Does Stability Preclude Contractionary Devaluation?

Abstract

In this paper we attempt to assess the relevance of correspondence principle in determining the possible effects of currency devaluation on balance of payments and employment. We developed a model in line with Buffie (1986) who derived a very strong result that if the model is locally stable and if labour and imported inputs are gross substitutes then devaluation will certainly improve labour employment and balance of payments at the same time. For the general production function the Buffie model predicts that devaluation cannot contract both employment and balance of payments at the same time since either of them is incompatible with the stability of the model. Buffie results by and large depend upon stability conditions of the model and what we have demonstrated that stability analysis of the model unfortunately is not free of error. In the corrected model we observe that the results derived by Buffie do not hold in general.