The Exchange Rate, Diversification, and Distribution in a Modified Ricardian Model with a Continuum of Goods

Arslan Razmi
JEL codes: 
ADBI Working Paper Series

Several recent empirical and theoretical studies have revived interest in the relationship
between the level of the exchange rate and economic development. This paper develops a
dynamic model based on the Ricardian framework with a continuum of goods to consider the
issue from a somewhat different perspective. In the short run, a devaluation can boost profits
despite real wage rigidity. Moreover, the resulting diversification can offset the negative
consequences for the trade balance of higher employment and profitability at home. Over
the longer run, and in the presence of learning by accumulation, the initial boost to profits
and investment induced by a devaluation could enable a country to gain a permanent
foothold in new sectors at a higher real wage. While directly suppressing the real wage could
also lead to diversification, what makes nominal devaluation a particularly useful tool is that it
makes it possible to expand domestic profits while limiting internal distributional conflict and
the ensuing negative effects on development.