Devaluations and Efficiency Disjunctions in a Small Open Economy

An exchange rate devaluation oriented to correct internal and external imbalances is considered in a tradeable/non-tradeable model where the domestic prices are rigid downwards and wages are set by unions. First, the policy is ineffective as long as there is an efficiency disjunction, i.e., the efficient sectoral outputs do not correspond to the economy’s optimal output level. Second, having successfully tackled the efficiency disjunction, the devaluation will not necessarily improve the trade balance because it may not be matched by an increase in the sectoral output. Furthermore, a devaluation will not necessarily contract the output in the non-tradeable sector. Spill-over effects among the two sectors as well as the patterns of private consumption and wage indexation are key factors to determine the effects of the devaluation.