Overvaluation of the exchange rate: the Peruvian case, 1968-1975
Mendoza, Valdemaro J.
Master of Arts
Between 1968 and 1975 the exchange rate became increasingly overvalued in Peru. During the same period.the government began to participate increasingly in the economy implementing a massive investment program. Expansionary fiscal and monetary policies supported its activities and resulted in an increase in the level of domestic demand over the production possibilities of the country. The current account balance deteriorated progressively reaching in 1975 a deficit of a magnitude never before experienced by the economy. Both, the overvaluation of the exchange rate and the overspending policy contributed to the formation of the trade disequilibriums. In 1975 international reserves were depleted and the first of a series of devaluations which would continue during 1976 and 1977- took place. The analysis of the effects of the overvaluation and the devaluation of the exchange rate is undertaken in terms of a two goods model of tradables and non-tradables under the small country assumption. An overvalued exchange rate favors the absorption of tradables while resources are shifted towards the sectors of production of non-tradables. To improve the balance of trade, a devaluation will have to reduce the domestic absorption of tradables and increase their level of production, if full employment of resources or short run inmobility of factors exist, devaluation will have to rely in the reduction in the level of domestic absorption to improve the balance of trade. In the long run, devaluation will favor a composition of absorption compatible with domestic production. The main conclusions of the analysis of the effects of the overvaluation and the devaluation in Peru are: i) The overvaluation by itself could not explain either the significant Increase in the demand for imports, or the increase in the domestic demand for exportables; ii) The nature of the Peruvian imports and exportables permits the conclusion that the trade disequilibriums resulted principally from the increase in domestic demand; iii) The principal effect of the overvaluation was manifested in the allocation of resources; iv) The initial effects of the devaluations was not strong enough to significantly improve the trade balance. However, exports increased and imports were reduced in the short run due to the reduction in the level of domestic absorption; v) This reduction resulted also in a decrease in the absorption of non-traded goods which determined a decrease in the level of domestic output.