final agent in the model is the central bank, which issues money tofinance government deficits and to purchase foreign exchange in the offitialmarket generated by trade balance surpluses.The balance of trade measuredin terms of imporcables, denoted b, is given by:

-(13)Thus,b—py- cZ 17-gZat any instant the stock of money in domestic currency units (M) isgiven by:(14)M5(b(u) def(u)) P(u)du.The domestic-currency value of the stock of international reserves (which wedenote R) depends on the current official exchange rate, rather than on therate that prevailed at the time the foreign exchange was purchased by thecentral bank:(15)3,SfRb(u)P*(u)du.EquilibriumSince the economy in question is small, domestic-currency prices ofexportables and importables are governed by the law of one price:(16)PsP;Pzas we abstract from world inflation and assume that the exchange rate forcurrent account transactions is fixed, the domestic currency prices of Xand Z are constant.Equilibrium in the nontradable goods market is given by: gNUsing (3), (5b), (6), (7) and (8), this becomes(17)ThisyN(p,e)(l-O)e8c[y(p,e)-t,e(m v)J equation can be solved for the real exchange rate chat clears themarket for nontradable goods.To do so, it is convenient to assume that the

-itcan be shown thare(18)with-characterized by trade balance equilibrium, in thisinitial equilibrium iscase,18y0. j/The solution for e ia given by:e(p,gN.r,m v)the following expressions-[yNesfor the partial derivatives:(l-9)e0c1y[(l/9)e8c1eq0;/8(l-8)e8c where0;/-l/e2-(1--G)ec2(l-9) c2(m v)-/y 0; 0, 0.The model il aolved by combining equation (18) with equationsin(10) to yield a system of two differential equationaorand v.(9) andTo do so,notice first that, since F and Tz are both exogenous, and since we will beof vconsidering only discrete changes in these variables, the definition.implies char aMaking use ofthis property, equation (9) can bewritten as:—(19)h(p,m/v),— -m2y/mh1Similarly,(20)th 0;substitutingg(p,gN,t,m v),y1(l-c)gl-(1-c1)where--h21/rn10.in (10) produces:(18)wherec2eil(l9)(m v)el(l-O)c2e1(m v)e3 0;where all derivatives are evaluated atThe equilibrium defined bystable. th'9gir 0;g20209)e(m ')e2-c2[(l-G)e(a v)eq l[ '9 0,0. 2! 0 can be shown to he saddle-pointThe determinant of the system consisting of the linearized versionsof (19) and (20 is given by:See Khan and Montrel (198').is derived after substituting for eq from equationThe sign of1/g2/(18)- 0

-19--h2g4(l m/v) 0,(21 so the roots are indeed of opposite sign.is depicted in Figureloci inrn-vThe equations1.The phase diagram for this systemth— 0 and"—0trace out a pair ofspace with slopes given by;—-I,—andv*/m* 0.1,:,0The signs of the arrows are derived from the partial derivatives in (18 and(20), and the saddle pathThus,positive slope. j/premiuminSSthrough the equilibrium point A must have aalong stable paths the real money supply and thethe dual exchange market will tend to move in the same direction.The Role of DevaluationIV.To analyze the workings of the model, we consider the effects of thetwo types of shocks which in Section II we associated with a devaluationcrisis- -an expansionary fiscal shock consisting of an increase in govern-ment spending on nontradable goods, and an adverse terms of trade shock.Webegin this section by analyzing the role of a nominal official devaluationin our model.We then analyze the effects of an expansionary fiscal shockand of a permanent adverse terms of trade shock in consecutive subsections.jJThe slope of the saddle path SS is given by:hdv2—dmmSSwhere 0,—l'2 V'l is the negative root.

Figure1.Steady State EquilibriumVSLS 00m

201.-The Role of DevaluationA steady-state— 0.b —configuration1 is characterized byBy differentiating equation (14), this can be shown to imply that-def.However

2 Fiscal and Credit Policies and Devaluation Crises Table 2 summarizes the behavior of domestic credit and fiscal policies for the period immediately preceding the 20 devaluation crises. In addi- tion, data for a control zrou of countries that maintained a fixed rate for 10 or more years are also presented. L/ The following indicators can be