The NGDP Effect of Devaluation or Why Exports Don't Matter

Lars Christensen effectively argues that during a currency devaluation, the primary transmission mechanism for monetary policy has little to do with restoring competitiveness, but instead works through the money supply on one hand and velocity on the other.  In equation form, MV=PY=NGDP.   The purpose therefore of the currency devaluation in a depressed economy is not to increase competitiveness in order to boost exports (although he concedes that it is one effect of the devaluation) but to increase nominal spending through the expansion of the money supply and increased velocity.   Lars provides the concise example of Argentina, who abandoned its dollar peg in 2002, resulting in a rapid increase in the money supply, velocity, therefore boosting NGDP and consequently real GDP.

While Argentina provides an informative example of the benefits of devaluation on an economy in stagnation, I thought it would be important to look at a country that used monetary policy to avoid crisis all together.   Poland, as shown by Marcus Nunes last February, provides a unique example of the use of monetary policy to stabilize the broad economy in a time of international economic malaise.  Under normal circumstances, Poland’s continued economic expansion would be of little note, but the world economies since 2007 have been anything but normal.  What makes Poland remarkable is that outside of a minor decrease in RGDP growth in late Q4 2008 (-0.4%), the economy has continued to expand at the same level as it did prior to Lehman’s demise.   A close examination of Poland reveals that competitiveness plays little importance in the transmission mechanism for monetary policy in maintaining Poland's impressive rise....

 

Below are two graphs, the first shows the exchange rate between Polish zloty versus the Euro from January 2006 up until two weeks before Lehman’s collapse (September 1, 2008).  The second shows Polish exports as a percentage of GDP.  

 

 

From January 2006 up until September 2008, the zloty appreciates against the Euro quite significantly as Poland continues to increase its exports.  Likewise, RDGP continues its upward climb.  But as the US and European economies fall into crisis, the Zloty changes course and depreciates against the euro and unexpectedly, exports fall significantly.

 

If devaluation worked primarily through the export channel of monetary policy, the decrease in exports would spell the end of Poland's RGDP growth.  But the Polish devaluation was not about increasing exports at all, the devaluation was a means to an end.  And the end result was maintaining NGDP on trend through the velocity and through the money supply. 

 

 

The monetary policy lesson is simple, as long as economy is without major structural problems, maintaining NGDP on trend allows an economy to make adjustments and maintain real growth regardless of fluctuating headwinds that are happening around them.   It is a lesson that Bernanke and the ECB are learning the hard way (hopefully).