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NBER WORKING PAPER SERIESDEVALUATION CRISES AND THE MACROECONOMIC CONSEQUENCESOF POSTPONED ADJUSTMENT IN DEVELOPING COUNTRIESSebastian EdwardsPeter MontielWorking Paper No66NATIONAL BUREAU OF ECONOMIC RESEARCH1050 Massachusetts AvenueCambridge, MA 02138February 1989Afirst version of this paper was written while Edwards was a visitingscholar in the Research Department of the International Monetary Fund. Wehave benefited from discussions with Saul Lizondo. We are particularlyThis paper is part ofgrateful to Mohsin Ehan for very helpful comments.NBER's research program in International Studies. Any opinions expressed arethose of the authors not those of the National Bureau of Economic Research.

NBER Working Paper #2866February 1989DEVALUATION CRISES AND THE MACROECONOMIC CONSEQUENCESOF POSTPONED ADJUSTMENT IN DEVELOPING COUNTRIESABSTRACTThis paper develops our analytical model to explore the relationshipbetween the dynamics of macroeconomic adjustment and the timing of theimplementation of an adjustment program featuring an official devaluation.The effects of postponing adjustment depend on the source of the originalshock,In the case of fiscal expansion, postponement implies a largereventual official devaluation and greater deviations of macroeconomicvariables from their steady-state values.shocks,For adverse terms of tradepostponement does not affect the size of the eventual officialdevaluation, but does magnify the amount of post-devaluation overshooting bykey macroeconomic variables.Sebastian EdwardsDepartment of EconomicsUniversity of CaliforniaLos Angeles, CA 90024Peter MontielResearch DepartmentInternational Monetary FundWashington, DC 20431

I.IntroductionAn important issue in the design of stabilization programs refers tothe :iminz of different policies.In particular,determining the consequ-ences of alternative timings of devaluations has for a long time concernedpolicymakers in the developing countries. In spite of this policyinterest the literature on stabilization and devaluation has not analyzedthis issue in detail.The purpose of this paper is to develop a generalequilibrium dynamic model to explore the relationship between the dynamicsof macroeconomic adjustment and the timing of the implementation of astabilization program that includes a nominal devaluation as its principalcomponent./Inparticular, we explore the effects of postponingadjustment on the cumulative deviations of key macroeconomic variablesfrom their steady-state values and on the degree of overshooting of thesevalues following the implementation of adjustment measures.The model is derived from well-articulated micro foundations anddistinguishes between equilibrium and disequilibrium movements in realexchange rates.We investigate the characteristics of two different types ofexchange rate crises:(a) those provoked by inconsistent fiscal policiesand (b) those generated by exogenous terms of trade shocks.A centralaspect of our discussion is determining conditions under which a nominaldevaluation will be required to render the adjustment process effective.j/ A number of authors have investigated the process of macroeconomicMost studies, however, have focusedadjustment in developing countries.on a particular aspect of the adjustment process, without providing ageneral and integrated picture that "fits" (or is consistent with) themore salient stylized facts. See, for example, Blanco and Garber (1986),Connolly et al. (1987), Rodriguez (1978), Khan and Lizondo (1987), Krugman(1979) and Edwards (1983).

This is, indeed, an important policy issue, since the cole of devaluationshas for some time now been at the centet of conttoveraies surrounding theso-called orthodox adjustment programs.LAn importantinnovationofouris that it relates the timing of adjustment to the size of theanalysis(corrective)devaluation, and thereby to the path of a number of key macro-economic variables during the disequilibrium process and the adjustmentperiod.In developing our model we make a special effort to capture the moreimportant stylized facts associated with balance of paymenta crises, devaluations and stabilization programs.For this reason, ye start in Section Ilwith a brief exposition of those facts,in Section illcccpresent themodel, while in Section IV ye illustrate how the model works.centrate on two possible causes of devsluation crises:exogenous shocks to the international terms of trade.Here ye con-fiscal shocks andThe central part ofthis section deals with the consequences of postponing adjustment anddevaluation,Finally, Section V contains the concluding remarka, includingsome thoughts regarding directions for future research.II.Macroeconomic Polity, Real Exchange Rates andand Devaluation Crises: The Stylized FactsIn this section we briefly analyze the circumstances preceding 20 majordevaluation crises in developing countries.Our main interest is to providea simple "list' of the most salient atylized faotathat, we believe, shouldbe captured by a unified model that deals with devaluation crises and macro-economic adjustment processes. We focus both on policy induced disturbances--shocksj/to domestic credit as well as fiscal polity- - and on externalSee, for example,Buire (1983).

shocks in the form of terms of trade changes. We then analyze the behaviorof the following endogenous variables:(1) real exchange rates; (2) thecurrent account; (3) the monetary system's foreign assets position;(4) the black market premium; and (5) real wages.1.The SampleTable 1 contains the list of the 20 devaluation episodes analyzed inthis paper.The choice of countries in the sample was basically determinedby data availability; only those major devaluation episodes for which dataon (most) of the variables of interest were available were incorporated intoAll these countries devalued their currencies by at leastthe analysis.after having maintained a fixed (official)tJ.S,dollar for two or more years.J.57exchange rate with respect to theThirteen of them implemented a stepwiaedevaluation, where after the nominal exchange rate adjustment they attemptedto once again fix the parity (Panel A of Table 1),succeed and experienced recurrent devaluations.Many of them did notSeven of the countriesadopted a crawling exchange rate after devaluing (Panel B).This table alsocontains data on the amount of each nominal devaluation measured as thepercentage change of the official exchange rate with respect to the U.S.dollar.It is interesting to note that all of these devaluations were fol-lowed by some kind of predetermined regime (either fixed or passive crawl)and not by a freely floating nominal rate, as most theoretical models ofexchange rate collapse have assumed (Krugman, 1979; Flood and Garber 1984;Obstfeld 1986).Inthe model we developed below we take this importantstylized fact into account and deal with exchange rate crisis where the official exchange rate is fixed at a new (higher) level after the devaluation.

-4-TableDevaluation Crises in Selected Developing Countries:Rate of Devaluation (percentage) 1/1.(Percentage of Devaluation)CountryA.Three YearsAfterStepwise DevaluationsColombiaColombiaCosta kistanSri LankaYugoslavia.Year ofOne YearDevaluationYear ofAfterTwo YearsCrisisDevaluation 9711979197219671965Devaluations 20.00.07.10.00.00.00.0by Crawling rnational Financial Statistics.j/ Devaluation of the official rate with respect to the U.S. dollar.the case of multiple rates the IFS reports the most common of them.In

The data in Tab1 refer to the official exchange rate.Many of thesecountries, however, had an active parallel market during the period surrounding the devaluations. In subsection 11.5 below we discuss the behaviorof the parallel market exchange rate.The existence of this parallel marketis another important stylized fact not captured by traditional models, butexplicitly incorporated in our unified model.2Fiscal and Credit Policies and Devaluation CrisesTable2summarizes the behavior of domestic credit and fiscal policiesfor the period immediately preceding the 20 devaluation crises.tion,data for a controlzrouof countries that maintained a fixed ratefor 10 or more years are also presented. L/found in this table:In addi-The following indicators can be(1) rate of growth of domestic credit (Panel A);(2) rate of growth of domestic credit to the public sector (Panel B)(3) percentage of credit received by the public sector as proportion oftotal domestic credit (Panel C)(Panel D);;(4) fiscal deficit as proportion of GD?and (5) growth of domestic credit to the public sector as aproportion of CNP.All these indicators have been constructed using datafrom various issues of the International Financial Statistics as well asseveral IFS tapes.For the devaluing countries these indicators arereported for 3 years, 2 years, and 1 year prior to the devaluation as wellas for the year of the devaluation. While PanelAdeals with monetary (ordomestic credit) policy, the rest of the panels take us beyond the monetaryLI Extreme care should be taken when using "control groups" to performmacroeconomic empirical studies.See Goldstein and Montiel (1986), andEdwards (l989b).See Appendix for the countries in the control group.

-6-Table 2.indicators of Macroeconomic Policy In Devaluing Countries DuringYear of Devaluation and 3 Years Preceding Devaluation:Comparison to Control Group of FixersThree Years Two Years1 YearPrior toPrior toPrior toDevaluation Devaluation DevaluationAnnual Rate nF (Drv,.rrh nFA.First QuartileMedianThird .235.419.322.1Annual Rate of Growth of Domestic Credit to Public Sector (Percentage)B,First QuartileMedianThird 4.811.231.069.222.733.258.95.70Ratio of Domestic Credit to Public Sector to Total Domestic Credit(Ratio x 100)C.First QuartileMedianThird scal Deficit asD.Perc of GDPFirst QuartileMedianThird Quartile0.003.305.890.130.84Mean3.5E.Year ofDevaluation46.07.825.549.1011,427.928.127. 314.024. 2.33.151.9Growth of Credit to Public Sector as Proportion of GNP (Percentage)First QuartileMedianThird Quartile0.7Mean2.4Source:See 0.030.76ID1.6

-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