Discrete Devaluation as a Signal to Price Setters

Abstract

The central hypothesis of this paper is that both the extent and speed of adjustment of the real exchange rate is affected by the way the central bank manages the nominal exchange rate. Specifically, a large discrete adjustment of the nominal exchange rate is more likely to result in fast adjustment of prices as opposed to a policy of smooth and continuous crawling peg. In the context of a monopolistic price adjustment framework, it is shown that a discrete and unexpected devaluation of the exchange rate shortens implicit price contracts and increases the rate of price adjustment in the nontraded goods sector, because firms tend to strengthen their expectations about an overall increase in costs and about an aggregate as opposed to a local shift in the demand curve for the firm's output. A discrete change in the exchange rate acts as an "information signal" that leads to fast overall adjustment of nontraded goods prices. The hypothesis is tested and not rejected at the macro, sectoral and firm level using macro and microdata on Greek prices prior to and after the January 1983 discrete devaluation.