The real income channel and contractionary devaluations in a heterogeneous agent model for Latin America

Abstract

Rationale In Latin America, it is not unusual to see exchange rate depreciations in excess of 20% in a single year. Although depreciation tends to stimulate a country’s net external demand, it does not always lead to increased output. It is worth understanding which channels may explain this outcome. Takeaways •In conventional macroeconomic theory, exchange rate depreciations have expansionary effects on economic activity. However, the empirical evidence shows that, in the case of emerging market economies, devaluing the exchange rate may cause output to contract. •One channel that explains this evidence, known as the real income channel, operates through the erosion of purchasing power as a result of rising prices for imported goods, which can lead to a fall in the real consumption of households with limited access to financial markets. •This article discusses a heterogeneous agent model calibrated for the main Latin American economies that allows the importance of this channel to be measured. The results show that this channel may have a sizable macroeconomic impact, particularly on economies more open to international trade.