It happened in one country after another during
the 1990s: a large, contractionary currency devaluation followed
by surprisingly mild rates of inflation.
But when Kellogg School Finance Professor
Sergio Rebelo and his co-researchers looked closely at the
aftermath of the devaluations, they observed a remarkably
similar set of economic reactions.
Whether in Finland, Sweden, Mexico, Korea,
Thailand, Malaysia, the Philippines, Indonesia or Brazil,
the same patterns in pricing emerged. In each country, the
prices that changed most were those of imports and exports
at the dock. The prices of these goods in retail stores were
more stable, Rebelo's team found.
"To sell a good in a retail store, you
need to use local labor, real estate and transportation services,"
explains Rebelo, the Tokai Bank Distinguished Professor of
International Finance. These distribution-associated costs
can be quite large, he adds — up to 50 percent for the
retail price of the typical consumer good. The presence of
these local costs tends to stabilize retail prices.
At the other end of the scale were the prices
for goods produced solely for local consumption. Rebelo and
his co-researchers noticed that the price of the so-called
"nontradable goods" — housing, education,
health and transportation — seemed least affected by
currency devaluations. These distinctions make it clear that
aggregate measures of inflation — such as the Consumer
Price Index — are insufficient to understand the effects
of large devaluations, Rebelo says.
"Retail prices behave very differently
from producer prices. Tradable good prices behave differently
from nontradable good prices. And the prices of brands that
are purely domestic behave differently than the prices of
non-local brands," Rebelo says.
"Once these distinctions are made, it
is not difficult to understand why inflation, as measured
by the Consumer Price Index, is often so low after large devaluations."
Rebelo's research associates include Ariel
Burstein, an assistant professor at the University of California
at Los Angeles; Craig Burnside, a professor at the University
of Virginia; and Martin Eichenbaum, an economics professor
at Northwestern University. Their latest findings will be
published in upcoming issues of the Journal of Economic Theory
and the Journal of Monetary Economics.
The team has worked together for the past
several years to gain a deeper understanding of currency crises
and how they unfold. Recent crises have occurred in Mexico
in 1994, Asia in 1997, Brazil in 1999, and Turkey and Argentina
Rebelo believes most currency crises stem
from the inability — or unwillingness — of governments
to collect enough taxes to finance their spending. "When
this happens, the government, sooner or later, has to resort
to printing money or using other financing strategies that
tend to destabilize the exchange rate," he says.
The Asian currency crisis, explains Rebelo,
was a prime example. In the mid-1990s, many banks in Korea,
Thailand, and Indonesia were close to bankruptcy.
"To avoid an exchange-rate depreciation,
governments in these countries needed to increase taxes or
reduce spending to finance the bailout of bank depositors,"
Rebelo says. "This move was politically very difficult,
and that made the crises unavoidable."
Rebelo notes that currency crises tend to
be dramatic events, often associated with severe financial
distress. "But they are also times in which there are
a lot of opportunities for companies that understand how these
crises unfold," he adds.
With a firm grasp on the behavior of prices
during devaluations, Rebelo and his co-researchers are now
turning their attention toward developing theories that explain
"The hope is that our studies will improve
our understanding of the economic effects of movements in
exchange rates," he says.
About Professor Sergio Rebelo
Prof. Rebelo has published widely
in macroeconomics and international finance. He has studied
the causes of business cycles, the impact of economic policy
on economic growth, and the effects of exchange-rate-based
stabilizations. He has received a Sloan Fellowship, an Olin
Fellowship from the National Bureau of Economic Research,
and grants from the National Science Foundation and the World
He is a fellow of the National Bureau of Economic
Research and of the Center for Economic Policy Research. He
has been a member of the editorial board of various journals,
including the American Economic Review and the Journal of
Prof. Rebelo has served as a consultant to
the World Bank, the International Monetary Fund, the Board
of Governors of the Federal Reserve System, and other organizations.