Do Exchange Rate Devaluations Matter? VAR Evidence from the Czech Republic

Abstract

What happens if a country devalues its currency? Standard macroeconomic theory would argue for expansionary effects, while recent theoretical contributions and the empirical evidence do not appear overly supportive. Devaluations have been mostly used by developing countries, but even industrialised countries may resort to depreciatory currency floors in the presence of the zero lower bound, as recently witnessed in the case of Switzerland or the Czech Republic. This paper tries to evaluate the impact of a currency devaluation on macroeconomic variables using data for the Czech Republic. The results based on vector auto-regressions with sign restrictions suggest that while there is a positive short-lived impact on consumer prices, the effect on output is more ambiguous and potentially mildly expansionary at longer horizons. This showcases the real, albeit qualified, possibility of using exchange rate management as an unconventional monetary policy tool, conditional on retaining an independent monetary policy.