Local Manufacturing Hurt by Depreciations in a Theoretical Model Reflecting the Australian Experience

The model is motivated by data showing that the Australian production of local manufactures is hurt by depreciations and invigorated by appreciations. The paper briefly presents such evidence and then proceeds to a theoretical analysis. The model aims at capturing short-to-medium run exchange rate effects in an economy with goods and services aggregated into four commodities: Rural goods (agricultural, pastoral, forestry, fishing and mining products), imports, local manufactures and services. The latter three are directly consumed. Rural goods enter consumption only indirectly after processing by the manufacturing sector. Exports are exclusively rural goods. The model has a Keynesian flavour. Production of local manufactures and services is not constrained by the availability of resources and of labour. Variable inputs per unit of output are assumed to be constant. There are also fixed inputs. Variable inputs are imports in the case of the import sector, rural goods and imports in the case of the local manufacturing sector, and labour in the case of the services sector. The prices of imports, local manufactures and services are set by constant mark-up factors on variable costs. This assumption is based on a picture of imperfect competition with constant elasticity of demand at the firm level. The total production of rural goods is an exogenous parameter. The price of rural goods is determined in the export market. It falls with increasing exports. The economy is not assumed to be small in its export market. The domestic consumption demand schedule is modelled as predetermined in the sense that in the time span under consideration the relationship between quantities consumed and nominal prices is not affected by the exchange rate. The nominal wage rate is assumed to be pre-determined in the same sense. No specific functional form is imposed on the consumption demand schedule: the analysis is based on general assumptions, mainly non-inferiority and gross substitutability. In view of gross substitutability, there is a competitive relationship between imports and local manufactures. A depreciation raises the price of imports and ceteris paribus such an increase raises the consumption of manufactures. However the analysis shows that this enhancing influence of a depreciation on manufacturing is weaker than other causal channels which work in the opposite direction. An increase in the price of imports raises variable costs and thereby the price of local manufactures. This leads to a decrease in the output of local manufactures. In the course of the analysis, it is first shown that a uniquely determined equilibrium exists for every exchange rate above a lower bound. Then the effects of a change in the exchange rate are investigated. In most cases the results are unambiguous. In particular this is true for the output and the price of local manufactures. Other conclusions are that a depreciation increases exports and the amount of services provided. In some cases unequivocal results can be obtained only with the help of further assumptions. This concerns the domestic price of rural goods, the balance of trade in domestic prices and import penetration