Devaluation and the Role of Voluntary Unemployment

Abstract

. This paper analyzes the effects of devaluation on investment as well as the other macroeconomic variables of interest in the' small open developing economy producing traded and nontraded goods. In so doing, the paper makes use of a perfect foresight dynamic optimizing model, emphasizing the role of imported capital good and the labor market distortions that are prevalent in most developing countries. A particular attention is paid' to the nontradables sector where labor market is rigid by workers' reservation wage and thus voluntary unemployment is possible. The paper intends to see how much the results differ from those of the standard full employment model. Various simulation results reveal that the introduction of voluntary unemployment in' the nontradables sector significantly changes the consequences of devaluation. The situation following devaluation in typical developing countries is likely to be worse than that of the full employment model. While devaluation improves the balance of payments on impact in all cases considered, both sectoral and aggregate investment fall larger than in the full employment model. Moreover, real output of the economy as well as employment in the nontradables sector falls in all cases considered, and falls larger than in the full employment model. The results show that devaluation may turn out to be quite a harsh experience for developing economies, especially those with labor market rigidity.